Looking for Answers in Utilities' Earnings

Utilities’ first-quarter earnings rarely offer much excitement. This year will be different; we expect lively coronavirus commentary from utilities. In this article, we discuss the key COVID-19 issues that could have short- and long-term implications for investors.

We also include two lists of utilities to watch this earnings season: One group we consider value and one group we consider high quality. Atypical volatility among utilities stocks during the past month has created a wide spread between the overloved and the underloved. The value stocks could get an outsize lift if management commentary pushes the market toward our more positive outlook. We expect the most consistency from the quality stocks; if the market were to turn down, as it did in mid-March, investors should be ready to pounce.

COVID-19 Concern: Energy Demand Since stay-at-home orders spread across the United States in late March, we've been incorporating a 2% drop in electricity demand in 2020 into our forecasts. We believe a slight increase in residential demand will only partially offset what could be the largest-ever single-year drop in commercial and industrial demand. Initial data supports our outlook.

• Electricity demand nationwide is down 4.9% since April 1 compared with the same period last year, according to data from the U.S. Energy Information Administration. If this holds through April, it would be the largest drop in demand in April since the EIA began reporting monthly data in 1973. It would be on par with monthly declines at the height of the previous recessions.
• Not surprisingly, the biggest declines are in places with high shares of commercial load (New York) and industrial load (Southeast, Midwest). As we expected, the load is flat or up in areas with large shares of residential demand such as Florida and California.
• On April 7, the EIA cut its 2020 electricity demand growth forecast by 210 basis points primarily because of revisions in its second- and third-quarter forecasts related to effects from COVID-19 precautionary measures. A slight upward revision to residential demand didn't offset the large downward revisions to commercial and industrial. The EIA now expects a 3.1% drop in electricity demand this year, down from a 1% decline in its previous 2020 outlook published in March. But we think that's going too far. We still expect a 2% annual drop based on Morningstar's forecast that COVID-19 disruptions will ease this summer.
• The Edison Electric Institute reported a 6.1% drop in electricity demand during April 5-11 compared with the same week in 2019. The 64.2 terawatt-hours of electricity used that week was the lowest weekly total since May 2003, according to the trade group.

Our near-term electricity demand forecast relies in part on Morningstar's outlook for a 2.9% drop in U.S. GDP in 2020, based on a monthly analysis of the COVID-19 outbreak severity and industry-specific effects.

We make several adjustments that result in a smaller drop in electricity demand than the drop in GDP. First, Morningstar's monthly economic outlook suggests diminishing COVID-19 effects during the peak-demand summer months, which will mitigate the full-year impact on demand. Second, the current March-May height of economic shutdowns is the lowest point of annual electricity demand due to moderate weather. Third, we incorporate our view that electricity use is becoming less sensitive to GDP changes as the share of industrial demand shrinks relative to residential demand.

We think the highly disruptive March and April could lead management teams to lower the full-year earnings guidance ranges they announced before the COVID-19 outbreak. Some management teams might be hesitant to make immediate changes before the critical summer months, but we are already assuming most utilities’ 2020 earnings will be at the low end or below guidance ranges set before the COVID-19 downturn began. Summer remains the critical season for electric utilities.

Usage trends among customer classes will be critical, too. Commercial and industrial customer rates tend to have lower margins and more fixed charges than residential rates, minimizing the immediate earnings impact. Demand trends--robust residential usage and sinking industrial demand--could have the biggest impact on 2020 earnings for Edison International EIX, NextEra Energy NEE, American Electric Power AEP, and Entergy ETR relative to their peers.

COVID-19 Concern: Liquidity and Dividends Our biggest concern going into mid-March was a possible lockup in credit markets. This is critical, given the constant access to capital markets that utilities require to fund daily operations and capital investment. Utilities were quick to the markets starting in early March, with many companies locking up their financing for the entire year in just a few weeks.

