Hawaiian Electric Industries HE
May 09, 2010 - 11:43pm EST by
2010 2011
Price: 22.12 EPS $0.91 $14.70
Shares Out. (in M): 93 P/E 24.3x 12.0x
Market Cap (in $M): 2,049 P/FCF 15.4x 0.0x
Net Debt (in $M): 904 EBIT 188 0
TEV ($): 2,953 TEV/EBIT 15.7x 0.0x

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I am short Hawaiian Electric Industries (HE). The stock is over $22 but I believe it's worth high teens at the most. The company is a pairing of a bank and a regulated electric utility. They are both inferior to their peers yet the company is trading at a multiple (1.5x tangible book) on par with median comps because of its relatively high dividend yield at 5.5%.

The operating units do not have the earnings power to support the dividend, and I believe there is a growing possibility they will have to cut it or execute yet another dilutive share offering to avoid a credit rating downgrade.  


Let's meet our protagonists
Hawaiian Electric Company (HECO) is the amalgamation of 3 utilities covering 5 islands; Hawaii, Oahu, and Maui/Molokai/Lanai. (Kaui is serviced by a cooperative.)   Book value per share of HE is $14.10 and LTM EPS is approximately $0.85.

American Savings Bank (ASB) is the 3rd largest bank by deposits on the islands, with $4 billion at year-end and $5 billion of assets. It's levered 10:1. Book value per share of HE is $5.32 and LTM EPS is approximately $0.24.

The holding company owes $300 million face value through senior unsecured bonds and has book value of -$3.86.

Consolidated book value is $15.56 and LTM EPS is $0.91. Note that the current dividend is $1.24 per share annualized. Over the last 5 years they have earned $5.90 per share cumulatively and paid out $6.20 so they are clearly not earning the dividend. Over the last 15 years they have sold 45 cents worth of stock for every dollar worth of dividends they've paid.


"Of each particular thing ask: what is it in itself? What is its nature?"
HECO is an inferior utility for a number of reasons. The remoteness of their territory in the middle of the ocean means their plants must be fueled mainly by petroleum products, which are more expensive per unit of energy than coal (50% of generation nationwide) and natural gas (20%). This goes a long way towards explaining why their average monthly residential bills are the highest in the country at app. $200 per month in 2008 relative to a national average of about $90.

Bills dropped to $150 last year due to the lagged effect of declining oil prices. This speaks to volatility that cuts both ways.

In addition, because their service territory consists of islands that are not connected, they have duplicative headcount and asset levels across the utilities because of the lack of efficiencies that come with the scale effects of a congruous territory.

HE's rate base of $2.1 billion works out to nearly $5,000 for each of their 442,000 customers, compared with West Coast peers like Southern California Edison (SCE) at $2,900 and PG&E at $3,800 (includes gas as well as electric).

Their customers per employee ratio stands at 193 versus 282 at SCE and 485 at PG&E. (Gas typically has a higher/better ratio than electric because they don't own the upstream E&P part of the value chain, while electric typically owns at least some upstream assets in the form of power plants.)

Members may recall from mikeperry22's original writeup of HE in December 2008, or from other past utility writeups, that utility regulators set both the authorized ROE a utility is allowed to earn, as well as the amount of revenues they believe the utility will need in order to achieve that ROE. Authorized revenues are often determined through a subjective line of reasoning depending on regulatory agendas.

Given the high rates on the islands, it's difficult for the regulators as political appointees to authorize ever greater revenues in order to put money into Hawaiian Electric's pockets at the expense of ratepayers. In addition, the utility suffers from chronic regulatory lag in recovery of all of its costs. Further, my perception is that the utility is run as if it is an asset owned by the citizens, and therefore not necessarily subject to market discipline in their competition for investment capital - I believe around half the shareholder base still consists of Hawaiian residents.

In combination, those factors have led HECO's 3 utilities to consistently earn less than their authorized ROEs for a long period of time. Over the last 20 years, on average, they have earned between 1.9% and 3.4% less. Only 5 times out of 60 opportunities (20 years x 3 utilities) during that period have any of the 3 utilities actually earned at or above their authorized level.

