To Our Shareholders,
For the quarter ended March 31, 2016, the net asset value (“NAV”) per Class AAA Share of The Gabelli Utilities Fund increased 11.3% compared with an increase of 15.6% for the Standard & Poor’s (“S&P”) 500 Utilities Index. See page 2 for additional performance information.
The Drama of the Deal
The S&P Utility Index provided a strong 15.6% return in the first quarter of 2016, compared to a 1.4% return for the S&P 500 Index. We attribute the sector strength to its defensive appeal in the face of global economic weakness, strong fundamental outlook, heightened merger activity and growing market confidence that U.S. interest rates will stay low for the foreseeable future. A weakened U.S. and global growth outlook led the Fed to hold benchmark rates unchanged at its mid-March meeting and outline plans to hold benchmark rates low for the foreseeable future.
The March 31, 2016 10 and 30 Year U.S. Treasury yields were 1.8% and 2.6%, respectively, which compares to year-end 2015 rates of 2.3% and 3.0%, respectively. The electric utility median current return is 3.3%, which represents 183% of the ten-year yield, and the median payout ratio of 62% of 2016 earnings leaves ample cushion for ongoing dividend growth. While interest rate level changes influence near-term performance, long-term utility total returns are primarily driven by earnings and dividend growth, and economic weakness highlights the low-risk profile of utility earnings streams. After growing a modest 1% during the mild weather of 2015, consensus estimates call for 2016 and 2017 growth rates of 5.3% and 5.9%, respectively.
The first quarter of 2016 was highlighted by “deal-drama” as two utility mergers appeared certain to be rejected by regulators only to be revived in dramatic last second fashion, including Exelon’s March 23 approval to buy Pepco Holdings and Macquarie’s (0.1% of net assets as of March 31, 2016) March 28 approval to buy Cleco Corp (1.4%). More importantly, three major transactions were announced in the quarter, including Canadian utilities Fortis (0.2%) and Algonquin’s (0.1%) agreements to buy ITC Holdings (0.2%) and Empire District Electric (0.7%), respectively, and Dominion Resources’ (0.6%) agreement to acquire Questar (0.1%). The consolidation trend is in full bloom!
Investment Outlook
We emphasize that utility stocks are more than bond proxies, and share prices are driven by long term earnings and dividend growth. We expect the utility sector to provide a low risk 7%-9% annual total return over the long term, based on the median current return of 3.4% and 4%-6% annual earnings and dividend growth. We believe valuation multiples are supported by strong fundamentals, low interest rates, and ongoing takeover potential. Solid fundamentals include healthy balance sheets, credit ratings, improved regulatory principles, focused strategies, low natural gas prices, and opportunities to invest in transmission, cleaner generation, and smart grid technology.
The utility and energy sector is in the midst of one of the more aggressive investment cycles seen in decades, leading to dramatic changes in the way that natural gas is drilled and transported and power is generated, transmitted, and delivered. The need to address climate change provides utilities with accelerated investment opportunities, and is likely to create a new round of winners and losers. Natural gas and renewable power plants are clear winners, while older inefficient coal-fired power plants face near term retirement. Electric utilities with clean power generation portfolios and/or operating in constructive regulatory environments are significantly better positioned than non-regulated merchant power companies dependent on fossil fired power plants. Natural gas utilities benefit from low prices, low customer bills, and growing demand.
Growing Environmental Awareness Sets Opportunity Framework
Despite the Supreme Court’s February 9, 2016 decision, granting a stay in the EPA’s finalized Clean Power Plan (CPP), utilities continue to invest heavily in lowering greenhouse gas emissions and increasing renewable output. The August 2015 CPP would set greenhouse gas emission standards for existing power plants, including CO2 emission reductions of 32% from 2005 levels by 2030 (19% from 2012 levels). The CPP set carbon targets, and the individual states would submit plans to implement and comply with interim targets between 2022 and 2030. Given that carbon reduction technology does not exist, compliance plans involve improving efficiency at existing coal plants, retiring coal units, increasing gas and renewable generation, and improving demand side efficiency.
Over the past few years, public and political support of environmental investment, combined with the low cost of natural gas, has allowed for an increasingly constructive regulatory environment, which includes numerous adjustments and mechanisms to address infrastructure investment, as well as rate design changes to address efficiency and distributed generation. Many state public utility commissions allow frequent (quarterly, semi annual, or annual) rate adjustments for environmental, transmission, renewable, and other items as well as “pass-throughs” for fuel, healthcare, and pension expenses. As a result, investors can take comfort that utilities can earn healthy and low risk returns on investment and enjoy significant investment opportunities. Plans to address climate change have led to a heightened level of activity, including coal power plant retirements, renewable development, Federal Energy Regulatory Commission (FERC) transmission projects, and corporate restructuring, including mergers.
