|Shares Out. (in M):||326||P/E||8.1x||9.7x|
|Market Cap (in $M):||9,670||P/FCF||nmf||nmf|
|Net Debt (in $M):||9,531||EBIT||1,944||2,190|
This is my VIC application dated January 28, 2009. I’ve inserted some updated commentary in italics. If you could design the perfect business for this environment it might be Southern California Edison.
· Monopoly franchise to deliver an essential product
· Earnings are decoupled from demand
· Pension liability is decoupled from actual results
· Main cost input (purchased power/natural gas) is passed straight through to its customers
· Earnings growth of 10%+ is a virtual lock
· Trading at a discount to the broader market
You can probably guess that it’s a utility since it has Edison in the name. Utilities tend to make people yawn. For sure, these businesses are boring, but what’s exciting is when you get to buy them at the right price at the right time. This one is a layup.
Edison International (EIX) has been trading below $32 for much of the last 3 months. By the end of 2012 I believe EIX will be worth no less than $34 ¼ and as much as ~$60, representing upside of 7% to 88%. Factoring in the current dividend ($1.24 annually per share or 3.9%) and assuming it does not grow, the IRR would be between 5.5% and 20%.
One of the most exciting aspects of this story is that even though you have a chance to more than double your money in 4 years, the margin of safety in the current share price is so high that the odds of losing any money over that time period are minimal. Heads you win, tails you don’t lose.
I believe EIX is mispriced because the company owns two businesses that appeal to investors with very different risk tolerances. In a climate of fear, concerns about the riskier business have caused investors to oversell the stock to a price where new buyers only have to pay a modest price for the rapidly growing, but defensive business, and they get the risky one for nearly free.
The stock has dropped to the point that the other business has actually had a negative implied value for the last couple of months. I will elaborate on this later.
In addition, senior management, while not new to the company, assumed their current positions last summer and they have been unwilling to promote the stock at this early stage in their tenure.
They just had their first road show in March.
EIX is a holding company that owns several operating subsidiaries. The two most important ones are Southern California Edison (SCE), a regulated electric utility whose 50,000 square mile service territory encompasses most of Los Angeles and the surrounding area, and Edison Mission Group (EMG), which includes a portfolio of generating plants selling electricity in competitive markets in the Midwest and on the East Coast. SCE was founded in 1895. EMG was formed in 1986.
As of 2008 Q3 SCE’s book value per EIX share was $19.90 and EMG’s book value per EIX share was $8.60. The midpoint of management’s core EPS guidance of $3.81 per EIX share for 2008 breaks down to $2.23 for SCE, $1.72 for EMG, and ($0.14) at the holding company level.
As of 2008 Q4 SCE’s book value per EIX share was $19.99 and EMG’s book value per EIX share was $8.24. Total book value was $29.21. There are some holdco eliminations and miscellaneous stuff.
Management introduced 2009 guidance after SCE’s recent general rate case (GRC) decision gave them earnings clarity on the regulated side for the next 3 years. The midpoint of 2009 (both GAAP and core) EPS guidance is $2.49 for SCE, $0.70 for EMG, and -$0.14 for the holdco, which works out to a total of $3.05.
UTILITY FINANCE 101
SCE makes money through a regulatory supported model called cost of service ratemaking. In this model all prudently incurred operating costs and capital investments are recoverable from ratepayers.
The process for forecasting a utility’s earnings in cost of service ratemaking works in reverse. You start by taking the amount of assets they own that are used and useful in serving their ratepayers (this is called the “rate base”), multiply by the percentage capitalization the regulator requires them to maintain as equity, and multiply that product by the ROE the regulator has authorized them to earn. The authorized ROE is determined through a cost of capital regulatory proceeding that involves market-based benchmarking versus peers. In other words, it’s anchored to reality – not necessarily driven by political ideology.
To give you an example of that calculation at work, in 2007 SCE’s average system rate base was $11.7 billion. They were required to maintain a minimum ratio of equity to total capitalization of 48%, and they were authorized to earn an 11.6% return on common equity. $11.7 billion x 48% x 11.6% = $651 million
Actual net income was higher at $707 million for an ROE of 12.1%, but it’s in the ballpark. Over time actual ROEs have tended to be somewhat higher than authorized ROEs, but the reasons why are not important at the moment.
