Spin-Off Should Stabilize This Energy Company's Earnings
We believe PPL is a good candidate at the right price for a core holding in an income portfolio.
PPL (PPL) recently announced plans to spin off its competitive energy business, PPL Energy Supply, and merge it with the generation assets of Riverstone Holdings. The publicly traded company, to be named Talen Energy, will comprise 15,320 megawatts of generation capacity and be the third-largest independent power producer behind NRG Energy (NRG) and Calpine (CPN).
We've increased our PPL fair value estimate to $37 per share from $36 to reflect the incremental value we estimate shareholders will receive for PPL's 65% stake in Talen when incorporating our bullish outlook for earnings from Riverstone's assets.
Our $5.4 billion value for Talen Energy implies a 5.5 times EBITDA multiple on our midcycle 2017 EBITDA estimate of $1.3 billion, discounted at a 12.0% cost of equity. This compares with management's $1.07 billion 2015 adjusted EBITDA estimate. We assume Talen Energy's management achieves 90% of the $155 million in targeted annual synergy benefits. Our midcycle natural gas price assumption is $5.40 per thousand cubic feet, which drives our midcycle power prices. We previously attributed $5 per share to PPL Energy Supply in our stand-alone PPL fair value estimate. For PPL's regulated holdings, our valuation implies a 15.5 times multiple on our 2014 earnings estimate.
We view the transaction as credit-negative, as PPL Energy Supply bondholders will no longer have the implied credit support from PPL. Total debt will include PPL Energy Supply's $2.7 billion outstanding and Riverstone's expected $1.25 billion after refinancing debt, which now sits at Riverstone's three funds that it is contributing to Talen.
The spin-off, which is expected to close by the second quarter of 2015, will focus PPL's management team on its regulated operations. With widely diversified service territories, we believe PPL is a good candidate at the right price for a core holding in an income investor's portfolio.
In Diversity There Is Strength
PPL's supply segment has a diverse fleet of coal, nuclear, gas, and oil generation. Two thirds of PPL's generation comes from baseload operations, which benefit from the spread between fuel costs, typically coal, enriched uranium, and natural gas. Gross margins typically average between $15 and $30 per megawatt-hour. Management has run this segment more conservatively than most of its peers, with virtually all of its expected output hedged two years out.
The international delivery segment operates 4 of the 15 electricity distribution networks providing electric service in the United Kingdom. This has made PPL the largest distribution utility in the U.K. as measured by regulated asset value. Under the current five-year regulatory regime, which ends in 2015, revenue will grow at 3.5% plus an annual inflation adjustment. The inflation adjustment differentiates the U.K. from most U.S. regulation and offers some protection from its primary nemesis. Additionally, Central Networks is able to earn performance rewards.
Returns at PPL's Pennsylvania distribution and transmission segment have improved with rate increases that state regulators granted to recover higher operating costs and investments. We expect PPL's distribution and transmission segments to file for higher rates every two years, given the firm's $4.7 billion transmission and distribution investment plans through 2018. In the Kentucky utilities segment, which includes generation, transmission, and distribution assets, we expect PPL will file for new rates every two years in that state to recover planned $5.6 billion of capital expenditures through 2018.
Hard-to-Replicate Assets Offer Advantage
We think PPL's regulated utilities and low-cost merchant power generation combine to give the company a narrow Morningstar Economic Moat Rating. PPL's utilities own a difficult-to-replicate network of regulated power generation, transmission, and distribution assets and provide an essential energy source: electricity. In exchange for its monopoly position, regulators set PPL's returns at levels that aim to keep customer costs low while providing adequate returns for capital providers. This implicit contract between regulators and the utility should, in the long run, allow PPL to earn its cost of capital and leads us to assign PPL's regulated utilities a narrow economic moat.
A merchant generation fleet of fossil fuel and nuclear power plants makes PPL one of the lowest-cost power providers in the Eastern United States. Although we consider fossil fuel generation to be a no-moat business because of its sensitivity to commodity prices, we consider nuclear generation to have a wide economic moat as it is the lowest-cost, most reliable power source in the region. Existing nuclear plants face virtually no substitution threat because no other power generation source can match the cost or scale of an existing nuclear plant. Additionally, high capital costs are a significant barrier to entry for new nuclear plant developers.
Risks Include Regulation and Legislation
In the supply segment, PPL hedges power prices and fuel costs to mitigate earnings volatility. At its regulated utilities, PPL faces regulatory and legislative risks that create uncertainties around costs and allowed returns, especially given the significant capital expenditure plan from 2014 to 2018. As with all regulated utilities, PPL faces the risk of an inflationary environment that would raise borrowing costs and make other investments more attractive for income-seeking investors.
Andrew Bischof does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.