Another Wave of Consolidation: M&A Activity Update
We attribute the recent wave of consolidation to strategic positioning, as electric utilities invest to comply with the “stayed” Clean Power Plan and incorporate a greater dependence on natural gas. In addition, the low interest rate environment allows for a low-cost of capital to acquire other utilities and utility assets. By acquiring a smaller electric or gas utility, an electric utility achieves greater scale, complimentary assets, and/or potential synergies. Highlighted below is some of the more significant deal activity over the past twelve months:
- On March 28, 2016, Cleco Corp. finally received Louisiana Public Service Commission approval to be purchased by Macquarie Infrastructure and Real Assets (group of investors) for $55.37 per share in cash. The purchase price represented a 15% premium to the previous day’s close and 10.0x EV/EBITDA. The deal closed on April 13. The final approval was somewhat of a surprise given that it reversed a February 2016 ruling to reject the sale.
- On March 23, 2016, Exelon Corporation (0.7% of net assets as of March 31, 2016)) received its final regulatory approval from District of Columbia Public Service Commission to acquire Pepco Holdings for $11.9 billion, or $27.25 per share, which represented a 20% premium to the previous day’s close. We expect an early 2016 close.
- On February 9, ITC agreed to be acquired by Canadian utility, Fortis, for $11.3 billion (includes the assumption of $4.4 billion of ITC debt), or $44.90 per share, in cash and stock. The transaction price consists of $22.57 per share in cash and 0.752 FTS shares and represented a 14% premium to the previous day’s close. The $44.90 per share transaction price represents 21.4x our 2016 earnings estimate of $2.10 per share and 12.2x EV/EBITDA multiples, which are at the higher-end of recent utility takeover multiples. The companies expect the transaction to close in late 2016.
- On February 9, Empire District Electric Co. announced an agreement to be acquired for $34 per share in cash by Algonquin Power & Utilities Corp., a Canadian based energy company. The $34 per share purchase price represented a 21% premium to the previous day’s close and 50% to the December 10, 2015 close. The C$3.4 billion (US$2.4 billion) enterprise value, including assumed debt, represents a 1.49x multiple of Empire's projected rate base, a 10.9x multiple of our 2017 EBITDA estimate and 21.9x our 2017 earnings estimate of $1.55 per share.
- On February 1, Dominion Resources announced an agreement to acquire gas utility Questar Corporation (STR) for $25 per share in cash, which represented a 23% premium to the previous day’s close. The ~$6.0 billion transaction includes the assumption of ~$1.6 billion in debt. Headquartered in Salt Lake City, Utah, Questar is a natural gas distribution, pipeline, storage, and cost-of-service gas supply company. We consider the multiples paid to be reasonable and in-line with other transactions, including 19.1X Questar’s 2016 and 2017 earnings estimates of $1.31 per share and an EV/EBITDA multiple of 9.6X. Dominion Resources expects the transaction to be accretive upon closing at year-end.
- On December 17, 2015, UIL Holdings of New Haven, Connecticut and Iberdrola USA (0.1%) combined to form a separate publicly traded utility called AVANGRID (0.3%). Iberdrola owns 81.5% of AVANGRID and former UIL shareholders own 18.5%. The combination includes Iberdrola USA’s utilities (New York State Electric & Gas, Rochester Gas & Electric, and Central Maine Power) and UIL’s utilities (The United
Illuminating Company, The Southern Connecticut Gas Company, The Connecticut Natural Gas Corporation, and The Berkshire Gas Company). The transaction was announced on February 25, 2015, and proposed a total value of $52.75 per share to UIL, a 25% premium to the previous close. The value represented a 21.1x P/E to UIL’s 2015 EPS guidance of $2.50 per share, and 11.2x EV/2014 EBITDA and 9.8x EV/2015E EBITDA. UIL shareholders received one share of the new company for each share held plus $10.50 cash per share.
- On October 26, 2015, Duke Energy (1.1%), based in Charlotte, North Carolina, agreed to acquire Piedmont Natural Gas (0.2%), also based in Charlotte, for $6.7 billion enterprise value, or $60 per share, which represented a 40% premium to the previous day’s close. We consider the multiples to be high at 30.8x 2016 estimated EPS, and 13.6x EV/EBITDA, as well as 338% price-to-book value.
- On September 4, 2015, Emera (0.3%) of Halifax, Nova Scotia agreed to acquire TECO Energy (1.3%) of Tampa, Florida, for $10.4 billion (including assumption of $3.9 billion of debt), or $27.55 per share in cash. The price represented a 31% premium to the preannouncement closing price and 10.4x our 2016 EBITDA estimate for TECO Energy and 23.0x 2016 earnings. The transaction is expected to close in mid-2016.