In order to determine customer rates (cents per kilowatt-hour) for the coming year, utilities add their expected costs on top of authorized net income to get their revenue requirement, and divide by the amount of kWh they expect ratepayers to consume.
Inevitably actual revenue collected is different from authorized revenue (i.e. summer was hotter than expected so ratepayers ran their air conditioners more and consumed more kWh or vice versa). Differences are smoothed by balancing accounts that correct for over-collections and under-collections once per year, or more often if the amounts go outside budget by more than 5%. This can lean on the company’s liquidity, but generally it’s a non-issue.
This aspect to the model is extremely important. Southern California Edison’s earnings are decoupled from demand. If consumption goes up they don’t make more money. If consumption goes down they don’t make less money. California’s regulators have recognized that a model in which utilities make more money by selling more electricity leads to greater pollution and does not incentivize utilities to support conservation efforts.
In this model SCE’s earnings are not exposed to fluctuating energy prices. Energy costs are passed through 100% to ratepayers with no markup. Balancing accounts are also used to true up variances.
Decoupling is a key point of departure from the past, since electricity consumption, and utility earnings, have historically declined somewhat during recessions.
SCE operated under a slightly different decoupling model from 1983 through January 1, 1997, at which point it was suspended. It was reinstated in its current form on June 14, 2001 as the California energy crisis was being resolved.
Decoupling ultimately means that the way to grow EPS, assuming a fairly constant capital structure and authorized ROE, is to grow the rate base through capital investment. Going forward SCE’s rate base will be growing substantially.
WHY THE RATE BASE, AND THEREFORE EPS, WILL GROW
The rate base will grow because massive investment is needed across the 3 main categories of utility assets in order to improve the reliability of the electric grid, and to support expanded use of renewable energy sources.
Generation (power plants) probably accounts for ¼ of SCE’s rate base, distribution more than ½ (the “last mile” power lines), and transmission about 10% (long distance power lines), with the rest miscellaneous.
Twenty years ago SCE’s rate base was $10.6 billion. It has hardly grown since then in part because deregulation forced the company to sell off some of its generating plants in 1998, and because SCE, as well as the utility industry in general, have gone through a long cycle of muted capital investment levels because of strong public reaction to dramatic rate increases during the oil shocks of the Seventies. Adjusted for inflation, the amount of rate base per SCE customer is just half of what it was nearly 50 years ago.
We are now at the beginning of a huge capex cycle. Edison Electric Institute, the industry’s trade group, estimates that total industry capex will go from $41.1 billion in 2004 to $75.5 billion in 2009.
From 2008 to 2012 SCE intends to spend approximately $20 billion on capex.
That capex schedule should result in a rate base of $23.2 billion by 2012, or approximately double 2007’s level. Current shareholders are unlikely to be diluted, and should therefore retain all the earnings power of a larger rate base. Operating cash flow is running at ~$3 billion and there are other ways the company can raise money to temporarily make up any shortfalls without violating the 48% equity capitalization minimum, which is calculated through a special regulatory formula.
I should have noted that short-term debt, such as credit line draws and commercial paper, do not count against the regulatory formula.
After the recent GRC decision, SCE released updated capex guidance. Their “base case” is as follows:
Considering the economy fell off a cliff since the earlier capex projections were released in the fall of 2008, and considering the immense pressure the CPUC was under, this should be considered a very good outcome. This should result in a rate base of $21.1 billion by 2012 (+80% over 2007) and $23.1 billion in 2013.
Holding constant their required minimum level of equity capitalization and authorized ROE, core EPS would be as follows.
That earnings growth represents a CAGR of 15.2% from 2008 – a growth rate that is almost without peer among large cap listed companies. Management has suggested a long-term CAGR of 12% in order to manage expectations.
EPS, updated for the latest capex projections, would be as follows:
2012 estimated EPS represents a CAGR of 12.2% from 2008.
