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After digesting tax reform, US utilities look forward to smoother ride in 2019


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After digesting tax reform, US utilities look forward to smoother ride in 2019

U.S. investor-owned electric utilities are expected to have a much smoother 2019, following a year in which financial uncertainty as a result of federal tax reform roiled the sector and prompted wariness on the part of Wall Street and rating agencies. Utility analysts in 2018 also kept a close watch on tumultuous events in California and South Carolina that raised questions about their political and regulatory environments.

"There is not a great abundance of big themes this year if you're not a California utility," John Bartlett, portfolio manager and electric utility analyst at Reaves Asset Management, said in a recent interview. "What I think Wall Street is expecting in the near term here is a number of folks to update their capital expenditure forecasts. But I don't think that there is really going to be a whole lot of surprises coming out over the course of the next year."

PG&E Corp. and Edison International, however, remain under a regulatory, political and legal microscope after another season of deadly wildfires in California. Concerns are rising that equipment owned and maintained by PG&E Corp. subsidiary Pacific Gas and Electric Co. could be linked to the deadliest wildfire in California history, while Edison International subsidiary Southern California Edison Co. also revealed transmission line problems shortly before major fires sparked in its service territory.

"We're conservative folks, so we're perfectly happy to be late to a lot of these companies. But Pacific Gas and Edison really have a tough political road ahead of them," Bartlett said. "The real question is not whether or not this is going to get solved, but really how violent the journey is going to wind up being. Because everybody's going to have to pay, probably."

South Carolina utility SCANA Corp. also rode through a turbulent year, but its financial outlook has greatly improved.

The Public Service Commission of South Carolina on Dec. 14 voted unanimously to approve the more than $14 billion merger between SCANA and Richmond, Va.-headquartered Dominion Energy Inc. SCANA stock closed up more than 6% at $50.98 on Dec. 14, as analysts expect the deal to close by year-end.

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Analysts do not expect a major ramp up in M&A in the new year.

"Consolidation is always going to be tough in utility world," Jay Rhame, portfolio manager and research analyst at Reaves Asset Management, told S&P Global Market Intelligence. "These things are really, really hard to get over the finish line."

Great Plains Energy Inc. and Westar Energy were able to complete their stock-for-stock merger of equals in June, about two years after their initial deal was announced and later rejected. The newly combined company, Evergy Inc., has indicated it expects to "burn through" cash and buy back up to 60 million shares by mid-2020 as part of a plan to rebalance its capital structure.

The outlook is not as bright for Avista Corp. after Washington regulators denied approval of Hydro One Ltd.'s acquisition of the Spokane, Wash.-headquartered natural gas and electric utility. The Washington Utilities and Transportation Commission raised concerns about Ontario Premier Doug Ford's decision to bring wholesale changes to the government-controlled utility's board and senior management. The commission said the developments "elevated the provincial government's political interests above the interests of other stakeholders."

Bartlett said the industry overall is "in great shape" on the M&A front and there is not really a "problem child" that seems like a ripe target.

"We had a problem child, it got snapped up quickly, with SCANA," Bartlett said. "The California situation is really too complicated for any third-party to kind of come in there at this point. So that's sort of the locus, if you will, of all the problems in the utility business."

While the value proposition of utility mergers is "very straightforward," Bartlett said the "economic proposition of going through the whole process of doing them is not as apparent."

Interest rates

Industry observers also do not see rising interest rates having the same impact on the utility sector as the lower corporate tax rate, despite the uneasiness in U.S. financial markets.

"It feels like interest rates are perhaps less of such a pressing issue ... because I think generally the market expectation for further rate increases is maybe a little bit but not as much as it was a year ago," Rhame said. "I think really the biggest near-term driver is how long this defensive trade continues to last. And then we'll see if the economy is OK and the market is OK. In the interim, the defensiveness is a pretty attractive place to be right now."

Moody's analyst Ryan Wobbrock made a similar distinction when it comes to the impact on credit quality.

"Because it has moved slowly and interest cost is a pass-through for regulated utilities, it's not an overwhelming negative at this point," Wobbrock told S&P Global Market Intelligence. "A rising cost structure is never a good thing, but it's not maybe risen to the level of driving outlooks."

Ratings outlook

Moody's in June downgraded its outlook on the regulated utilities sector to "negative," citing lower cash flows and higher debt levels from federal tax reform along with increased capital spending. The move came after Moody's in January lowered its ratings outlook to "negative" from "stable" for 24 regulated utilities and individual holding companies following the reduction in the corporate tax rate to 21% from 35%.

In November, the rating agency maintained a negative outlook on the regulated utility sector for 2019 "because of increasing debt to fund capital spending and dividends, as well as stalled cash flow growth as utilities continue to sort out the implementation of tax reform with state regulators."

These trends will keep the sector's ratio of consolidated funds from operations to debt down at about 15% in 2019.

"There's just more debt in the system now than there was before," Wobbrock said. "You tag on to that cash flow headwinds caused by tax reform and we're seeing metrics drop even further."

The Moody's analyst said he believes the financial ratio for the sector should improve after utilities fully absorb the near-term implications of tax reform.

S&P Global Ratings in November released its 2019 top industry trends to watch for in the U.S. regulated utility sector.

"Rating trends across regulated electric, gas, and water utilities in North America remain mostly stable, reflecting generally supportive regulatory oversight," S&P Global Ratings wrote.

The rating agency also pointed out that the sector's financial metrics "weakened in 2018 as a result of U.S. tax reform, robust capital spending, and flat to slightly negative load growth."

"We expect only modest financial improvement in 2019, reflecting somewhat improving margins partially offset by rising debt," S&P analysts wrote. "Margin improvement will reflect productivity improvements from technological investments, favorable fuel cost trends, and higher revenues from robust capital investments and acquisitions."

Fitch Ratings, meanwhile, said it sees "limited headroom at current rating levels" for U.S. regulated electric and gas utilities.

"Past transgressions of levered M&A or reluctance to issue equity to support capital expenditures came home to roost with the implications of tax reform," Fitch Ratings analyst Barbara Chapman said in November at the Edison Electric Institute Financial Conference. "Parent-level debt remains high and companies will have to remain vigilant to keep within rating categories: something we think companies are willing to do."

"In terms of key assumptions, we're really not expecting a different macro backdrop than what we've seen in the past year," Chapman added. "More of the same is good and it indicates stability. But it's never what we expect to do. It's what you don't expect."