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Goldman Sachs upgrades FirstEnergy, Pinnacle West; PPL downgraded to 'sell'

Goldman Sachs, which has indicated it remains neutral on electric utilities for the first half of 2017, raised FirstEnergy Corp. and Pinnacle West Capital Corp. to "neutral" from "sell" and downgraded PPL Corp.

The brokerage also raised its EPS estimates and increased the price target for FirstEnergy to $34 from $29.

Goldman Sachs, which downgraded FirstEnergy to "sell" in July 2016 based on "greater-than-expected headwinds" at its nonregulated segment, said the upgrade is tied to cost savings and increased regulated distribution revenues expected in 2017, improved valuation and share price underperformance. FirstEnergy's stock has lagged the utility sector index by 8% and the S&P 500 by 20% since the July 26, 2016, downgrade, the brokerage noted in a Jan. 16 research report.

"[FirstEnergy] lagged peers partially on concerns about its leveraged non-regulated segment and partially on the potential EPS drag of lower corporate income taxes given discussion by the president elect," analysts wrote.

"Our new estimates come in above consensus as we expect slower earning declines at the competitive segment coupled with stronger growth in the near-term for the regulated segments; however, we find limited longer-term regulated growth as [FirstEnergy] settled on several rate case stay out agreements," the analysts added.

Goldman Sachs said FirstEnergy's plans to transform its business and eliminate merchant exposure could lead to further upside.

"We value [FirstEnergy] on a sum-of-the-parts basis, valuing the regulated utility and holding company separately from the company's non-regulated segment," analysts wrote. "Efforts by [FirstEnergy] to divest or separate the non-regulated business ... could present potential valuation upside, although our sum of the parts assumes this segment remains a drag."

Goldman Sachs added that FirstEnergy likely still needs about $500 million to $600 million of equity from 2017 to 2019 to fund regulated growth and pension liabilities, as well as to control its high leverage levels.

On Pinnacle West, Goldman Sachs said improving free cash flow and reduced regulatory risk are factors in the upgrade.

Goldman Sachs said the "path appears more clear for a rate case settlement" in Pinnacle West subsidiary Arizona Public Service Co.'s ongoing electric rate case.

"As a result, we no longer see the rate case process as an overhang and per historical precedent, settlements of rate cases in Arizona often occur after all testimony gets filed which could be a potential positive for PNW's shares should this occur," analysts wrote.

Goldman Sachs also increased its 12-month target price for Pinnacle West stock to $74 from $71. Analysts said they now see an almost 6% EPS growth rate for Pinnacle West from 2016 to 2020, which is above peer averages of 4% to 5% through 2019.

In downgrading PPL to "sell" from "neutral," Goldman Sachs pointed to lower EPS estimates tied partially to foreign currency headwinds and limited capital allocation upside. The brokerage lowered its price target on PPL shares to $33 from $34.

"PPL remains a well-managed company with a strong history of managing costs, but macro issues may outweigh the micro," analysts wrote.

In addition, Goldman Sachs noted that PPL's shares have underperformed the utility sector index by 9% since Brexit. The brokerage said it expects foreign currency "to continue to pressure earnings going forward" for potentially another six to 12 months.

PPL has revised its foreign currency hedging strategy to mitigate exposure to the declining foreign exchange rate and historic lows in the British pound following Britain's June 2016 vote to leave the European Union. PPL's electric distribution networks in the U.K. serve 7.8 million customers.