FirstEnergy Returns to Its Regulated Past
There is opportunity for investors when the market revalues the company as a fully regulated narrow-moat utility.
U.S. utilities have lost their appetite for merchant generation. Weak electricity demand, renewable energy growth, and falling natural gas prices have squeezed margins.
Several large utilities have reduced or eliminated their commodity-sensitive businesses, and FirstEnergy (FE) soon will join them. By 2019, we expect FirstEnergy’s earnings will come entirely from less-volatile fully regulated businesses, many with wide and narrow economic moats. As a result, we recently upgraded our moat rating to narrow from none.
However, returning to its regulated past is likely to require a big move: allowing FirstEnergy Solutions to fall into bankruptcy. We estimate this could cost shareholders $1.7 billion for FES' unfunded liabilities and other cross-guarantees plus a potential $1 billion settlement with creditors to avoid years-long litigation. S
till, we think the stock is cheap today, trading at a nearly 25% discount to our $40 fair value estimate and a 30% discount to fully regulated utilities. We think the market is too concerned about the pending bankruptcy; even in a scenario where FirstEnergy assumes FES’ entire $3 billion of debt, our fair value estimate is reduced by only about $2, to $38 per share.
Once FES worries subside and the market revalues FirstEnergy as the fully regulated and narrow-moat utility that it is set to become, investors should realize attractive upside.
The Disappearing Diversified Utility
In the past several years, most U.S. diversified utilities have reduced their exposure to merchant generation or exited the commodity-sensitive business altogether. Ameren (AEE), American Electric Power (AEP), Duke Energy (DUK), Entergy (ETR), and PPL (PPL) have taken this approach, as the outlook for higher power prices diminished because of declining growth rates for electricity demand, strong renewable energy growth, and shale-affected natural gas prices. This strategy benefited more-conservative shareholders with the prospect of lower earnings volatility and solid dividend growth.
FirstEnergy has followed this strategy, significantly downsizing its merchant generation portfolio over the past five years. Its unregulated fleet, managed by FirstEnergy Solutions, will total about 12 gigawatts of capacity after the sale of six additional power plants to LS Power and the transfer of the Pleasants Power Station to Monongahela Power, a regulated affiliate in West Virginia. Both transactions are expected to close in early 2018. This compares to approximately 23 GW following its merger with Allegheny Energy in 2011. (We use FES in referring to FirstEnergy’s entire unregulated fleet, which also includes plants legally owned by Allegheny Energy Supply and FirstEnergy Nuclear Operating Co.)
FES’ earnings steadily declined as power prices fell and margins compressed at its nuclear and coal-fired plants. FES was caught short power in early 2014 when an unplanned nuclear plant outage required the company to replace the lost electricity generation with spot market power during the polar vortex, the worst possible time. The company changed strategy, reducing sales to more closely match its self-generation such that it would not get caught short power again, but operating earnings continued to decline compared with prior non-polar-vortex years.
Chuck Jones became CEO in January 2015 and immediately started lobbying regulators in Ohio for help with FES’ unprofitable coal and nuclear plants. This effort eventually failed, although FirstEnergy’s three Ohio utilities received a rate increase to support their regulated distribution systems. In November 2016, FirstEnergy announced that it would exit the merchant generation business in 12-18 months and return to its roots as a fully regulated electric utility. Jones indicated that FirstEnergy would attempt to find a buyer for FES’ power plants, but if none was found, FES would probably file for bankruptcy. We estimate the value of the FES assets are materially less than the approximately $3 billion of debt remaining on its balance sheet as of Sept. 30, 2017. Management has publicly agreed with our assessment.
Finding a Buyer for FES’ Assets: Too Little, Too Late
We think it is unlikely that Ohio or Pennsylvania will provide subsidies for FES’ nuclear or coal-fired power plants. Even if they do, long legal battles are likely and the outcome uncertain. Although we think there is a decent chance that the Federal Energy Regulatory Commission will require PJM to provide some form of compensation for coal and nuclear plants, it is unclear whether a long-term solution--at least one that potential acquirers of FES’ plants can input into their valuation with a high degree of certainty--can be in place in the time frame that FirstEnergy has laid out for separation or bankruptcy of FES.