HECO's history of poor results stretches beyond just the last 20 years and has led to multiple rounds of diworsification away from the utility business. For example, in 1983 the company restructured to adopt a holding company format and since that time has entered and exited the following businesses...

• HEI Investment Corp
• Hawaiian Electric Renewable Systems
• Dillingham Tug and Barge Corp
• Young Brothers, Limited
• Malama Pacific Corp
• Lalamilo Ventures
• Hawaiian Insurance & Guaranty Company

American Savings Bank is the latest in that series of extracurricular activities. It was acquired in 1988. By nearly every metric it is inferior to local comps like Bank of Hawaii and to West Coast mainland peers, and by all appearances the culture at HECO is in full effect at ASB. To their credit, however, they did not take TARP money.

You might ask what synergies exist between a savings bank and a utility. The answer is none. ASB's purpose is basically to be there to fund the holding company's dividend when the utility can't.


Bull case...?
Investor relations is touting utility revenue decoupling as a "game-changer" and arguing that the bank's loan portfolio, which is dominated by 1-4 family residential mortgages, is solid. Bulls suggest the utilities may soon be able to earn their authorized ROEs, which range from 10.5% to 11.5% at the 3 utilities, in contrast with their consolidated earned ROE of 6.4% last year.

The payout ratio may be unsustainable on current earnings, but with the economy improving the bank's NPAs will diminish, and with the cost cutting they've done at the bank the normalized earnings power has been enhanced. In addition, the utility is about to be allowed to adopt revenue decoupling so its earnings power will be improved too. In anticipation of that future scenario the stock can be valued on a premium multiple now. The dividend will be maintained. The storm has passed. It's safe to take a margin loan at 1% and buy this stock to earn 5.5%.

{Quick explanation of decoupling}
Historically, after utilities are authorized a certain level of revenue, they make an estimate about how many kWh they'll sell and use that estimate to determine unit rates. If unit sales volumes are higher than estimated they get a bump to earnings because pricing stays in place on those incremental volumes. If volumes are lower their earnings get nicked. In other words, shareholders bear the risk of underages or overages relative to the forecast. Many utilities, including HECO until now, still operate under this model.

Under decoupling ratepayers bear the risks of underages or overages. If kWh sales volumes are less than forecast in a given year, the utility gets to turn around the next year and raise rates more than originally planned in order to true up the shortfall.


...or Hackensack Bulls?
I suppose any minor league team can hang with the Yankees for an inning of two, but most of the time things are going to revert to the mean before the teams get through all the outs.
Hawaiian Electric has dodged a number of bullets over the last two years that would have forced them to cut the dividend, but were spared by fortuitous non-recurring items.   For example, oil prices fell at an opportune time for the utility, having a positive impact on working capital and freeing up cash. The bank was able to sell MBS securities after a rebound in the fixed income markets to free up capital that could be upstreamed. Regulatory forbearance went into effect, and so on. One question is whether or not these challenges will continue to cooperate by popping up in a sequential manner instead of simultaneously.

Another question is whether or not these minor leaguers have evolved into big league talent. Even if they have, they still play in a ballpark with train tracks running through the outfield.

The Hawaiian economy historically lags the mainland, and is dependent on federal/defense spending and tourism, mainly from the West Coast and Asia. California unemployment is 13% and the state and the region face long-term structural problems. If you believe Jim Chanos, China is also headed for a reckoning. The saving grace for Hawaiian tourism may have to be a continual widening of the gap between the haves and the have-nots from those regions, but that doesn't seem like a good foundation for a bullish thesis..

Meanwhile, the bank is under-reserved by $45 million, or $48 cents per share pre-tax. Recall that common equity is $5.32 per share, or $492 million. I want to specifically point your attention to the fact that at year-end the residential land portion of their loan book amounted to $96.5 million. I am told these are basically undeveloped plots with just roads going out to them. The following is how the ratio of non-performing and restructured loans to total loans in that segment evolved over the last 4 years.