However, the rush to the debt markets came at a high price. Credit spreads that had hovered around 100 basis points for most utilities during the past few years doubled or tripled in some cases, primarily because of the drop in U.S. Treasury yields. Coupon rates remain historically attractive and will remain an earnings tailwind for most utilities. We expect updates from management teams regarding 2020 financing plans after the recent activity.

Given plenty of liquidity and flexible capital investment plans, we don’t see any immediate dividend cut risks among our coverage. Payout ratios climbed with our recent 2020 earnings revisions but remain at reasonable levels. Utilities with payout ratios above 75% might have to forgo 2021 dividend increases if COVID-19 effects worsen. Directors at most utilities won’t revisit dividend increases until late this year, when companies will have a better view on the financial impact.

Even in the center of the storm, we believe Consolidated Edison's ED dividend is still secure. Con Ed serves New York City, the epicenter in the U.S.’ fight against COVID-19. On March 25, we reduced our 2020 earnings per share estimate to $4.00 from $4.43. In the near term, Con Ed is likely to experience higher operating costs and a significant reduction in usage from commercial and industrial customers following Mayor Bill de Blasio’s order to close all nonessential businesses. In 2019, C&I customers represented about half of Con Ed’s retail electric sales.

Although we reduced our 2020 earnings estimate and our five-year EPS growth rate by 50 basis points, to 2.7%, just below the bottom of Con Ed’s 3%-5% target, we believe the dividend is secure. Con Ed has a strong balance sheet and New York has a favorable regulatory framework. Although Con Ed increased its dividend 3.4% on Jan. 16, the 46th consecutive annual increase, we expect increases to be only 1%-3% over the next five years due to the impact of COVID-19.

We think CenterPoint Energy’s CNP recent dividend cut is a unique situation and not indicative of dividend stress sectorwide. On April 1, CenterPoint cut its dividend to an annual rate of $0.60 per share from $1.16 following the announcement by 53.7%-owned Enable Midstream Partners that it would reduce its common unit distribution by 50%. We had assumed about a 10% cut in Enable’s distribution due to the dramatic decline in commodity prices, but not to the level to which it was cut. The reduction will lower cash flow to CenterPoint by approximately $155 million on an annual basis.

However, other factors contributed to the dividend cut. On March 5, we lowered our 2020 EPS estimate to $1.40 from $1.59 due primarily to the Houston Electric rate case and equity returns having a more negative impact than we estimated. Our EPS estimate was also pressured by approximately $300 million more equity, expected to be issued this year, than we had assumed and a lower earnings contribution from Enable due to weak commodity prices. Although CenterPoint announced a dividend increase of $0.01 per share on an annualized basis on Feb. 3, we believed further increases would be suspended until 2024.

CenterPoint’s CEO abruptly resigned on Feb. 19, and it was announced on April 2 that the CFO had taken a position at another utility. We suspect there were disagreements between CenterPoint’s board and management that may have been partially driven by the 2019 Vectren merger being more dilutive than expected. Thus, we believe several factors contributed to the dividend cut.

COVID-19 Concern: Capital Investment We expect most utilities to shift 5%-10% of their 2020 growth investments into 2021-22 due to tight capital and labor markets as a result of the economic effects of COVID-19. After our reductions, we expect utilities we cover to invest $126 billion in 2020, up $8 billion from 2019. Overall, for most of the utilities under our coverage, the shift of capital expenditure didn't have a material effect on our fair value estimates. We don't believe COVID-19 will affect utilities' policy-based investments in safety, clean energy, and grid modernization that support our long-term growth outlooks.

However, utilities with a large share of C&I customers, usage-based rates, and less adaptive rate-making have the most near-term risk both from earnings effects and the ability to implement capital plans. We highlight Con Ed, Entergy, Evergy EVRG, and Hawaiian Electric Industries HE, whose capital plans we have already reduced and we believe are most at risk for further reductions.

We think renewable energy investment will remain a priority. We continue to believe renewable energy will grow to at least 22% of U.S. electricity generation in the next decade based on existing state policies and corporate demand, up from 10% in 2018.

