Capex Growth Drivers Abound For Edison International
Summary Southern California electric utility Edison International’s share price has experienced substantially more volatility than normal this year as investors have been pushed between negative regulatory news and positive energy policy. Its short-term outlook is hampered by a delayed rate case decision and faltering progress on a nuclear plant’s decommissioning settlement. Its longer-term capex, however, is supported through 2030 by California’s strong push away from fossil fuels toward renewable energy. The company’s shares are overvalued on a forward basis, but a continuation of recent volatility could create an attractive buying opportunity in the months ahead. Investors in southern California electric utility Edison International (NYSE: EIX ) have experienced an above-average amount of volatility over the last twelve months (see figure) as the company has been beset by a combination of regulatory uncertainty, interest rate uncertainty, and a rapidly-shifting energy policy outlook in its service area. While above its TTM lows, the company’s share price also remains substantially lower than it was at the beginning of 2015, reflecting the fact that a strong long-term growth outlook is being offset by adverse regulatory behavior. This article considers Edison International as a potential long investment in light of these conditions. EIX data by YCharts Edison International at a glance Edison International is a public utility holding company operating primarily in the regulated electric transmission and distribution sectors in southern California. While the company comprises a number of wholly-owned subsidiaries and minority investments, the bulk of its earnings is provided by subsidiary Southern California Edison (SCE). SCE is a regulated electric utility with a service area that includes the Los Angeles metro and surrounding rural areas as far east as the Nevada border, providing it with 5 million customers from the area’s 14 million residents. With $20 billion in grid assets including 103,000 miles of transmission and distribution lines, SCE would be one of the country’s largest electric utilities were it an independent entity. While it used to be a diversified utility, 84% of the electricity that it now distributes and transmits comes from purchase power agreements following the legislatively-mandated sale of its coal generation capacity in 2010 and the decision to decommission its nuclear capacity in 2013 following an extended shutdown. 23% of its electricity is now derived from renewable sources, primarily geothermal and wind complemented by small amounts of solar, biomass, and hydro. Reflecting the unique nature of the California electric market, SCE has experienced lower revenue from its individual customers over the last five years even as electricity prices have increased, reflecting its implementation of efficiency improvements that have reduced annual electricity consumption by an amount equal to 1.2 million houses. Edison International also owns a number of unregulated subsidiaries, although these are not material contributors to its earnings at this time (although this could change in the future). SoCore Energy installs solar PV arrays on retail buildings in 19 states. California, especially the southern half, has the largest solar energy potential in the U.S. and, while solar PV remains a tiny contributor to the state’s overall energy portfolio at this time, a combination of regulatory and policy factors will drive installation rates over the next several years. Edison Transmission develops, constructs, and operates large-scale transmission lines. California’s electric generation portfolio has shifted over the last decade from existing fossil fuel capacity to new renewable capacity, especially wind and geothermal. This new capacity is often sited in different locations than the existing fossil capacity and requires new transmission lines to connect it to high-demand regions such as the Los Angeles metro, as the wind capacity in particular is often located outside of the city. California’s continued policy efforts to move the state away from fossil-based electricity in favor of renewables through at 2030 will drive demand for Edison Transmission’s services. While the subsidiary’s track record in submitting successful bids for large transmission projects has been limited to date, the number of opportunities in this area will continue to increase. Finally, Edison International owns minority stakes in a number of firms operating within the clean energy sector. These include Clean Power Finance, Optimum Energy, Proterra, SCIEnergy, and Enbala Power Networks. None of these stakes are meaningful contributors to the parent company’s earnings as this time, but like the unregulated subsidiaries, they operate in a sector that will achieve faster growth than the regulated utilities sector over the next several years. Q2 earnings report Edison International reported Q2 earnings over the summer that beat on diluted EPS despite missing on revenue. While both lines fell on a YoY basis, the results weren’t comparable due to the fact that the company’s regulators haven’t finalized the 2015 rate base yet, forcing it to use the 2014 rate base for its earnings report. Revenue came in at $2.91 billion (see table), down by 