We have valued FES’ remaining generation portfolio assuming some form of PJM compensation for fuel-secure power plants. Obviously, there is a high degree of uncertainty due to the early stages of rule-making at PJM that would eventually have to be approved by the FERC and that could face legal challenges. However, our analysis, assuming FERC and PJM support, still indicates a significant spread between our valuation, roughly $2 billion, and the approximately $3 billion of debt at FES. Thus, we think FES bankruptcy is likely.
It has been over a year since FirstEnergy announced its planned separation from FES and the potential for bankruptcy, and no major new claims or guarantees have become public. Thus, we have a high level of confidence that FirstEnergy can separate itself from FES at a cost of roughly $2.7 billion. The separation cost input into our fair value estimate of $40 per share includes $1.7 billion of parental guarantees and our assumption of a $1 billion settlement payment. FirstEnergy is valued in our discounted cash flow analysis like the majority of regulated narrow-moat utilities, using a cost of equity of 7.5% and a longer forecast period of returns on invested capital above weighted average costs of capital. Using these inputs, our discounted cash flow analysis results in a fair value estimate of $40 per share.
Our fair value estimate is not overly sensitive to the cost to achieve separation. If FirstEnergy assumes 100% of FES’ debt--a worst-case scenario--and the cost to separate equals $4.7 billion ($1.7 billion of guarantees and $3 billion FES debt), our fair value estimate is reduced to $38 per share. However, this is higher than the current share price of approximately $30, as well as the roughly $33 valuation of FirstEnergy shares if we used a no-moat rating and a 9% cost of equity--the return we estimate investors demand of a diversified equity portfolio. Thus, we think the market values FirstEnergy without taking into consideration the change in its economic moat following the separation. We think this is a mistake, as the separation is highly likely and 90% of the remaining businesses have wide or narrow moats.
Current Discussions, History Support Our Settlement Estimates
Since September 2016, FES has held ongoing discussions with a creditors group representing a large group of the Bruce Mansfield plant sale leaseback noteholders and secured and unsecured pollution control notes. FirstEnergy officials have reported that they have attended only one meeting with the creditors group and are not actively involved in these discussions as of early November. We expect FirstEnergy to become actively involved in the near future and note that the company is continuing to provide access to an unregulated $500 million money pool that had net borrowings of $67 million at Sept. 30, 2017. FirstEnergy expects the unregulated money pool to have a neutral to slightly invested position at the end of March 2018. However, on April 2, 2018, a mandatory put on a $98.9 million pollution control bond is likely to be tendered by holders and, based on comments from management, we expect this would probably trigger a bankruptcy filing if a prepackaged agreement is not reached before this date.
Although the details of a prepackaged bankruptcy agreement are subject to negotiation and difficult to predict, we reiterate our expectation that FirstEnergy would make a settlement payment to FES creditors to avoid years-long litigation. Our expectations of a settlement payment are based on the following:
In March 2003, Xcel Energy announced that it had reached an agreement with the creditors of its troubled affiliate merchant generator, NRG Energy. In consideration of the agreement, Xcel surrendered 100% of its equity ownership in NRG and paid approximately $750 million to creditors. There are many similarities between this situation and the one that confronts FirstEnergy today. Like FES, NRG’s earnings collapsed with declining power prices and the burden of a huge amount of debt--$10 billion in the case of NRG. There were also some key differences.