- On August 24, 2015, The Southern Company (1.2%), based in Atlanta, Georgia, agreed to acquire AGL Resources (0.3%), also of Atlanta, for $12 billion enterprise value, or $66 per share, which represented a 36% premium to the previous day’s close. We consider the multiples (10.0x EV/EBITDA, 21.0x 2016E EPS) to be reasonable. The Southern Company expects the transaction to close in the second half of 2016.
- On June 29, 2015, WEC Energy Group (1.8%) completed its acquisition of Integrys Energy Group. The agreement valued Integrys at $9.1 billion enterprise value, and consisted of stock, cash, and the assumption of $3.3 billion of debt. Each Integrys share received 1.128 shares of WEC Energy Group and $18.58 per share in cash.
The state public utility commissions in Connecticut, Maryland, Washington D.C., and Louisiana all initially denied merger requests, but following further concessions, acquiesced. NextEra’s (4.2%) pending agreement to buy Hawaiian Electric Industries continues to face challenges.
- On December 3, 2014, Hawaiian Electric Industries announced an agreement to sell its utility operations to NextEra Energy for $4.3 billion, including $1.7 billion of debt, and the spin-off of its banking business, American Savings Bank, to shareholders. Hawaiian Electric Industries (1.4%) shareholders will receive: 0.2413 shares of NextEra Energy ($25.19 per share at NEE closing price), a $0.50 per share special dividend, and shares of American Savings Bank valued at ~$8.00 per share (1.75x tangible book of $464 million). The total value at the time of the transaction ($33.69 per share) represented 19.8x our 2015 earnings estimate of $1.70 per share and 8.2x our 2015 EBITDA estimate of $506 million. The $25.69 per share of utility value represented 20.6x our 2015 utility earnings estimate of $1.25 per share (includes allocated parent expenses) and 9.5x our 2015 utility EBITDA estimate of $434 million. We expect the transaction to close in the first half of 2016, subject to Hawaii Public Utility Commission approval, but also expect that NextEra Energy will terminate the merger agreement should the Public Utility Commission’s demands become too onerous.
We also expect to see significant turnover of assets owned by yieldco’s, MLP’s, and independent power producers. These sectors have experienced significant declines in shareholder value, and some may be challenged financially. As such, we expect to see larger wind farms and solar plants owned by yieldco’s, merchant power plants owned by independent power companies, and gas storage and midstream pipelines, to be purchased by utilities and private equity. We also believe that the depressed state of the all three sectors could lead to the takeover or merger of an entire entity.
Are Investors Too Focused on the Fed? We Think So
Similar to most equity investments, utility stocks are negatively impacted when interest rates rise, but they are more sensitive to longer term rates. Given that U.S. Treasury yields have been in a long term decline since 1981, when they peaked at 15%, many believe that a period of higher rates is inevitable. A primary reason for the long term decline in interest rates has been the Federal Reserve’s aggressive stance toward inflation. The Fed has been active with its various tools, including the recent move in the Federal Funds rate, to control inflation and encourage growth. Should economic growth accelerate, the Fed’s long term fight against inflation would likely continue via hikes in the short term benchmark rates to slow inflation potential. The increases in the short term benchmark rates act to minimize economic stimulus and inflation, and put downward pressure on longer term interest rates. The Fed’s supervision provides some comfort that the low rate environment will likely continue.
The current 3.3% utility dividend return is 183% of the 1.8% yield on the 10 year U.S. Treasury Note. Utility dividend return becomes less compelling when returns on other investments increase, including U.S. Treasury yields. In addition, the present value (or stock price) is often determined by the present value of future cash flows. As such, the higher interest rate (discount rate), the lower the present value of an equity (or fixed income) investment, assuming all other variables hold constant. Utility stocks often appear to be more sensitive to interest rates than other stocks, because the variables impacting changes in utility revenues, expenses, etc., are less sensitive to other factors. The negative impact of potentially higher interest rates is partially mitigated by the following:
- ROE’s Set Based on Interest Rates: A utility’s cost-of-capital, including return on equity (ROE), is set by state public utility commissions, and increases (decreases) as interest rates rise (fall).
- Annual Riders Minimize Inflation Risk: State public utility commissions and FERC regulatory principles have improved to include more frequent rate adjustments, which mitigate inflation risk.
- Annual Dividend Hikes: Utilities target annual dividend increases which serve to mitigate the negative impact of higher rates. In 2015, electric utilities increased the annual dividend by a median of 5.4%.