5.6% YoY and missing the analyst consensus by $173 million. Diluted EPS on a continuing basis came in at $1.15, down by 21% YoY but beating the consensus estimate by $0.32. Edison International financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 2,901 2,512 3,115 4,356 3,016 Gross income ($MM) 1,830 1,726 2,085 2,174 1,777 Net income ($MM) 407 327 448 508 566 Diluted EPS ($) 1.15 0.91 1.28 1.46 1.63 EBITDA ($MM) 1,052 1,052 1,270 1,309 1,019 Source: Morningstar (2015). The quarterly earnings call was notable for its heavy focus on regulatory issues, with analysts proving to be uninterested in most other topics. In addition to the missing 2015 rate base decision, there were also a number of questions about a potential settlement with regulators regarding how much SCE will have to pay of the total decommissioning costs incurred by the aforementioned nuclear power plant closure. In August, it was announced that the state’s consumer advocate was pulling out of the settlement, which would have allowed SCE to recoup the majority of the decommissioning costs from consumers, following allegations of illicit communications by the company regarding it. Edison International ultimately countered that it could find evidence that only one such incident had taken place and that the settlement should remain in place. Outlook The regulatory scheme that SCE (and thus Edison International) operates within is notable for the manner in which it decouples the subsidiary’s earnings from volatility within the electric retail market, allowing investors to pay less attention to the types of conditions that investors in other utilities must keep an eye on. For example, rather than have its earnings be impacted by retail electric sales, the subsidiary’s regulators determine an appropriate earnings level in advance (most of the time) and then adjust actual sales to reflect this afterward by either refunding or billing customers the difference. This regulatory scheme provides Edison International and its customers with a number of advantages. First, it minimizes the opportunity costs incurred by the state’s energy efficiency schemes; whereas an unregulated utility or a regulated utility without such a decoupling mechanism has a disincentive to minimizing electricity use by its customers, Edison International doesn’t benefit from higher-than-calculated retail sales. Second, the mechanism also removes weather from the uncertainty surrounding the company’s future earnings. While this year’s stronger-than-normal El Nino is expected to bring wetter and potentially also cooler conditions to southern California through next spring, possibly resulting in fewer cooling-degree days in Q2 for the service area, the decoupling mechanism allows investors to ignore this risk. A downside of the decoupling mechanism is that it increases the importance of future capex to Edison International’s future earnings growth. The combination of an aging infrastructure and rebounding Los Angeles housing market (see figure) have supported the company’s capex in the past, allowing it to record roughly $3.9 billion annually in four of the last six years. This in turn has resulted in a 9% rate base CAGR and 21% EPS CAGR since 2009. Infrastructure replacement and reliability investment spending has reached a high-water point, however, and the company is forecasting it to decline slightly between 2015 and 2017. Transmission investments will pick up the slack, however, including large projects with total expenses of $3.5 billion, and the company expects this to push its total capex up to $4.6 billion in 2016. Case-Shiller Home Price Index: Los Angeles, CA data by YCharts I expect the transmission projects to be indicative of the drivers of Edison International’s capex during the rest of the decade that will more than offset declines resulting from slower infrastructure replacements and upgrades. The state of California has staked a major position in replacing fossil fuel consumption with renewable energy. This move has rested on three broad policies: a cap-and-trade scheme that limits greenhouse gas (GHG) emissions from power plants, a low-carbon fuel standard (LCFS) that limits emissions from motor fuels, and a renewable portfolio standard (RPS) that is among the most ambitious in the U.S. All three of these will have the combined effect of transforming California’s electricity market over the next 15 years in a shift that will require electric utilities to overhaul their existing distribution networks and build vast new transmission infrastructure. First, the LCFS requires motor fuels sold in California to achieve progressively lower fossil GHG tailpipe emissions that meet or exceed legislative reduction targets. This makes the state’s motor fuels more expensive, providing drivers with an additional financial incentive to avoid them by adopting either plug-in hybrid electric vehicles or battery electric vehicles. Vehicle electrification reduces demand for motor fuels but increases demand for electricity by a comparable amount, placing additional strain on the existing grid. Furthermore, electric vehicles only achieve lower GHG emissions than those running on motor fuels when the electricity is derived from low carbon sources, so transmission lines to connect existing demand areas to new generating capacity must also be constructed. Edison