Xcel Energy’s market capitalization was about $5 billion, or half of NRG’s debt. FirstEnergy’s market capitalization is $15 billion, or 3 times FES’ debt. In addition, NRG’s lenders were requiring an additional $1 billion of collateral, which NRG had no hope of paying. Xcel had to cut its dividend as it was relying on cash from NRG. FirstEnergy’s dividend only relies on cash from its regulated utilities, and we believe it is secure. Xcel would later have to suspend and then cut its dividend with the write-off and settlement payments to creditors, as its retained earnings would be negative. Paying a dividend with negative retained earnings would have violated federal utility regulation at that time.
A key similarity, in our opinion, is that both FirstEnergy and Xcel have solid opportunities in their healthy regulated businesses and were trading at material valuation discounts to regulated peers due to the overhang of the potential bankruptcy of their unregulated affiliates. Xcel saw the wisdom of paying creditors $750 million to avoid litigation. We believe FirstEnergy will reach a similar conclusion.
The settlement payment is subject to negotiation and difficult to predict, but our guess is roughly $1 billion. The good news is that the guarantees and FES’ debt relative to the size of FirstEnergy is much smaller than XEL’s commitments relative to its size at the time of the NRG bankruptcy. Thus, our FirstEnergy fair value estimate is not tremendously sensitive to the amount of the settlement payment.
FirstEnergy’s Moat Sources
We believe a regulated utility can establish a narrow economic moat if the majority of its operations are in jurisdictions with constructive regulatory environments. Following the expected bankruptcy and separation from its no-moat merchant business FES, we believe FirstEnergy overall is a fully regulated narrow-moat utility. The company’s wide-moat FERC-regulated electric transmission businesses and narrow-moat utilities in Ohio, Pennsylvania, and West Virginia will represent about 90% of estimated operating earnings in 2019, up from 76% last year. Partially offsetting these moaty businesses is Jersey Central Power & Light, a regulated utility in New Jersey, which we rate as not having a moat in large part because of a poor regulatory framework.
After separating from FES, FirstEnergy will derive approximately 28% of its operating earnings before parent company expenses from four FERC-regulated transmission companies with 24,500 miles of transmission lines. We believe electric transmission is a wide-moat business due to its efficient scale competitive advantage. Once a transmission line is serving a region, there is little incentive for a competitor to enter a market. Capital costs for new transmission lines are too high and incremental revenue too low to offer sufficient returns on invested capital for two competing transmission owners. In addition, the FERC prevents new transmission lines from being built unless there is a demonstrated economic need to do so. And if there is a need, many times it is more economical to increase the capacity of an existing transmission line than constructing one in a new right-of-way.
Electric transmission also has a favorable regulatory framework under the FERC. Rates are based on a formula that allows FirstEnergy’s transmission businesses to recover expenses and earn a return on investment. The formula rate mechanism considers forecast expenses, investment base, revenue, and network load each year, then adjusts annually to true up returns. Thus, regulatory lag--the difference between allowed returns and actual returns--is close to zero. In other words, a transmission owner is virtually assured of earning the FERC-allowed return on its investment. This formula-based rate-setting framework is more investor-friendly than typical state regulation that requires a utility to invest capital before adjusting customer rates to collect a return on and return of that capital.
FirstEnergy will have spent approximately $4.2 billion over 2014-17, when it completes the first phase of its “Energizing the Future” strategy. The majority of the investments were in smaller-scale projects replacing older equipment with updated technology in the ATSI system in northern Ohio and western Pennsylvania. FirstEnergy is now targeting annual investments of $800 million-$1.2 billion between 2018 and 2021 as it continues Energizing the Future to its transmission systems in central and eastern Pennsylvania, West Virginia, and New Jersey. We assume capital expenditures of $1 billion per year, driving annual rate base growth of 9%. This results in operating earnings growth of 7.1%, less than rate base growth due to declining average allowed returns on equity as the investment mix shifts to jurisdictions with lower allowed ROEs and equity ratios. However, we still expect the weighted average ROE to equal 10.5% in 2021, well above our estimate of the cost of equity for these businesses.