- Utility Stocks Pay Higher Dividends Than Other Sectors: The present value of a higher near term dividend stream is less impacted by changes in interest rates than a lower near term dividend stream.
Earnings Growth
We continue to forecast earnings growth of roughly 4%-6% per annum for the foreseeable future. The successful formula driving our strong fundamental and earnings outlook remains: Investment Opportunities + Constructive Regulation = Earnings Growth. Utility sector capital investment grew from $41.1 billion in 2004 to
$82.8 billion in 2008, with major spending on environmental control equipment, renewable generation, and transmission. In 2013 and 2014, utility capital expenditures were $90.3 billion and $98.1 billion. The Edison Electric Institute currently projects industry investment at $108.6 billion in 2015. In view of pending Clean Power Plan compliance plans, we expect significant investment for the foreseeable future.
Given strong financial conditions and favorable tax positions, utilities are well positioned to fund investment. The average regulated utility credit rating is BBB+, and the rating agencies cite state level regulation improvement, including numerous transparent and timely cost recovery mechanisms. Ongoing rate adjustments to recognize infrastructure investment allow utilities to earn healthy returns on investment. The growing investment, or rate base, translates to stronger earnings growth. State public utility commissions currently award allowed ROE’s, or profit levels, of roughly 9.3%-10%. Allowed ROE’s have declined, but not as much as long term interest rates.
Electric Transmission
The FERC’s favorable incentive oriented regulation continues to make transmission investment one of the more compelling uses of capital for electric utilities. The favorable regulatory treatment is designed to help the nation repair, upgrade, and expand its aging transmission network. Allowed ROEs have ranged as high as approximately 14%, though recent FERC rate decisions reset the benchmark at a lower level. In June of 2014, FERC lowered New England transmission base ROEs to 10.57% from 11.14%, and capped incentive ROE’s at 11.74%. Allowed ROE decisions in two pending Midwest Independent System Operator complaints are expected in late-2016 and mid-2017. Nonetheless, transmission growth opportunities command premium multiples, and are among the more desirable projects sought by utility management teams.
Gas Pipelines and Reserves in Rate Base
Electric utilities are becoming increasingly dependent upon natural gas to fire generation, and they are eager to minimize the price and reliability risk associated with the commodity. Partially driven by the 2013/2014 polar vortex, as well as size and scale, some electric utilities are building and developing natural gas pipelines and investing in natural gas reserves. As mentioned, electric utility industry leaders The Southern Company, Duke Energy and Dominion resources recently announced transactions to buy local gas utilities, which each have large pipeline projects in development. Pipelines examples include: Central Penn (WGL Holdings (0.3% of net assets as of March 31, 2016)), Constitution (Piedmont Natural Gas, WGL Holdings), and NEXUS (DTE Energy (less than 0.1%)).
- Access Northeast ($3 billion; November 2018) – EverSource (2.4%) teamed up with Spectra Energy to enhance the Algonquin and Maritimes pipelines, which would help alleviate congestion for the winter of 2016/2017.
- Atlantic Coast Pipeline ($5 billion) – Dominion Resources, Duke Energy/Piedmont, Southern/AGL Resources have ventured to build a pipeline that runs from West Virginia through Virginia to North Carolina.
- PennEast Pipeline ($1 billion) – AGL Resources, New Jersey Resources (less than 0.1%), Public Service Enterprise Group (0.4%), South Jersey Industries (0.2%), Spectra Energy Corp. (0.9%), and UGI Corp.(0.7%) are building a 105 mile interstate pipeline from the Marcellus region of Pennsylvania into New Jersey. The pipeline is targeted to be in service in late 2017.
- Mountain Valley Pipeline – EQT Corp, NextEra Energy, Consolidated Edison (0.3%) and WGL Holdings (0.3%) agreed to build a 301 mile pipeline through West Virgina to Southern Virginia at a cost of $3.0-$3.3 billion.
- Sabal Trail ($3 billion) – NextEra Energy and Spectra Energy plan to build a 465 mile interstate pipeline that would originate in Alabama and transport gas to Georgia and Southeast Florida. The pipeline would include a NextEra Energy built Southeast connection which would run an additional 126 miles to the Martin Energy Center.
- Southeast Supply Header: Spectra Energy and CenterPoint Energy (0.1%) plan to build a 286 mile pipeline from eastern Texas and northern Louisiana to Mississippi and Alabama.
- Southeast Pipeline: EQT Corp and NextEra Energy plan to build a 330 mile pipeline to connect the Utica/Marcellus to Southeast (West Virginia).