At least 30 states have adopted renewable portfolio standards (RPS), which are mandates that a certain percentage of their electricity must come from renewable sources like solar and wind by a certain date. California’s established goal is 20% by 2010, and they are talking about introducing a second goal of 33% by 2020. SCE is currently at 15.7%, well ahead of the other two big California electric utilities, Pacific Gas & Electric (PCG), and San Diego Gas & Electric (SRE). Governor Schwarzenegger also has initiated a program called One Million Solar Rooftops.
SCE is now at over 17%, the highest level in the nation.
As a result, SCE has begun to roll out solar installations on commercial rooftops ($850 million over 5 years possibly going into rate base) that will act like miniature power plants across the greater Los Angeles area. Here in the early stages of the renewables industry, the state wants utilities to take the lead building these kinds of facilities in order to support the development of the market for suppliers.
Despite recent spending above levels authorized by the California Public Utilities Commission (CPUC), SCE’s average fleet age for equipment like poles, transformers, and power lines continues to increase. Massive increases are needed just to hold the average fleet age constant.
The company is making the case to the CPUC that spending increases now will save money in the long run. This is because if you graph out the failure rate of electrical equipment over its lifetime the shape is like a bathtub. Failure rates are high early on, they fall dramatically as the equipment is broken in, stay low for many years, and they start to rise dramatically again towards the end. Replacing equipment while it’s working is less expensive than the cost of replacing equipment after it has failed while in service and caused damage to the rest of the grid.
Over ½ of the $20 billion in capex will be spent on distribution, including $1.6 billion on a futuristic project called Smart Connect.
Smart Connect involves replacing traditional meters read by humans with electronic meters that can communicate with SCE. The program is beginning rollout this month.
Real-time two-way connection between SCE and new smart meters in ratepayers’ homes will eventually allow the company to send price signals to customers to reduce consumption at peak demand times. For example, ratepayers will see a signal on a home display that prices are increasing when demand is heavy, and they will be alerted that they can save money by postponing activities like running the dishwasher until later in the day when demand is lower and prices are cheaper.
Regulators want this for 3 basic reasons.
1. It improves system reliability by smoothing out consumption patterns over the day.
2. Smoother consumption narrows the difference for wholesale electric prices between peak and off-peak hours, and reduces the risk of exposing ratepayers to increased purchased power costs. (SCE purchases 60% of its electricity from third parties. Remember that all energy costs are passed through to customers.)
3. It reduces the need to fire up peaker plants due to sudden spikes in demand. Peaker plants tend to consume large amounts of energy getting fired up to operating levels quickly in response, so the benefit of using them less frequently is reduced pollution.
The company wants SmartConnect because less money taken out of customers’ pockets for energy means they can take more out to pay for capital investments.
New investments in transmission are needed to improve grid reliability. According to Edison Electric Institute…
Useful lives are typically 40 to 70 years.
Investment in transmission is also needed to connect renewable generating resources to end-users because renewables tend to be located in remote areas. Solar tends to be clustered out in the desert because that’s where the sun shines most reliably. Wind farms need to be in particular corridors where the wind blows most reliably.
Transmission investment is also a direct green solution. According to ITC Holdings, line losses were 5% in 1970 and by 2001 they were 9%. Lower line losses would mean less electricity being produced to satisfy the same level of baseload demand, and therefore less pollution.
By the end of 2012 transmission is expected to be 20% of SCE’s rate base, up from 10% currently. This is important for a variety of reasons.
28% of SCE’s projected capex is earmarked for transmission, and 54% of those dollars will be spent on projects that have been awarded ROE incentive “adders” of at least 125 bps. This is one of the ways that SCE is able to earn an ROE that is higher than the CPUC-authorized number.
The company’s latest capex forecast for the 2009-2013 time period estimates that 32% of capex will be spent on transmission. The only real unattractive thing about transmission is that SCE’s FERC-regulated earnings are not yet decoupled from end user demand. But again, at this weak point in the economic cycle, they represent only about 10% of the total.
This section probably seems like a long winded way of simply saying that large investments are needed, but I think it’s important to understand that spending lots of money to grow the rate base is not just some management fantasy concocted to justify faster earnings growth. This is real.