Beyond 2021, FirstEnergy has identified over $20 billion of future investment opportunities. In addition, we think it is unlikely that the FERC regulatory framework will change in the foreseeable future. Thus, we have a high level of confidence that FirstEnergy’s transmission businesses will earn returns on invested capital over and above our estimate of the cost of capital for at least the next 20 years, fulfilling our basic financial requirement for a wide-moat business.
FirstEnergy’s State-Regulated Utilities
FirstEnergy has 10 regulated distribution utilities serving over 6 million customers across approximately 65,000 square miles in Ohio, Pennsylvania, West Virginia, Maryland, New Jersey, and New York. The regions served are one of the largest contiguous service territories of any utility in the United States. Five of the six states are restructured, the exception being West Virginia. FirstEnergy’s two integrated regulated utilities in West Virginia have 3,970 megawatts of generating capacity. We have a high level of confidence that nine of FirstEnergy’s distribution utilities will earn returns on invested capital above our estimate of the cost of capital for at least the next 10 years, thus fulfilling our basic financial requirement for a narrow moat.
Ohio Edison, Cleveland Electric Illuminating, and Toledo Edison represented 36% of FirstEnergy’s distribution deliveries in 2016. We estimate the three utilities in Ohio will contribute about 20% of operating earnings excluding corporate and other in 2019 after the separation of FES.
The deregulation of the Ohio power industry began in 1999, and the transition has been anything but smooth, with numerous legal challenges to the hybrid approaches the Public Utilities Commission of Ohio has taken. The proximity of inexpensive shale gas has pressured the profitability of Ohio’s coal and nuclear power plants. However, once FES is separated, FirstEnergy shareholders’ only concern is the regulatory framework for distribution; we believe it is constructive for investors and have a high level of confidence that it will remain that way for the foreseeable future.
In October 2016, the Ohio PUC authorized FirstEnergy’s three distribution utilities to implement a distribution modernization rider providing for the collection of $204 million (grossed up for income taxes) annually for three years, with the possibility of a two-year extension. The DMR is a unique framework in that FirstEnergy has to demonstrate sufficient progress in the implementation of the grid modernization programs, not actual expenditures. The flexibility in this rider was driven by the desire of the Ohio PUC to assist FirstEnergy in maintaining its investment-grade ratings. Although the DMR does not specify a return on equity, the grid modernization program included in the Electric Security Plan IV passed in March 2016 specified a 10.88% ROE. We believe the DMR and the Ohio PUC’s willingness to assist FirstEnergy in maintaining its credit ratings demonstrate the narrow-moat regulatory framework in the jurisdiction and gives us confidence that the three distribution utilities can earn their cost of capital for at least the next 15 years.
Met-Ed, Penelec, Penn Power, and West Penn Power represented 35% of FirstEnergy’s distribution deliveries in 2016. We estimate that the four utilities in Pennsylvania will contribute about 27% of operating earnings excluding corporate and other in 2019 after the separation of FES.
In January 2017, the Pennsylvania Public Utility Commission approved a settlement agreement that provides for an estimated annual pretax operating earnings increase of about $203 million for FirstEnergy’s four utilities. Although the settlement agreement was “black box” with no specified ROEs, we believe the rate case will allow the businesses to earn above their cost of capital for the two-year stay-out period.
We believe the Pennsylvania regulatory framework is constructive for shareholders due to the PUC’s use of fully forecast test years and rate riders for many infrastructure investments. These riders were reset to zero after the last rate case, but if costs exceed the amount recovered in the January base rate case then the rider restarts. This framework reduces regulatory lag and results in higher realized returns, giving us confidence that the four Pennsylvania utilities will earn above their estimated cost of capital for at least the next 15 years. Thus, we believe these four businesses have a narrow moat.
West Virginia and Maryland
Monongahela Power and Potomac Edison represented 15% of FirstEnergy’s distribution deliveries in 2016. We estimate that the two utilities serving West Virginia and Maryland will contribute 15% of operating earnings excluding corporate and other in 2019 after the separation of FES. Mon Power is an integrated utility that also owns two large coal plants and 40% of the 1,200 MW Bath County pumped storage hydroelectric plant.
