Con Ed Catalysts Can’t Overcome Structural Burden
Con Ed is the 6th largest producer of solar power and aggressively moving into the solar + storage markets. Con Ed has little exposure to traditional solar “losers”. 90% of earnings are derived from its regulated activates and will be the major driver of future performance. Free cash flow has a 7-yr average of +$475 million a yr, demonstrating conservative cash management. ED offers stability of earnings and dividends, but not much growth. Founded in 1880, Consolidated Edison (NYSE: ED ) is one of the original electric utilities in the US. Serving New York City and surrounding areas, ED offers a stable outlook and adequate dividend yield, just not very exciting future growth prospects. With over 90% of its earnings derived from regulated activities, ED can be considered a more “pure” utility than others of its size. Con Ed operates electric, natural gas, and steam networks servicing about 4.9 million customers, 3.6 million electric and 1.2 million natural gas. In addition, ED invests in transmission projects and solar power generating systems. ED is the 6th largest generator of solar power in the US. At the end of 2014, Con Edison Development had a total 446 MW of solar and wind generation in operation. The company is in development stage of a combined residential solar and storage pilot project. As of June 2015, Consolidated Edison Company of New York, Inc. CECONY represented 95% of combined EBITDA, and ED’s stock performance is tied to the performance of CECONY. Investors should be aware CECONY is under a base rate freeze through the end of 2016. Fitch offers a great recap of allowed return on equity and rate case issues in their Oct 2015 review: Relatively Restrictive Regulation: Authorized returns on equity ROEs continue to be below national average, and an increasing use of regulatory deferrals and rate freezes to limit pressure on customer retail rates has somewhat constrained Fitch’s view of New York regulation. That being said, CECONY and Orange and Rockland ORU enjoy several mechanisms that Fitch considers to be supportive of credit quality including forward-looking test years, multi-year rate plans, trackers for large operating expenses, and a revenue decoupling mechanism that isolates net margins from variations in retail sales. Those mechanisms do support the utilities’ long-term financial stability. Base Rate Freeze Manageable: The 2015 rate order that extended a base rate freeze at CECONY one additional year through 2016 will pressure credit metrics over the next two years but some mitigating factors lessen the adverse effect on operating cash flows and help keep the utility in line with the existing rating level, albeit at the lower range of the ‘BBB+’ rating category. CECONY will be allowed to continue the use of a revenue decoupling mechanism and trackers that provide recovery of fuel, pension and property tax expenses, and storm costs, including collection from customers on an annual basis of $107 million related to Superstorm Sandy. The rate order reflected an authorized ROE of 9%, which is significantly below the national average and below the 9.2% ROE authorized in CECONY’s previous rate order. However, the 9% authorized ROE is consistent with those received by utility peers ORU and Central Hudson Gas & Electric in their recently settled rate cases. Pending Rate Case Filing: Management has announced publicly that it intends to file a rate case in the first quarter of 2016 for new rates that would become effective in early 2017. Given the prolonged rate freeze, CECONY’s rate request to recover spent capex could be sizeable, and as a result, lead to heightened regulatory risk. Under Fitch’s rating case scenario that assumes CECONY operating under a 9% ROE over 2017-2019, the utility’s credit ratios modestly improve from weaker 2015-2016 levels. Fitch’s rating case also assumes that CECONY can continue to effectively control O&M to support the financial profile. ED has very little power generation and is mainly a distribution company. The majority of generation is wind and solar with a combined total of 446 MW, about equal to a medium-size natural gas combined cycle plant. The company is test driving a solar + storage platform for better utilization of its residential solar customers. In July, ED announced a demonstration project to develop a combined residential solar and storage program to better control the availability of intermittent power. The goal is to generate 1.8 MW of capacity and aggregated energy of 4 MWh. While small in comparison with the total needs of its customer base, this could be a footprint for further development not only in NYC but elsewhere. A good description of the solar + storage project is offered in an article on capitalnewyork.com: The final, and perhaps most sci-fi of the projects, is called the Clean Virtual Power Plant , which envisions a constellation of homes equipped with solar and storage, essentially large batteries. The homes would be wired together so they could act both as source of power for individual homes or be conducted by the utility like a symphony, with power dispatched to wherever it is needed on the grid or even sold into the state’s energy marketplace. The marriage of storage and solar is a crucial element for renewable energy as it allows power from the sun to accrue for use when it is cloudy or when it is dark. Con Ed writes