The risk to this growth is ratepayer and local political revolt against the increased rates necessary to pay for the investments. The average bundled rate across SCE’s total customer base would have to increase from about 13.7/kWh in 2008 to 17.4 cents by 2012.
One factor that should restrain backlash in the medium-term is that SCE uses a state mandated tiered pricing system based on consumption levels, and ratepayers in the lowest two tiers, the ones who can least afford to pay higher rates, are exempt from rate hikes. Even if meaningful push back takes just two years to develop, by then rate base and EPS will have grown by 40% over projected 2008 levels.
Also, while President Obama’s stimulus package and general push towards renewable energy doesn’t necessarily mean incremental profit opportunities for SCE, it should provide political reinforcement for California’s plans to build out the electrical infrastructure.
There may be concerns that SCE might not be able to precisely manage such a massive ramp up in capex - $20 billion over 5 years vs. $9.2 billion in the last 5 years. It’s been 30 years since they executed a major capex cycle. Fine. The recession may play into SCE’s hands in the sense that dramatically lower prices for raw materials like steel will decrease the risk that they run over budget if the projects are mismanaged. Lower prices for natural gas will also help decrease pressure on rates since it’s 50% of the generation mix.
TWO WAYS TO THINK ABOUT VALUING EIX
If you buy EIX at current levels you are paying a fair price for a jewel of a monopoly business whose growing earnings are for the most part recession-proof, and getting a half-decent business for nearly free.
Actually, it’s free at this point.
PCG is far and away the best comp for SCE (same regulators, similar returns on capital, fairly similar weather in their service territories, similar size of the electric business in terms of customer count, revenue, kWh deliveries, etc.). The main point of difference is that PCG also does natural gas, which provides them with some diversification, but it’s only ¼ of their revenues. They also tend to issue bonds on a senior unsecured basis,
whereas SCE’s bonds are typically first mortgage, and preferred stock is a smaller portion of PCG’s capital structure (2% vs. 9%).
Since they are purely a regulated utility and do not own any unregulated subsidiaries operating in competitive markets, looking at their public market valuation is probably the best way to figure out how SCE would be priced as a stand-alone company.
EIX is currently trading at 1.12x book. PCG is currently trading at 1.5x book. That number (1.5x) also happens to be EIX’s median year-end multiple for the last ~50 years and the median large cap electric/integrated utility multiple for the last 15 years. (The group tends to trade between roughly 1x and 2x.)
EIX is now at 1.0x book and PCG is still at 1.5x.
Incidentally, PCG and SCE’s 5-year CDS quotes move nearly in tandem and are currently priced almost identically at about 370 bps.
PCG’s CDS are now about 30 bps less than SCE’s, but only because they have dropped faster. They are now quoted under 200 bps.
Applying 1.5x to SCE’s current book value of $19.90 per EIX share leads to a value of $29.85 per share. On that number the implied price you’re paying for EMG is $2.15, or just 25% of book.
1.5x on SCE’s updated book value of $19.99 works out to $29.98 per share.
There are 5 publicly traded independent power producers (IPPs) that EMG would be benchmarked to if it were a standalone company - Calpine, Dynegy, Mirant, NRG, and Reliant. The IPP group’s median price to book is currently 0.78x. On EMG’s current book value of $8.60 per EIX share that would imply EMG is worth $6.71 per share.
There are two concerns. First, the economics of competitive generation are highly volatile since electricity can’t be stored, and lower consumption due to the recession has greatly reduced prices. Competitive generation is to electricity what the refining business is to petroleum. Spark spreads are analogous to crack spreads. You take a commodity cost input and make a commodity cost output. Producers try to take a profit in the middle, but sometimes they are squeezed out of business at the bottom of the cycle. This concern is not specific to EMG.
The second one is. 80% of their generating assets are coal-fired, and may need $2 billion+ of environmental capex starting in 2012 in order to keep operating. Plus they’ve committed to buy $1 billion+ worth of wind turbines over the next couple of years. EMG’s common equity is $2.8 billion, and equity is ~1/3 of total cap.