International did miss out on an even larger potential driver of future capex when California’s legislature recently opted not to require vehicles operating within the state to cut petroleum consumption by 50% over 15 years, but the LCFS will continue to promote vehicle electrification during that time. Second, California’s cap-and-trade scheme should also drive investment in large transmission projects over the same period. If it works as designed then the scheme will be characterized by a steady increase to the price of GHG emissions from power plants over time, thereby increasing the financial incentive of switching to low carbon and ultimately zero carbon renewable generation capacity. As described above, much of this new capacity will not be co-located within existing fossil capacity and transmission capacity, and may not even be located near urban centers, thus requiring new transmission capacity to connect the disparate parts. The scheme will also make electricity more expensive by incentivizing the replacement of inexpensive fossil fuels with more expensive renewables, prompting many retail consumers to begin producing their own electricity via the installation of distributed solar PV and geothermal capacity. California’s policymakers have created a Distribution Resources Plan , which requires electric utilities to develop plans for replacing 1-way electric flows in existing distribution lines with variable, 2-way electric flows in anticipation of such a development. Edison International’s plan calculates that SCE will require $2.6 billion in additional capex by 2020 to meet its individual obligation. Finally, California’s legislature responded to the state’s rapid progress toward its initial RPS target of 33% renewables by 2020 by increasing it to 50% by 2030. This is an incredibly ambitious target that will require both huge investments in new generation capacity – the state already plucked the low-hanging fruit on its way to 33% – and new transmission and distribution lines to connect the new capacity to existing demand. Edison International has discussed adding generation capacity following its recent sales and closures of its existing capacity. In the meantime, however, the investments in lines alone will support the company’s planned capex through the next decade. Investors should be aware that Edison International’s decoupled regulatory mechanism does pose risks that partially offset its advantages. Foremost of these is the risk posed by higher interest rates. Unexpectedly slow growth in the U.S. has caused the Federal Reserve to delay its much-anticipated interest rate increase, and a recent weak jobs report has raised questions as to whether it will even occur in 2015. Spot rates for utilities have already risen, however, raising the prospect of Edison International incurring higher interest rates as it finances its expanded capex plans. In theory, regulators will permit the company’s allowed return on equity to increase to offset this increase, but as recent developments have demonstrated, such certainty is never assured. Valuation The consensus analyst estimate for Edison International’s diluted EPS results in FY 2015 has increased modestly over the last 90 days while that for FY 2016 has remained flat. The FY 2015 estimate has increased from $3.60 to $3.78 while the FY 2016 estimate has increased from $3.89 to $3.90. Based on a share price at the time of writing of $63.07, the company’s shares trade at a trailing P/E ratio of 13.1x and forward ratios of 16.7x and 16.2x, respectively (see figure). Its quarterly dividend of $0.42/share represents a forward yield of 2.6%. EIX PE Ratio (TTM) data by YCharts Conclusion Electric utility Edison International has experienced substantial share price volatility in 2015 YTD as its investors have been hit with numerous headline events ranging from positive news such as California’s increasingly-ambitious renewables goals and negative news in the form of regulatory uncertainty. Beyond this short-term uncertainty, however, the company is supported by a number of longer-term drivers of capex growth. Foremost among these is the triple presence of California policies designed to reduce the state’s reliance on fossil fuels in favor of renewable energy. At a minimum, these policies will support Edison International’s capex plans by creating demand for new transmission lines connecting new generating capacity to existing demand locations. Furthermore, these policies will provide additional capex support moving into the next decade, offsetting reduced capex from maintenance and reliability projects. As attractive as this long-term capex growth is, potential investors should be aware of ways in which Edison International’s regulatory framework could limit these advantages, especially given the prospect of higher interest rates in the future. In light of these limitations, I consider the company’s future P/E ratios to be high, especially compared to its trailing ratio. I encourage potential investors to wait for a better buying opportunity, as represented by the presence of a tighter spread between trailing and forward ratios such as was present at the end of 2015, before initiating a long investment. Given its share price volatility this year, such an opportunity could easily arise from unfavorable regulatory news.