Description

Thesis

Great Plains Energy, Inc. (GXP) is a regulated electric utility serving metropolitan Kansas City. The company may be purchased for 11x trailing earnings, less than 8x 2012 earnings and its dividend yield is 9.5%. GXP’s has $1.1 billion of unused credit capacity, ample liquidity to meet its funding requirements, and its debt is rated investment grade. The company’s earnings are likely to grow 35% during the next four years (regardless of economic conditions) as a result of a much needed capital expansion plan which it developed in conjunction with its regulators and various environmental groups including the Sierra Club. The combination of modest valuation, growing earnings (despite economic conditions), inelastic demand for electricity and generous dividend yield makes GXP an attractive investment which we are glad we own.

 Valuation

The essence of the GXP investment thesis is modest valuation (11x earnings) combined with growing earnings despite economic conditions.  GXP earnings will grow as a result of their capital spending program because GXP earns a return on its rate base. The return is determined by the Public Utility Commissions (PUC) in Missouri and Kansas.  Rate base is determined by the PUCs and represents the PUC’s determination of GXP’s assets needed to meet demand for its customers. The table that follows outlines GXP economics and assumes three equity issuances of $200 million each, one during each of the next three years.  I’ve assumed the equity issuace at the current share price $17.49.

GXP’s rate base needs to grow because there is not enough generating capacity in GXP’s region to meet demand.  GXP operates in the Southwest Power Pool (SPP) as defined by the North American Electric Reliability Corporation (NERC), an organization that coordinates electricity generating and transmission assets in North America.  According to NERC, the SPP is currently operating below the 12 ½% target capacity margin and if no new generating assets are added, summer capacity margin will fall to 5% by 2012.  What this means is that there is a high probability of blackouts in the SPP if generating capacity is not added in the next few years.

The NERC assessment was published last month however, and undoubtedly relies on data that predate the current financial mess.  How can we be sure that the SPP assessment is still relevant given the financial calamity we are now facing?  It turns out that electricity demand is very inelastic. If we look at a 26-year sample for the entire U.S., electricity demand increased each year during the period 1980 – 2006 with the exceptions of 1982, 2001 and 2006, i.e., demand increased year-on-year 88% of the time. In 2006, electricity sales were flat year-on-year, while in 2001 they were down 0.7% and in 1982 they were down 2.8%.  The inference we make from this data is that electricity demand is very inelastic. Looking at GXP’s region (metropolitan Kansas City) there are few large industrial users of electricity.  GXP’s largest customer is the city of Kansas City, most of their other sales come from homes and commercial customers.

GXP developed their capital plan, named the Comprehensive Energy Plan, in conjunction with their regulators and several environmental groups including the Sierra Club, and all agreed that the capital program was prudent and necessary.  It also helps to know that electricity prices in Missouri and Kansas are less than 8 cents per KWH while the national average is above 10 cents per KWH: this leaves regulators room to increase rates if necessary to fund GXP’s capital program.  

One more point regarding GXP’s capital program, GXP will be able to leverage a number of assets it acquired with an adjacent utility, Aquila, which are likely to reduce GXP’s need to issue equity to finance their capital program.  These assets include net operating loss carry-forwards, reduction in interest rate costs as Acquila’s legacy debt resets and rolls off as well as cost savings achieved by combining the two companies. As a result, GXP’s capital program will expand the company’s rate base by $2.8 billion in the next four years but is likely to require GXP to issue only $600 million of equity.

Dividend

One of the benefits of owning GXP is its generous dividend policy. GXP management’s stated objective is to payout 70% of the company’s earnings in quarterly dividends and, as recently as their conference call on November 6, GXP management stated that they are committed to maintaining the $1.66 dividend and eventually increasing it.

There are some who voice concern that GXP management will not be able to maintain the dividend in 2009 because $1.66 approximates the company’s likely 2009 earnings and may even exceed their earnings for the year.  We think the dividend is safe because while the risk of GXP earning less than $1.66 during 2009 is real, it is temporary and would be due to completion of capital projects and inclusion of those projects into rate base by the regulators (called “regulatory lag”).  All those involved with GXP including banks, rating agencies and regulators understand this process and know that while the exact timing (by quarter) of GXP’s earnings is difficult to predict, GXP is highly likely to exit 2009 at an earnings run-rate more than $1.66 per share.  But is there another reason to be confident that this will happen, given the recent financial turmoil?  Yes. Consider that GXP’s commercial paper program ran flawlessly during September and October of this year, something that General Electric, a AAA credit, was not able to achieve without the help of the Federal Reserve. This is possible because GXP is a regulated monopoly business producing a service (electricity) that has inelastic demand and its management team has demonstrated that they are prudent stewards of the business.

Catalyst