Last week, ALJ Galvin of the CPUC, issued a proposed decision (PD) in the ongoing Cost of Capital case. The PD recommendation of 10.4% is in-line with expectations in my opinion. It is a 90 bp step down from the current ROE but it was expected due to the changes in the interest rate environment since 2007, the timing of the last Cost of Capital case. The final decision is expected in mid-late December. This decision along with the resolution of the Edison Mission Energy overhang (1) should decrease the valuation discount for EIX, in my opinion. I continue to rate the stock a buy and re-iterate my $51 price target.
What does this mean for the other California utilities: This decision should help to lift the valuation overhang for PCG and SRE as well.
(1) EIX subsidiary EME elected not to make interest payments dated November 15 for numerous unsecured bonds, which sets up for a bankruptcy filing for EME. I believe this is a net positive for the equity story since EME will not be EBITDA positive till 2014 and results in a valuation discount for EIX.
Disclaimer: I am long EIX stock but do not intend to trade it over the next 24 hours.
Earlier this week, Dynegy Holdings LLC said it has reached an agreement in principle with most creditors; the only group excluded is the subordinated notes. Under the preliminary pact, HoldCo unsecured bonds will get 99% of the equity and current shareholders will get 1%, with warrants to buy additional shares for a total ownership stake of 13.5%. The owners of the Roseton and Danskammer secured lease obligation bonds will receive a $540 million claim plus half the proceeds from the sale of the plants for a maximum total recovery of $571 million.
However, not all note holders have signed on to the plan and subordinated bondholders support the appointment of a chapter 11 trustee to oversee the bankruptcy. I believe it is likely the Judge will order the appointment of an Independent chapter 11 trustee because current management was discredited in the examiner’s report. Please email me if you are interested in discussing further.
In a somewhat expected move, the independent examiner for the NY bankruptcy court, Susheel Kripalani, opined that the sale of the coal plants (CoalCo) for $1.25 bln was equivalent to the transfer of hundreds of millions of dollars away from creditors at DHI to shareholders at Dynegy Inc. My first read of the filing indicates its positive for unsecured bonds, negative for the equity and neutral for the Roseton & Danskammer leaseholders. Please email me if you are interested in discussing the ramifications.
In a somewhat expected move, Edison International has handed over control of the Homer City power plant to the owner lessor’s and taken an impairment charge of $1.032 bln. The Homer City senior secured bonds (8.137% of 2019 and 8.734% of 2026) are up 5-7 points on the news and more than 10 points since the start of the year.
I believe this is a positive event for EIX equity holders and Homer City senior secured bond holders, however it is bad for the rest of the EME capital structure. Please email me for details.
My price targets and recommendations remain unchanged.
I recommend that all investors read the disclosures provided in the Homer City, EME and EIX 8k’s.
I like the equity and the Homer City pass-through notes. My price target for the equity is $51 based on the value of the regulated utility, Tax NOL’s for EME and corporate drag. I believe the unregulated generation subsidiary, EME, will have positive value, even if it is in the form of tax NOL’s ( I am including $3/ share of tax NOL’s in my price target).
I estimate the debt/ kW for the Homer City pass-through notes is $760/ kW after factoring in environmental expenditure, whereas the replacement value is approximately $1,500/ kW, and therefore it makes sense to buy the PTC’s.
- My sum-of-the-parts analysis indicates a significant discount for EME despite the fact that debt at the EME level does not have recourse to the parent, EIX. (Please see my sum of the parts analysis attached below).
- On a related note, EIX management could use the upcoming maturities of credit facilities to re-negotiate terms that could help keep the EME option value alive. The credit facilities mature in June 2012 and the unsecured notes in June 2013.
- The regulated utility SCE has above-average ratebase growth of 6-8% due to transmission expenditure to meet new RPS mandates. I believe it deserves to trade at a premium to its large-cap regulated peers.
- PJM Capacity auctions for 2015/2016 should provide a lift in my opinion, as I expect clearing prices to exceed $200/ MW-day, a significant premium over 2013/14 and 2014/15 capacity prices.
- The possible restructuring of EME could unlock valuable tax NOL’s. I estimate the tax basis is approximately $2.5 billion. Therefore, I estimate the value of EME is at least $3/ share.
- Major ratecase regarding cost of capital coming up in 2012 and also negotiations with EME unsecured creditors are likely to cast a shadow over valuation and investor interest. Therefore, I believe this stock is more suitable to those investors that can stomach some volatility.
- Most sell-side analysts are already positive and its not clear what is required to revive investor interest in the story. There are 17 analysts covering this stock and as of February 5, 2012, the average rating is accumulate.
- The discount to other large-cap utilities could continue till such a time there is a change in management.
- PJM Capacity auctions for 2015/2016 should provide a lift in my opinion, as I expect clearing prices to exceed $200/ MW-day, a significant premium over 2013/14 and 2014/15 capacity prices. As a reminder results are expected in May 2012.
- Better than expected earnings at SCE, possibly after the resolution of the cost of capital case.
- Resolution of EME debt overhang by 2013.
What to buy in the EME structure? The only securities that I like are the Homer City pass through certificates maturing in 2019 and 2026 because they are covered in a liquidation scenario; I estimate debt after environmental capex of $760/ Kw versus market value of $1,500/ kW. The Homer City Funding 8.137 of 2019 last traded at approximately $90/ 10%.
I do not like the EME 7.5% unsecured notes of 06/15/2013, which is probably the most popular trade in the capital structure. Please email me if you are interested in discussing any of these trade ideas further.
Disclaimer: I am long EIX stock but do not intend to trade it over the next 48 hours.
Based on recent price movements (1), low hedging levels for 2013 and analyst forecasts, it is likely natural gas prices will be lower for the next few years than they were in 2011. In comparison, I estimate oil price forecasts are flat to positive and coal price forecasts are negative.
If forward prices and analyst forecasts for 2012 hold true, I believe it will be another bad year for the independent power producers, another good year for liquids MLP’s and another bad year for the coal miners. On a side-note, I believe the the delay in the implementation of CASPR is temporary and the EPA will succeed in implementing CASPR after some modifications.
In my opinion, it makes sense to remain long regulated utilities and short some coal names.
(1) Jan 2013 contract NG prices have declined approximately 30% over the past year. Producers have only hedged 13% of their total production for 2013 and are unlikely to do so with 2013 calendar strip prices below $4. This lack of hedging should translate into lower capital expenditure.
Disclaimer: I am long some regulated utilities.