In terms of regulatory frameworks, West Virginia and Maryland have historically been difficult states for investors. West Virginia is home to 85% of the rate base of these two utilities. The West Virginia Public Service Commission uses historical test years and has set ROEs below the industry average. However, due in part to its desire to support the coal industry, we believe recent decisions have been more supportive of FirstEnergy.
In 2015, the West Virginia PSC approved a black-box rate case settlement that didn’t specify a return on equity, but PSC staff recommended a 9.9% ROE. In addition, when the coal-fired 1,984 MW Harrison Power Station was transferred from unregulated affiliate AY Supply to Mon Power in 2013 for $1.2 billion, a 10% ROE was allowed. AY Supply is now seeking regulatory approval to transfer the 1,300 MW Pleasants Power Station to Mon Power for $195 million. We expect the West Virginia PSC to approve the transaction in early 2018.
West Virginia’s desire to support the coal industry gives us confidence that Mon Power and Potomac Edison will earn above their cost of capital for at least the next 15 years, supporting a narrow moat rating for these businesses.
JCP&L represented 14% of FirstEnergy’s distribution deliveries in 2016. We estimate that JCP&L will contribute about 10% of operating earnings excluding corporate and other in 2019 after the separation of FES.
Historically, New Jersey has been a difficult regulatory jurisdiction for investors. New Jersey has a strong consumer advocacy group that is active in rate cases and has significant influence with New Jersey’s Board of Public Utilities. In addition, the regulatory framework is poor, with historical test years used in rate cases and no allowance for construction work in progress and average to below-industry-average allowed ROEs, Although the last base rate increase that went into effect in January 2017 incorporated a 9.6% ROE, slightly less than the industry average we have observed in the past year, the regulatory framework will make it difficult for JCP&L to earn its allowed rate of return. In fact, for the period ending June 30, 2016, and before the rate increase, the earned ROE for JCP&L was a dismal 2.1%.
We do not see the regulatory framework improving in the foreseeable future. Thus, we have a low level of confidence that JCP&L will consistently earn at least its cost of capital over the next 10 years, and we do not believe this business warrants an economic moat. The good news is that after the separation from FES, we estimate that JCP&L will contribute only about 10% of consolidated operating earnings.
Strong Rate Base Growth, Diluted EPS Growth
Thanks to the modernization rider in Ohio and favorable rate riders in Pennsylvania, we expect capital expenditures for FirstEnergy’s distribution system to average almost $1.5 billion annually after the separation from FES. We estimate this will drive net property, plant and equipment (a proxy for rate base due to the variation in reporting of the 10 utilities) growth of almost 4% per year.
We expect annual operating earnings growth to average 4% over 2018-21 after the separation from FES, in line with the average of U.S. regulated utilities. We estimate that a fully regulated FirstEnergy will have annual operating earnings growth of 5.5% between 2018 and 2021, driven by FirstEnergy’s transmission businesses growing at 7.1% annually. This growth will be partially offset by the regulated distribution segment growing at 4% annually, in line with industry averages. We expect corporate and other to be flattish as the company rationalizes the parent support of a smaller business at roughly $250 million per year, a significant portion of that being parent company debt.
We assume about $2.6 billion per year of capital expenditures in FirstEnergy’s regulated businesses over 2018-21. Because of this investment, additional write-offs at FES after separation, and settlement payments to creditors, we estimate that approximately $2.5 billion of equity will need to be issued between now and 2021 to strengthen FirstEnergy’s balance sheet. The additional shares will dilute operating company earnings growth, resulting in earnings per share growth of only about 2.8% over 2018-21.
FirstEnergy cut its dividend 35% in 2014 and shareholders have not seen an increase since then, although the yield is currently slightly higher than peers’. We believe dividend increases in line with EPS growth are likely, beginning in 2019.
Charles Fishman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.