In addition, some electric and gas utilities are pursuing the inclusion of natural gas reserves in rate base, which secures gas supply, minimizes price risk and creates earnings power. Three utilities in the western U.S., including Questar Corporation, Northwestern Corp. (1.3%), and Northwest Natural Gas (1.1%), have implemented these programs. While Northwestern Corp. and Northwest Natural Gas’s programs are relatively new, Questar Corp.’s program has been successful in saving customers approximately $1.1 billion cumulatively since 1981.
Recently, NextEra Energy’s Florida Power & Light received Federal Public Service Commission approval for a $500 million per year natural gas reserve program. As more commissions become comfortable with the program, we expect additional or expanded programs to help drive rate base growth. Black Hills Corp. (1.5%) and NextEra Energy are already actively pursuing initiatives and other companies exploring this notion include DTE Energy, Duke Energy, Alliant Energy (0.3%), Portland General Electric, Xcel Energy (0.7%), and WGL Holdings.
Valuation High On Absolute Basis but Reasonable Relative to Interest Rates
Our electric utility universe trades at 19x forward earnings, which compares to the 20 year range of 10x-19x trailing twelve months earnings. However, utility stocks appear fairly priced relative to interest rates, specifically the 10 year U.S. Treasury yield. Because long term interest rates, specifically the 10 year and 30 year U.S. Treasury yields, were in a long term secular decline from the late 1980s, we measure the earnings yield as a percentage of the 10 year U.S. Treasury yield in order to gauge interest rate adjusted valuations. Should the twenty year relationship hold, the 10 year U.S. Treasury yield could rise 130 basis points without negatively impacting P/E multiples.
Our Approach
For several decades, utility companies have acquired other utilities and utility assets for the sake of gaining economies of scale and efficiency. Since 1995, the electric utility sector has experienced over 130 acquisition announcements and over 100 completed deals. Consolidation activity peaked from 1996-2000, when it appeared that the industry would deregulate. The electric and gas utility sector remains fragmented with roughly sixty electric utilities and thirty gas utilities. This is fifty more utilities than we need from the standpoint of economic efficiency.
More significant takeover premiums are normally associated with fundamentally sound, reasonably priced, mid cap and small cap utilities. Our investments in regulated companies have primarily, though not exclusively, focused on fundamentally sound, reasonably priced, mid cap and small cap utilities that are likely acquisition targets. Attractive takeover characteristics include constructive regulatory environments, healthy service areas, transmission growth potential, low-carbon footprints, strategic geographies or a particularly stressful situation. Given the significant long term demand for natural gas, we consider most gas distribution utilities, particularly those with pending pipeline development projects to be highly coveted.
Let’s Talk Stocks
The following are stock specifics on selected holdings of our Fund. Favorable earnings prospects do not necessarily translate into higher stock prices, but they do express a positive trend that we believe will develop over time. Individual securities mentioned are not necessarily representative of the entire portfolio. For the following holdings, the share prices are listed first in United States dollars (USD) and second in the local currency, where applicable, and are presented as of March 31, 2016.
American Electric Power Co. Inc. (AEP, Financial) (2.3% of net assets as of March 31, 2016) (AEP – $66.40 – NYSE) is one of the nation’s largest electric utilities. It serves more than 5.4 million retail customers in eleven states (Ohio and Texas are the largest), owns approximately 32,000 MW of generating capacity, 40,000 miles of transmission lines (the nation’s largest), and 223,000 miles of distribution lines. AEP is focused on becoming a premier regulated utility, and it plans to invest $13 billion over the 2016-2018 time period in regulated assets, driving 7.3% CAGR in net regulated plant. Management expects 4%-6% annual earnings growth, driven by capital investment and rate recovery, sustainable cost savings and O&M spending discipline. The company continues to transition its generation fleet from coal to more environmentally friendly sources. Some of the growth will come from AEP Transco, a transmission development subsidiary that is expected to grow to $0.87-$0.96 per share by 2019 from $0.39 per AEP share in 2015, driven by a $3.7 billion transmission capital investment plan for 2016-2018. AEP currently pays an annual dividend of $2.24 per share representing a payout ratio of roughly 60% (using $3.70 per share, midpoint of the 2016 earning guidance range), near the low end of the targeted payout ratio of 60%-70%.