The trend toward renewable energy continues. New legislation in Virginia, signed into law April 12, further advances the state’s renewable energy mandate. The Virginia Clean Economy Act mandates all utilities be 100% carbon-free by 2050, looks to retire all coal plants by 2024, and supports 5.2 gigawatts of offshore wind development. Arizona regulators recently indicated support for 100% clean energy by 2050, joining 15 other states in mandating either 100% clean energy or renewable generation.

The EIA recently revised estimates for wind and solar additions 5% and 10% lower, respectively, but still expects renewable generation to grow 11% year over year. We expect solar and wind projects will top natural gas projects during the next three years.

Offsetting the slowdown from COVID-19 supply-chain disruptions is the urgency for developers to capture the highest tax benefits. The 30% U.S. solar investment tax credit expired at the end of 2019 and begins a five-year step-down for projects that didn’t get started by the end of last year. Projects that start this year and are finished by the end of 2023 will receive a 26% investment tax credit. That falls to 22% for projects started in 2021 and 10% for projects started in 2022 and beyond. The indefinite 10% tax credit will continue to give solar projects a slight financial advantage against wind power projects, which received a brief boost in late 2019 with a one-year tax-credit extension for projects started in 2020.

The renewable energy industry had hoped to get tax break extensions in the $2 trillion Coronavirus Aid, Relief, and Economic Security Act. We think tax break extensions remain on the table for future COVID-19 stimulus plans.

COVID-19 Concern: Operating Costs On March 19, the Edison Electric Institute announced that all members have suspended electricity disconnections. Most of the utilities covered by Morningstar are members of EEI. In addition, roughly half of the regulatory commissions, legislators or governors have ordered moratoriums on disconnections.

A few states have mechanisms already in place to address an increase in bad debt/uncollectible expenses, including Virginia, Pennsylvania, and Ohio. Although it is uncertain if these frameworks will address 100% of the shortfall, companies that should benefit include Dominion D, PPL PPL, FirstEnergy FE, Exelon EXC, American Electric Power, Duke DUK, and AES AES. Regulators in Connecticut, Kentucky, California, and Wyoming have acknowledged the increased costs due to COVID-19 and instructed utilities in their jurisdiction to maintain records for potential inclusion in future rates.

On March 26, the Public Utility Commission of Texas issued an order allowing transmission and distribution utilities to add a surcharge to bills for uncollectible revenue. The funds will also be used to reimburse retail electric providers. The order allows utilities to establish a regulatory asset for costs related to COVID-19. What expenses will be allowed and collected in future rates will be determined by PUCT. The PUCT action was a positive for CenterPoint, AEP, Sempra Energy SRE, Xcel XEL, and Entergy.

Maintaining minimum staffing levels could be challenging and increase overtime costs. We expect most, but not necessarily all, expenses related to COVID-19 to eventually be recovered in rates. Some utilities have instituted plans for key workers to live on site at power plants and distribution/transmission control centers. If implemented, these contingency plans would significantly increase costs, but likely be recovered in future rate cases.

If COVID-19 costs become significant, regulators might allow cost recovery deferrals or securitization, similar to large weather-related expenses. Many utilities in hurricane regions have storm costs already built into rates. Entergy, NextEra, Duke, Emera EMA, Southern SO, and others have operations in hurricane-prone regions, where regulators are familiar with addressing these infrequent expenses. Some regulatory frameworks have automatic mechanisms to establish a regulatory asset for future collection in rates if costs exceed those already built into rates.

Although most of the costs associated with Superstorm Sandy were recovered by Con Edison in future rate cases, the utility had to wait several years and was subjected to considerable criticism over outages associated with the storm. With New York now experiencing some of the worst effects of COVID-19 in the country, we suspect Con Ed’s COVID-19-related costs are significant. We are not aware of any specific criticism to date, but when the next rate case is filed, we are confident that New York politicians will use it as an opportunity to blame Con Ed.