that its peak load usually comes after 5 p.m. The connection of multiple homes as one “plant” hews closely to a central idea of the R.E.V. in that it upends the traditional flow of power from a fossil-fuel plant through a transmission line to customers and instead manages energy traveling in multiple directions. “The project is designed to demonstrate how aggregated fleets of solar plus storage assets in hundreds of homes can collectively provide network benefits to the grid [and] resiliency services to customers,” the utility wrote. It is interesting Con Ed could be on the forefront of developing residential solar + storage networks, and has little exposure to the potential “losers” of power plants and transmission assets. The solar + storage network could potentially flow into micro grids currently being reviewed by the Department of Defense for several installations. In 2013, I penned an article for SA titled, Micro Grids Don’t Have To Be the Death Knell for Electric Utilities , and Con Ed could become an prime example of a regulated utility moving in this direction. While Con Ed’s exposure to the solar + storage and micro grid potential could be intriguing, I don’t think it will be sufficient to offset some of its structural problems with being 95% controlled by the fate of CECONY. These include the current rate freeze and its low allowed return on equity. The New York Public Service Commission has historically been tough on Con Ed’s rate structure. The current 9.0% allowed return on equity is lower than the recent national average award of 9.5% to 9.8%. Below is a graphic from the company’s investor presentation of PSC rate decisions since 2006, and the downward trend should be obvious. (click to enlarge) With one of the highest cost of living areas in the world, Con Ed is under constant pressure to keep utility costs low for residents and commercial customers. Real estate tax increases have historically been automatically included in rates decisions. However, as real estate taxes become more of a burden in the NYC area, there is movements within the community to remove its automatic inclusion. In 2014, Con Ed paid about $1.4 billion in real estate taxes, and $1.8 billion in total taxes other than income taxes. This represents 19.7% of total operating expenses and 27% of all non-fuel related operating expenses. In addition, a fatal gas explosion in Manhattan in 2014 and another one in this past March have led to added scrutiny of the utility from regulators. It is estimated legal issues and fines could total upwards of $1 billion. Con Ed and NYC have been pointing fingers at each other over who’s to blame, but Con Ed was just officially condemned by the New York Public Service Commission for the loss of life and property. The unflattering headlines will have a negative effect on the relationship between ED and state regulators, and the final resolution will take years of court proceedings. The state regulators have established reliability performance standards for every electric utility in the state, and levies a fine for non-performance. According to consulting firm Brattle, Con Ed could be exposed to a maximum of 0.90% reduction in its allowed ROE from its performance evaluations. So far, Con Ed has been levied only minor fines for non-performance, however, as of 2012, performance issues are included in future rate decisions, keeping the pressure on Con Ed to control costs while increasing reliability to its customers. ED current stock valuation could be considered as fairly valued based on its history. Below is the fast graph of the previous 20 years. (click to enlarge) Con Ed’s return on invested ROIC has been falling recently, but has hovered around the 6.0% mark, with is better than the industry average of 4% to 5%. According to ThatsWACC.com, ED’s weighted cost of capital WACC is 3.8%, making ED’s hurdle rate around 1.4% to 2.0%, and is better than many peers who do not generate ROIC in excess of its WACC. Below is a 20-yr history of ROIC, also from fastgraph.com. (click to enlarge) Dividend increases have been small, with a 5-yr growth rate of 1.3%, a 3-yr growth rate of 1.6% and a 1-yr growth rate of 2.4%. These numbers would hardly move the needle for dividend growth investors. On the plus side, ED has raised its dividend every year since 1974 and its payout ratio is a comfortable 73%. Since Jan. 2009, management has generated positive free cash flow demonstrating a conservative cash approach. During this 7-year timeframe, ED generated in excess of $3.2 billion in free cash, very admirable in a capital intensive industry. On a trailing twelve month basis, ED’s free cash flow was $471 million. Driving earnings higher will be Con Edison’s multi-year capital expenditure budget. The company plans on spending $13.9 billion capital in 2015-19, and should increase its 2014 regulated asset base of $24.0 billion. Compared to many of its top peers, Con Ed has offered below average total return performance. Below is a 10-yr total return chart from morningstar.com for ED and four of its peers, demonstrating this underperformance of a $10,000 investment. (click to enlarge) While ED has an interesting exposure to solar power, storage networks, and the potential of moving into the micro grid markets, investors should look elsewhere for either higher yield or higher growth – or both. Author’s Note: Please review disclosure in Author’s profile.