--2006     0.3%
--2007     0.1%
--2008     7.7%
--2009   42.3%

That looks like a problem. For perspective's sake their best pre-provision, pre-tax income level in the last 10 years was $103 million in 2002. In addition, the OTS requires permission before ASB sends dividends up to the holding company.

On the utility side, I don't think decoupling is necessarily the game changer it's made out to be. What decoupling does for sure is dampen the volatility of the utility's revenues. Lower volatility theoretically means a lower cost of capital and higher valuation multiples.

There are some other goodies that come along with it in this case such as O&M (operations and maintenance costs) escalators, but it's not enough to be considered a game changer because what decoupling does not do is solve the much bigger problem which is getting authorization for materially higher revenues.

It also doesn't solve the chronic regulatory lag in authorizing recovery of the utility's costs. Given the islands' high rates it's going to be difficult for the regulators as political appointees to be seen as taking even more money out of ratepayers' pockets to pad the utility's profits. It's worth noting that S&P specifically declined to alter their ratings stance (HECO: BBB neg watch, HE: BBB neg watch) following the announcement that the Hawaii Public Utilities Commission had authorized adoption of decoupling.

At issue here is cash flow. The utility has a track record of underestimating their capital expenditures. Consider that in 2004 (the most recent 5 year forecast for which we have a full 5 years of recorded data to compare) they forecasted their capex over the 5 years ending 2009 as $813 million. Actual capex was $307 million, or 38% over budget.  I think there is evidence that the company's PP&E may be under-depreciated and is therefore a factor contributing to those negative variances.  

HECO is now engaged in a massive capital program partly related to the Hawaii Clean Energy Initiative, the state's plan to wean itself off oil and replace fossil fuels with renewable sources of energy. The latest 5-year forecast is for $1.4 billion of capex. Budgeting risks are increasing, not decreasing.

Cutting O&M is not much of a solution.  Cash got so tight in the fourth quarter last year they had to defer O&M costs, but surprisingly, they explicitly acknowledged those delays were unsustainable. They're not sustainable because if you don't spend the O&M dollars the regulators authorized you to collect through your rate case decision, you risk having your revenue requirement cut in the next rate case because regulators will normally conclude that you overestimated your costs.  If you didn't underestimate O&M and just didn't want to spend the money, the notion of paying dividends at the expense of reliability won't fly.


What am I playing for?
I am in it for a dividend cut or a dilutive share offering. The lack of earnings support for the dividend is serious enough that the company now intends to use its credit facility at the holdco as a bridge until earnings power improves.

As the capital program moves forward it's going to put increasing pressure on the credit ratings. HECO and HE are only two notches above junk on negative watch. Just as it was in December 2008, the company may again be confronted with a choice between taking credit supportive steps at the expense of equity holders or facing higher borrowing costs. Regulators generally don't tolerate passing higher borrowing costs through to the ratepayers so stockholders can keep their dividend.

There is the risk to my short position that the Hawaiian economy will rebound, the utility will successfully navigate the regulatory docket and the bank will earn its way to safe ground, but I think it's apparent that that scenario is the one on which the market is already valuing the stock.

If I'm wrong about the dividend or the secondary you probably don't lose money on the stock price but you may lose 5.5% annualized on the dividend. For your PA you can avoid paying out much of that cash and get cheap exposure to an unexpected dividend cut by buying September 17 ½ or December 20 puts.

Even if things trundle along at ASB and HECO there is no justification for the current multiple, other than valuing it based on the dividend yield and ignoring the point that half the cash you're receiving is effectively just a return of capital rather than a distribution of profits. You could buy PCG and CASH for a slight premium to HE and create a far superior utility + bank combination.


"Sometimes when you bring the thunder, you get lost in the storm"
They report earnings tomorrow morning so unfortunately there's no opportunity to act on this idea if you like it. I realize that's bad form but I wanted to get this out and I finally had the time this weekend to write it up. Besides, the way this position is going they'll probably announce they found $100 million worth of gold buried under one of bank's REO properties and the stock will go to 25.  I kind of feel like Kenny Powers with this short - it keeps getting worse and nobody cares.  







Dividend cut


Secondary offering

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