Costs specific to COVID-19 might also take longer following a merger or where a utility just had a recent rate case. One example is the merger forming Evergy in June 2018. Great Plains Energy and Westar Energy agreed to four- and five-year “stay out” provisions in Kansas and Missouri, respectively, to gain regulatory approval. Whether these two states will allow earlier recovery of the costs associated with COVID-19 is a concern.

COVID-19 Concern: Market Volatility Utilities investors are not used to the level of volatility that hit the sector starting in late February:

• The Morningstar U.S. Utilities Index fell 36% between its peak on Feb. 18 and its bottom on March 23, exceeding the S&P 500's 34% peak-to-trough drop. Utilities also have outpaced the S&P 500 since the March bottom, climbing 30% compared with the S&P 500's 25% climb.
• During the third week of March, the Morningstar U.S. Utilities Index recorded six of its eight largest-ever single-day moves: three moves up by more than 8% and three moves down by more than 8%. On all but one of those days, utilities moved more than the S&P 500.
• Utilities have had bigger one-day moves than the S&P 500 on 26 of the 52 trading days since the beginning of February. Since the beginning of March, utilities have moved more than the S&P 500 on 21 of the 33 trading days.

This atypical sector volatility makes it more challenging for utilities to issue equity. We expected many utilities would need new equity this year to fund their capital investment plans. If market volatility continues, management teams might postpone their equity offerings and instead push back capital investment plans, as we discussed earlier.

Among those that we expect will need the most new equity in 2020-21 are Edison International, CenterPoint, Con Ed, Duke, NextEra, Xcel, and Eversource Energy ES. Edison faces the most imminent need for equity, in part to fund its $3.8 billion wildfire mitigation plan during the next three years, without straying too far from its regulatory allowed capital structure. In total, Edison plans $5 billion of annual capital investment and we project it will need to exhaust its remaining $1.3 billion at-the-market program balance. This dilution, along with $2.4 billion of equity issued in 2019 in part to fund California’s wildfire insurance plan, results in a dip in earnings this year before a rebound to our 6% annual average growth rate.

CenterPoint also will need to raise substantial equity in 2020. Its primary concern is maintaining a strong credit profile with the deterioration in Enable’s cash flow and its own capital investment needs. The dividend cut saves cash, but the drop in the stock price makes new equity more expensive.

Xcel was advantageous about locking in its equity needs for the next four to five years late last year. Although Xcel will issue the shares throughout 2020, it locked in $750 million at just over $62 per share, not far from where the stock trades today and at a 30% premium to our fair value estimate. Eversource has flexibility, depending on the pace of its offshore wind program, which we expect will be pushed out due to COVID-19 slowdowns. Similarly, we expect NextEra will be able to flex its new equity needs depending on the pace of its renewable energy development.

Highlighted Companies: Value We think these unloved utilities have less COVID-19 downside than the market thinks. These could be fast rebounders if management can calm the market's coronavirus concerns.

AES AES (5 stars) Earnings Release: May 7 Our 7% annual average EPS growth outlook is at the low end of management's guidance range through 2022 due to COVID-19 effects, but we think earnings growth will accelerate because of our bullish view of United States renewable energy. AES has narrowed its geographic and business focus by selling businesses in markets where it did not have a competitive advantage or opportunity for expansion. Today, the company has a stronger balance sheet and a rapidly growing renewable energy business supported by a well-positioned battery storage joint venture with Siemens.

Edison International EIX (4 stars) Earnings Release: April 30 We consider Edison a value, growth, and income triple play. California's political risk will always be a concern for Edison. However, California's progressive energy policies also create more growth opportunities than most other U.S. jurisdictions. Edison's electric-only business, recent regulatory success, and $5 billion annual investment plan give us confidence that it can increase earnings 6% beyond 2020. Edison has stakeholder support to harden the grid against natural disasters such as wildfires, integrate renewable energy, and support electric vehicle adoption.