However, each of the 5 IPPs has company-specific problems. None of those companies, nor EMG, has an investment grade credit rating, but only EMG has an investment grade parent - not a small detail at this stage of the credit cycle.
If EMG can’t support the turbine commitments on top of its current equity, the parent could inject more equity by floating a bond or borrowing on its credit line. Funding it with 30% equity, consistent with EMG’s past capital structure, would only require a $300 million infusion. The holding company has a $1.5 billion undrawn credit facility, not expiring until 2013, priced at 34 bps over LIBOR. If worse came to worse EMG could pay the termination fees to cancel the turbine deliveries.
At 510 bps, EMG’s 5-year CDS rates are lower than every one of the IPPs. (Note that Calpine does not have CDS.) The group’s median is 734 bps. So, it appears that the stock market and the CDS market have divergent view about EMG’s ability to survive.
Given that 22% of EIX’s shareholders are non-employee individual investors, I’m inclined to think that the view of the CDS market is currently more rational than the stock market’s. That group owns the stock because of SCE and the stable dividend.
Competitive generation is not the type of industry widows and orphans want exposure to when the environment is rough. In their haste to sell the stock they’ve simply overdone it. You can see that type of outcome in the recent trading activity of other income producing securities that appeal to retail investors, i.e. high-grade closed end muni bond funds trading at 30% discounts to NAV.
The IPP group’s historical median price to book is just over 1x. On that basis EMG would be worth at least the full $8.60 if it survives through the cycle. (The increased debt at the parent and increased equity at EMG would theoretically be a wash for book value on a consolidated basis.)
Over its limited history the group has not sustained a multiple of book materially over 1.0x because of the volatility of the industry’s economics and the capital intensity of building new capacity.
However, IPPs have for the most part only been around for the 10 years or so since deregulation in the 1990s. They botched the downside of the last cycle horribly and learned hard lessons that should help them survive the current cycle.
Let me make another point of no small importance. SCE is legally ring-fenced from creditors of EIX’s other subsidiaries, so if EMG failed it should not impair SCE’s ability to operate and generate value.
EMG also has only $74 million of debt maturities this year, and none after that until 2013.
No matter what you think EMG is worth, at the current price it is not ultimately going make the difference between making or losing money. Even if EMG goes to zero and you lose the $2.15, SCE’s growth over the next few years will be more than able to overcome that and deliver solid total returns for shareholders.
By the end of 2012, assuming a rate base of $23.2 billion, equity capitalization of 48% and the current share count of 325.8 million shares, which the company has maintained for the past 8 years, book value would be ~$34 ¼.
On a rate base of $21.1 billion book value would be $31.
Even a depressed multiple of 1.0x would give you a share price higher than the current quote. The company has only sustained a multiple below 1.0x twice in the last half-century, and the risks from those periods (huge non-cash earnings on gigantic nuclear projects with big cost overruns in the 70s, inability to recoup purchased power costs during the energy crisis in the 2000s) do not exist today.
Looked at another way, to get to a share price of just $34 ¼ on a P/B multiple of 1.5x, book value would have to be $22.83, or just $2.93 above where it stands today. SmartConnect alone might be enough to deliver that much growth, and it’s already under way. The FERC supported transmission investments should add another $5 per share of book value for a total of $30 ¾ , which would require just the current multiple of 1.1x to support a share price of $34 ¼.
If everything goes to plan and SCE book value gets to $34 ¼, and EMG survives, applying a multiple of 1.5x and adding EMG’s $8.60 (assuming it doesn’t grow) at 1x gets you to an EIX share price of $60. If the market still refuses to recognize the value here, management could spin off EMG after the credit crisis has passed.
Because SCE’s earnings are decoupled from demand (they’re almost bond-like in nature) and growing at a rapid pace, you can think of EIX as a something of a super-TIP. You get a high nominal coupon in the form of SCE’s current earnings yield, substantial inflation protection from its earnings growth, plus a few bonus coupon payments from EMG thrown in early on.
The midpoint of 2008 guidance for SCE’s core earnings is $2.23 per share. (2009 guidance has not been announced yet.) On the current share price that alone represents an earnings yield of 7.0%.
2009 midpoint for SCE is $2.49 for an earnings yield of 8.4%.
