Description

Great Plains Energy (GXP) is a fully regulated utility that, due to short term headwinds, is available at a mere 7x normalized earnings and 80% of book value. Though I guarantee this will not be the best performing idea on VIC, I believe GXP is very safe given the regulated nature of its business and cheap both on an absolute and relative basis, thereby providing decent returns with very little risk of permanent loss.

GXP is the combination of the old Great Plains and Aquila's regulated electric utility operations in Missouri (merger completed mid last year). After the recent divesture of Strategic Energy (an unregulated retail operation) GXP became a fully regulated utility serving 820,000 customers in Missouri (70%) and Kansas (30%). Half of GXP's customers are residential and the other half are commercial and industrial with no individual customer accounting materially for load sales. The company's regulated assets include transmission and distribution assets as well as 6,000 MW of generating capacity (76% coal, 17% nuclear, 7% other).

At the November 2008 EEI conference, GXP's management strenuously reaffirmed the company's 2009 earnings and dividend guidance of $1.30 - $1.60 and $1.66, respectively. A short three months later in February, in conjunction with the announcement of 4Q 2008 earnings, the company lowered its guidance to $1.10 - $1.40 and slashed the dividend by 50% causing the stock to plummet from $20 to $11 over the course of the next month. Much of the decline is likely attributable to selling by retail shareholders (50% of ownership) who owned the stock for the dividend (at the time it offered an 8% yield) and institutional holders upset with management's lack of credibility. A planned equity offering created additional overhang; the recent completion of which will satisfy the company's equity financing needs for at least the next three years.

Though it has been explained in past write-ups (see excellent EIX write up by snarfy on May 6, 2009) I'd like to provide some background on how GXP makes money. As a regulated utility the company is allowed to earn a return on the equity portion (determined by regulators, typically 50% debt and 50% equity for GXP) of their regulatory assets, also known as "rate base". A brief example: a regulated utility has rate base of $1bn, the regulators allow a 50%/50% capital structure and a 10% return on equity, so the theoretical earnings should be $1bn x 50% x 10% = $50mm. Though these are the theoretical earnings, a utility will often earn above or below this level if market conditions change from the time when rates were set (for historical test case jurisdictions). If the utility over-earns, the regulators will typically call them in for a rate case to lower rates; and if they under-earn the utility can file a rate case to have rates raised. Unfortunately, the rate case process is lengthy (9 - 12 months); as a result the utility can find itself in a position of under-earning for a period of time (this is known as "regulatory lag").

In GXP's case the reduction in guidance is a function of "regulatory lag", specifically a decline in load in excess of the company's expectations and higher than expected interest expense. The company just completed a round of rate cases that will raise rates and allow them to earn much closer to their theoretical earnings but not the full potential. Another round of rate cases next year should allow them to earn their regulatory returns. This second round of rate cases will also put into rates Iatan II, a large coal plant which is the final piece of a five year plan known as the Comprehensive Energy Plan (CEP) which has allowed GXP to significantly grow its rate base and earnings. The CEP was a plan developed by GXP and the MO regulators to install environmental retrofits on two of GXP's coal plants and to build a new coal plant (Iatan II) which should be completed next summer. As a result of the CEP and the general economic environment, GXP has had to go in for rate cases more frequently than it has in the past (they didn't have a rate case for 18 years).

Regulatory lag is unfortunate and will cause near term earnings to be strained. However, these lower near term results are temporary; in the next couple of years (end of 2010 and into 2011) the company should be able to earn its allowed return on a larger rate base which will yield earnings in excess of $2 per share. The summary model below outlines how the next few years should look. The equity units they recently issued are treated as debt until they are converted in 2012.

Financial Information

Note: GXP will benefit from some temporary cost saves related the Aquila merger as well as a sizable NOL over the next several years which I include in my model for purposes of funding the equity portion of CapEx spend but exclude from the normalized operating earnings above.

At 7x normalized earnings GXP is cheap on an absolute basis and relative to other fully regulated utilities which trade between 10x - 12x earnings. Even using the low end of the range, GXP is worth $21, 34% higher than the current price and pays a 5.3% yield while you wait.

Risks

Continued regulatory lag due to further load declines (this can be hedged by shorting other utilities subject to similar lag risks such as PNW, PGN & EDE).

Disallowance of a portion of Iatan II spend - GXP will spend more to build Iatan II than they originally estimated and it is possible that the regulators will try to disallow a portion of the spending above the initial estimate. However given that the cost increase was mainly due to inflation in materials and given the way the regulators ruled in the most recent round of rate cases with respect to overruns, I think it is unlikely that this will be a significant issue.

Catalyst

Reported earnings approaching theoretical earnings.

Successful and on-time completion of Iatan II.

Completion of next round of rate cases.