Duke Energy DUK (4 stars) Earnings Release: May 7 We think Duke Energy's valuation discount to peers does not reflect its favorable regulation and investment opportunities that support consistent earnings and dividend growth. Florida remains one of the most constructive regulatory jurisdictions, with sector-leading allowed returns on equity, automatic base rate adjustments, and strong growth investment potential. North Carolina and South Carolina have tougher regulatory environments but substantial infrastructure growth potential.

First Solar FSLR (4 stars) Earnings Release: TBD Management says its Ohio, Malaysian, and Vietnamese factories are running, helping meet what would be a record amount of shipments this year. As of February, First Solar had already sold out nearly two years of production capacity, likely securing enough cash flow to easily make it through any brief downturn. We continue to believe renewable energy--and especially solar--will be an investment priority for utilities that need to meet state environmental policy.

Vistra Energy VST (3 stars) Earnings Release: May 5 Among the independent power producers, Vistra is the most attractive, trading at a 13% discount to fair value and 30% cash flow yield. We expect Vistra to return substantial cash to shareholders through dividends and stock buybacks during the next three years. A drop in demand will put pressure on the retail business, which is approaching one third of earnings. Smaller struggling retailers could offer mergers and acquisitions bait. July and August still will be make-or-break months for 2020.

Highlighted Companies: Quality We think these utilities are best positioned to weather COVID-19. Another market swoon, like the one in mid-March, could offer a chance to get quality at a reasonable price.

Dominion Energy D (4 stars) Earnings Release: May 5 Dominion has been investing in wide-moat projects and utilities with favorable regulation. However, we believe it will be difficult for Dominion to execute its full investment plan due to COVID-19 supply chain disruptions and staffing issues. We recently reduced our 2020-22 capital expenditures estimate by 4%, to $23 billion, and $1 billion less than guidance. Even with lower revenue, higher expenses, and lower investment due to COVID-19, we still estimate 5.5% average annual EPS growth for 2019-24, in line with management's post-2020 target. We believe Dominion's dividend is secure due in part to cash flow from Cove Point and Dominion's focus on environmental, social, and governance risk. However, we expect only 2.5% average annual dividend growth due to its elevated payout ratio.

Southern SO (3 stars) Earnings Release: April 30 We consider Southern one of the highest-quality names in the industry due to its exemplary management, strong balance sheet, secure dividend, and constructive regulation. However, given the impact of COVID-19, we recently cut our five-year EPS growth rate by 50 basis points due to the lower rate base growth from the reduction in investment, lower sales, and higher costs. We believe in the current environment with supply-chain disruptions and staffing issues, Southern's five-year $40 billion capital plan will be difficult to fully execute. On April 15, Southern announced it would reduce its workforce at the Vogtle nuclear plant project by approximately 20% to address the impact of COVID-19.

NextEra Energy NEE (2 stars) Earnings Release: April 22 NextEra has the luxury of operating with highly constructive regulation in Florida, which we view as the premier regulatory environment for utilities. Florida offers peer-leading allowed returns on equity and automatic base rate adjustments for capital investments, boosting cash flow. We expect regulation will remain constructive even if the economy weakens. NextEra also has significant growth opportunities in the state. NextEra's competitive energy business, NextEra Energy Resources, is the largest U.S. renewable energy developer and best positioned to benefit from Morningstar's forecast for 8% annual U.S. renewable energy growth during the next decade. We also think NEER is well positioned to lead the next phase of renewable energy growth, including solar and battery storage.

WEC Energy Group WEC (2 stars) Earnings Release: May 4 WEC Energy is the largest Midwest utility, with nearly $22 billion in rate base and nearly all earnings derived from regulated operations. Constructive federal and Wisconsin state regulation supports roughly 80% of WEC's earnings. Illinois regulation has improved, producing investment opportunities and less regulatory lag for its Chicago gas infrastructure investment. Renewable energy will be a focus for WEC, including 300 megawatts of approved solar generation in Wisconsin. The company's $15 billion of investment supports our forecast for management to achieve the high end of its 5%-7% earnings growth target.

Andrew Bischof, CFA, CPA, and Charles Fishman, CFA, contributed.