SCE still has a General Rate Case pending before the CPUC. A decision is scheduled for a vote on January 29. It’s possible, because of the recession, the decision may not authorize the level of capital investment SCE is requesting.
That did in fact play out, but the result still provides for excellent growth.
The company’s last GRC was in 2006 (it’s a 3 year cycle). Every GRC has built in cost escalators that will allow for increased revenues and earnings indefinitely. Even in a doomsday scenario, a decision that authorizes no new investments or rate increases above 2006 GRC run rates and already approved projects like SmartConnect, SCE would still be able to grow EPS by ~4% per year. That would turn the 7% nominal earnings yield into a real 7%+ earnings yield, far better than the current 10-year TIP rate of 2%.
A doomsday scenario is highly unlikely. Commission president Michael Peevey was just reappointed by the Governor to a second 5-year term. The commission presidency is highly influential, and he has a constructive stance towards the state’s utilities. He has recommended approving over 90% of what they’ve asked for in the current GRC. For what it’s worth he was the president of SCE in the early 1990s.
There may be concern that the state begins paying its electric bills with IOUs, which would delay cash collections but not GAAP earnings. 6% of SCE’s electricity sales, or $568 million, were to public authorities in 2007. Probably 15% of that was to the state. This may turn into a liquidity problem at some point, but PCG will have it too.
Crisis averted – at least for now.
One of the beautiful angles to this stock is that if you aren’t convinced it’s cheap enough on an absolute basis you can still profit on a relative basis by shorting PCG against a long EIX position to create an EMG stub. Whatever macroeconomic/regulatory/ratepayer challenges SCE has to deal with will also have a similar impact on PCG.
EMG has contracted some revenues, coal and rail transportation costs through 2011 and probably has at least $3 of EPS over the next 3 years locked in already. (Sanford Bernstein’s analyst is expecting $6.65 over that period.) Recall that the implied price you’re paying for EMG is just $2.15. To borrow an analogy from Alice Schroeder, it’s like sitting down at the slot machine and putting in $2.15, knowing you’ll get $3 back when you pull the lever, and possibly as much as $6.65.
Okay, EMG is now like getting a free token to play with the knowledge you’ll get a positive result of some unknown amount.
Even if EMG shuts down in 2012 and wastes most of the current $8.60 per share of current equity retiring the coal plants, you will still get more money back just from the earnings than what you put into it through the current stock price, and you’ll still have the wind farms.
How do I know you will actually get that money out of EMG as cash in hand? Because that ~$3 per share of locked in earnings will need to be upstreamed to cover EIX’s $400 million annual dividend payments for the next few years, so SCE can conserve cash to fund its capex and still maintain its 48% minimum equity requirement. Don’t worry about SCE having to reimburse EMG later on – the CPUC would almost certainly not allow such a transfer.
Given that SCE will not grow quite as fast as expected a few months ago, there is slightly more room for the opco to support the holdco dividend and still maintain its 48% equity ratio. Also, the holdco’s credit facility capacity is enough to fund a few years’ worth of dividends, and tide them over until SCE can start upstreaming cash again.
Just to be clear – there is virtually no danger the dividend will get cut. Bernstein had a piece out on February 18 where they argue that EIX is the 4th least likely of the 47 utilities in their screen to cut the dividend. EIX has plenty of sources of cash.
POSSIBLE ROE INCREASE
On May 29, 2008 the CPUC approved a cost of capital mechanism that will automatically result in adjustments to the utilities’ authorized ROEs if the yield on a certain utility bond index moves outside of a pre-determined range.
The bottom line is if the current 7.76% yield on the Moody’s Baa-rated utility bond index (MOODUBAA <Index> <Go>) holds or rises through September 2009, the following month SCE’s authorized ROE will be increased from 11.5% to at least ~12.4%, in effect boosting earnings by 7.4% over what they otherwise would be for 2010.
The index was at 7.91% as of April 30.
I don’t think the investment community is very aware of this, and SCE is not going to bring it to anyone’s attention.
They finally inserted it into an investor presentation, but I think only because PCG has started touting it.
Passage of time