Empire District Electric (0.7%) (EDE, Financial) (EDE – $33.05 – NYSE) On February 9, EDE announced an agreement to be acquired for $34 per share in cash by Algonquin Power & Utilities Corp (AQN). The $34 per share purchase price represents a 21% premium to the previous day’s close and 50% premium to the unaffected share price prior to the December 10, 2015 announcement confirming that EDE was in the early stages of exploring strategic alternatives. The $2.4 billion enterprise value, including assumed debt, represents a 10.9x multiple of our 2017 EBITDA estimate and 21.9x our 2017 earnings estimate of $1.55 per share. The transaction is expected to close in the first quarter of 2017 pending approval of EDE shareholders, and the PUC’s of Arkansas, Kansas, Missouri and Oklahoma, the Federal Communications Commission (the FCC), the Committee on Foreign Investment in the United States and the Federal Energy Regulatory Commission (the FERC). Alogonquin Power & Utilities Corp. is a renewable energy and regulated utility company with an eclectic set of assets, including 35 clean energy facilities netting to 889 MWs of capacity in Canada and seven U.S. states and Liberty Utilities. Liberty is an electric, gas and water utility serving 485,000 customers in ten states. Algonquin will maintain EDE’s headquarters in Joplin, retain all Empire District Electric employees, and place the Empire management team to lead Liberty Utilities' Central U.S. Region.
Edison International (2.4%) (EIX, Financial) (EIX – $71.89 – NYSE) is one of the nation’s larger regulated electric distribution utilities through Southern California Edison (SCE), serving fourteen million residents (five million customers) in central, coastal, and southern California. Following divestiture of non-regulated businesses and settlement of most outstanding issues related to the closing of the San Onofre Nuclear Generating Station (SONGS) units, we consider EIX to be a relatively low risk high quality utility operating in a constructive regulatory environment. In late 2015, SCE’s 2015-2017 General Rate Case (GRC) was finally decided with higher revenues retroactive to January 1, 2015. EIX targets 7% annual rate base growth based on a 10.45% allowed ROE, a $12 billion 2015-2017 capital program and progressive regulatory principles. The capital program is directed toward replacing, upgrading and modernizing the distribution and transmission system to incorporate renewables, storage, electric vehicle charging stations and various smart grid applications. EIX currently pays an annual dividend of $1.92 per share representing a SCE earnings payout ratio of roughly 47% (using $4.09 per share, midpoint of the 2016 SCE earning guidance range), near the low end of the targeted SCE payout ratio of 45%-55%.
Eversource Energy (2.4%) (ES, Financial) (ES – $58.34 – NYSE) is New England’s largest electric and gas distribution utility and delivery system. ES, formerly known as Northeast Utilities (NU), is the product of the April 2012 merger between Northeast Utilities, headquartered in Hartford, Connecticut, and NSTAR, headquartered in Boston, Massachusetts, creating a premier New England distribution utility. ES serves 3.6 million customers in Connecticut, New Hampshire, and Massachusetts. We consider ES to be one of the better long term growth stories, driven by transmission investment, cost cutting opportunities, and oil-to-gas heat conversions in the Northeast. The company targets a 5%–7% long term earnings growth rate. ES formed a JV with Spectra Energy (SE) and National Grid (NG-LN) (0.1%) to construct Access Northeast, a $3 billion gas pipeline to supply the region’s electric generators with natural gas. Construction is expected to begin in 2017, with an in service date by the winter of 2018. In addition, ES expects its 180-mile, $1.6 billion Northern Pass electric transmission line to be completed in mid-2019, with construction to begin in late-2016/2017 following a final environmental impact statement and New Hampshire siting approval. The company expects further transmission development as aging nuclear and coal facilities are replaced.
Iberdrola S.A. (0.1%) (IBE, Financial) (IBE – $6.67/€5.86 – Bolsas y Mercados Españoles) headquartered in Bilbao, Spain, is one of the larger global power companies with operations primarily in Spain, Portugal, the UK, U.S., Mexico and Brazil. The company owns and operates ~44,600 MW of generation, including 14,200MW of renewables, and serves over ~20 million electric and gas customers. IBE’s strategy is focused on its renewable energy and regulated businesses in countries with high ratings, such as the U.S. On December 17, 2015, UIL Holdings of New Haven, Connecticut and Iberdrola USA combined to form a separate publicly traded utility called AVANGRID. Iberdrola owns 81.5% of AVANGRID and former UIL shareholders own 18.5%. The combination includes Iberdrola USA’s utilities (New York State Electric & Gas, Rochester Gas & Electric, and Central Maine Power) and UIL’s utilities (The United Illuminating Company, The Southern Connecticut Gas Company, The Connecticut Natural Gas Corporation, and The Berkshire Gas Company). The transaction was announced on February 25, 2015, and proposed a total value of $52.75 per share to UIL, a 25% premium to the previous close. The value represented a 21.1x P/E to UIL’s 2015 EPS guidance of $2.50 per share, and 11.2x EV/2014 EBITDA and 9.8x EV/2015E EBITDA. IBE targets earnings growth of ~6% annually from 2016-2020 and expects to invest over 17 billion euros (88% regulated or long-term contracted activities) during the same time period.
ITC Holdings Co. (0.2%) (ITC, Financial) (ITC – $43.57 – NYSE) On February 9, ITC agreed to be acquired by Canadian utility Fortis (FTS-C$41.38-TSE) for $11.3 billion (includes the assumption of $4.4 billion of ITC debt), or $44.90 per share, in cash and stock. The transaction price consists of $22.57 per share in cash and 0.752 FTS shares. The transaction price of $44.90 per share represents a 14% premium to the previous day’s close of $39.38 per share and 33% premium to the unaffected share price prior to the November 30, 2015 announcement regarding the strategic review. The $44.90 per share transaction price represents 21.4x our 2016 earnings estimate of $2.10 per share and 12.2x EV/EBITDA multiples, which are at the higher-end of recent utility takeover multiples. The companies expect the transaction to close in late 2016 pending receipt of approvals from the ITC and FTS shareholders, FERC approval, as well as IL, KS, MO, OK and WI. ITC is the nation’s only pure-play transmission company with substantial expertise in transmission operation and development. The transaction makes strategic sense for FTS given that ITC provides regulated rate base growth opportunity, increases diversification, and is accretive to earnings. Based in St Johns, NL Canada, FTS would be among the larger fifteen utilities in North America with a rate of C$28 billion (U.S. $18 billion) and plans to list on the NYSE. FTS currently serves ~2 million electric and 1.2 million gas utility customers throughout Canada, the United States and the Caribbean.
National Fuel Gas Co. (NFG, Financial) (4.9%) (NFG – $50.05 – NYSE) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, New York, gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast, gathering and processing systems, and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. NFG’s ownership of 800,000 net acres in Pennsylvania, including 780,000 acres in the Marcellus Shale, holds enormous natural gas reserve potential. On February 4, 2016, NFG took near-term strategic actions to adjust to the ongoing low natural gas price environment in the Marcellus: (1) lowered the 2016 capital budget (2) delayed the Northern Access 2016 pipeline expansion by roughly one year with new in-service target date of November 2017, and (3) reduced its drilling program to operate one rig in 2016 and 2017. NFG’s actions highlight its unique asset mix and flexibility to endure the current depressed price environment. The company continues to lower well costs and extract operational efficiencies, resulting in lower required break-even realizations in the WDA. We continue to expect above average long term earnings and cash flow growth from rapidly growing gas production and strategically located pipeline expansion. The company has increased its dividend for over forty consecutive years.
NextEra Energy Inc. (NEE, Financial) (4.2%) (NEE – $118.34 – NYSE) is the holding company for Florida Power & Light (FP&L), the largest electric utility in Florida, and NextEra Energy Resources (NER), a leading wholesale renewables operator. We regard NEE as one of the better positioned electric companies to grow earnings and dividends over the next several years. FP&L operates one of the premier utility franchises in the nation, with favorable long term demographics and above average rate base growth potential, due to the power plant rate adjustments, flexible amortization, and other regulatory mechanisms. FP&L’s four year rate plan (2013-2016), premised on an allowed ROE of 10.5% (+/-100-basis points), expires at year-end 2016 and has filed for another constructive multi-year plan. NEE also agreed to purchase Hawaiian Electric Industries (HE) on December 3, 2014, while spinning off American Savings Bank to shareholders. NEE will finance the deal with 0.2413 shares of NEE per share of HE and the assumption of tax liabilities related to the spin off. Additionally, NER owns and operates the nation’s largest renewable power portfolio, with a significant pipeline of future growth opportunities. In mid-2014, NEE IPO’d 20% of a new publicly traded yieldco (NextEra Energy Partners-NEP (less than 0.1%)), to help drive non-regulated renewable generation growth. Many of these projects and opportunities are likely to be “dropped down” into NEP. In addition, NEE entered into a Joint Venture with Spectra Energy on a 465 mile, $3 billion (NEE to fund $1 billion) intrastate pipeline from Alabama through Georgia to southern Florida. The project includes an associated $550 million 126 mile expansion to FPL’s Martin Energy Center.
PNM Resources Inc. (2.6%) (PNM, Financial) (PNM – $33.72 – NYSE) is a public utility holding company headquartered in Albuquerque, New Mexico. Regulated electric utility subsidiaries include Public Service Company of New Mexico (PSNM) and Texas-New Mexico Power Company (TNMP). PNM expects rate base growth of 5%-7% per annum at both PSNM and TNMP. PNM’s 2016-2019 capital plan totals $1.7 billion, including $547 million in 2016, $425 million in 2017, $398 million in 2018 (excludes $165 million for PV 3) and $352 million in 2019. In late 2015, PNM received final approval of its major environmental plan and ownership changes for the San Juan coal units. Additionally, PSNM refiled an important New Mexico rate case on August 27, 2015. It requested a $123.5 million annual revenue increase, based on a 10.5% allowed ROE using a rate base of $2.5 billion, for the test year October 2015-September 2016. PSNM expects a NMPRC rate order in the third quarter of 2016. In December 2015, the NMPRC agreed to clarify future test year standards begin 13 months after a rate case is filed. We expect BART and other investment to be recognized in the 2018 future test year rate order. We expect the use of a forward-looking test year to provide PSNM greater opportunity to earn its allowed ROE. Assuming fair regulatory treatment, PNM targets 7%-9% annual earnings growth, which includes 2016 earnings guidance of $1.55-$1.76 per share, and 2017 earnings power of $1.94-$2.01 per share.
Southwest Gas Corp. (3.1%) (SWX, Financial) (SWX – $65.85 – NYSE) is a natural gas distribution utility serving 1.9 million customers in geographically diverse portions of Arizona (~1.0 million, or 53%), Nevada (~700,000, or 37%), and California (~185,000, or 10%). From 2008 to 2010, customer growth slowed, due to the overall slowdown in the new housing market and the increase in idle/vacant homes resulting from foreclosures and challenging economic conditions. Over the past several years, customer growth has improved, and over the long term, we expect that the service area will return to higher growth rates as the favorable regional climate and lower housing prices attract customers to inhabit vacant homes. SWX also owns Centuri Construction Group, a full service underground piping contractor that provides trenching and installation, replacement, and maintenance services for energy distribution systems. The pipeline construction business is growing strongly, given the industry’s focus on safety related pipeline replacement programs and achieved the $1 billion revenue milestone. The 2014 acquisition of Link-Line Group’s pipeline construction business expanded the scope and scale of the business, allowing the potential for some type of financial engineering. We consider SWX to be a high quality gas utility with a focused, low risk strategy and solid earnings outlook, driven by recent and future rate increases, expanded infrastructure tracking mechanisms, customer growth, and cost controls.
Severn Trent PLC (0.3%) (SVT, Financial) (SVT – $31.21/2,170 p – London Stock Exchange) is an international provider of water and wastewater services. Severn Trent Water, the UK based utility, provides water to eight million people and wastewater services to nine million people in the Midlands and Mid-Wales. In January 2015, Severn Trent accepted the Final Determination from OFWAT, the UK water regulator, regarding the utility’s five year investment and rate plan for 2015-2020. The plan will likely allow SVT to continue to provide steady and modestly growing returns. Additionally, as one of the UK’s premier water and wastewater providers, Severn Trent is well positioned to provide duly needed expertise and infrastructure investment opportunities in less developed regions across the world. Severn Trent Services, the non-regulated water and waste water service division of the company, which focuses on water purification projects and operating plants and systems for municipalities, has a growing presence in Europe, the Middle East, and Asia. Strong earnings and cash flow profile combined with water and wastewater infrastructure expertise make SVT an attractive takeover candidate.
Westar Energy Inc. (1.8%) (WR, Financial) (WR – $49.61 – NYSE) is an electric utility serving 700,000 customers in central and northeastern Kansas. WR is well positioned to grow its earnings, given a constructive regulatory environment that allows for annual rate adjustments outside of a general rate case to recognize environmental and transmission investment. The company targets long-term EPS growth of 4%-6% off of its 2015 normalized earnings of $2.21 per share. In late 2015, WR implemented a $78 million rate increase based on a 53.45% equity ratio and an undisclosed ROE level (~9.35% inferred off of a 10.926% allowed pre-tax return). WR’s five-year capital expenditure program totals $4.2 billion, including $1.1 billion in 2016, $794 million in 2017, $751 million in 2018, $706 million in 2019, and $810 million in 2020. Management prefers to own the new capacity and believes it can lead to lower customer rates as well as Clean Power Plan compliance. A significant portion of the capital investment (transmission and environmental) is eligible for annual riders, which minimizes regulatory lag. Over the next five years, WR plans to invest over $1.2 billion on transmission rate base, or roughly $250 million per year. WR’s attractive wind resource, constructive regulation and transmission geography, make it an attractive takeover candidate.
April 13, 2016
Note: The views expressed in this Shareholder Commentary reflect those of the Portfolio Manager only through the end of the period stated in this Shareholder Commentary. The Portfolio Manager’s views are subject to change at any time based on market and other conditions. The information in this Portfolio Manager’s Shareholder Commentary represents the opinions of the individual Portfolio Manager and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. Views expressed are those of the Portfolio Manager and may differ from those of other portfolio managers or of the Firm as a whole. This Shareholder Commentary does not constitute an offer of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this Shareholder Commentary has been obtained from sources we believe to be reliable, but cannot be guaranteed.
