Trend Watch After EPA Rules: Time to Rethink Utilities? (AEP, XLU, IDU, RYU, UPW, ETR, ITRI)

The utilities sector had been performing incredibly.  We recently highlighted the strong performance seen this year and over the last year with many of these names up 20% to 30% along with the allure of the high-yield dividends.  The problem is that the valuations on many names were getting high even if these are somewhat defensive for investors, and now the real costs of new Environmental Protection Agency rule proposals may further weigh on the sector.  There are caveats here, but at least some investors may start to reconsider their positions and we wanted to dig down to filter out the noise from the risks in the sector.

American Electric Power Co., Inc. (NYSE: AEP) has outlined the charges, the impact on jobs and prices, and more for the new EPA rules being proposed.  It is asking for relief, and what the company is giving for projections may only add pressure on the entire sector of utilities.  The ETFs include Utilities Select Sector SPDR (NYSE: XLU), iShares Dow Jones US Utilities (NYSE: IDU), Rydex S&P Equal Weight Utilities (NYSE: RYU).  Those three ETFs are all down 3% to 4% from their very recent highs.  The ProShares Ultra Utilities (NYSE: UPW) uses leverage, so it is down more from highs than peers with a drop of more than 5.5%; it is also up almost 50% from its year lows.

Entergy Corporation (NYSE: ETR) has been the dog of the utility and power generation sector.  At $67.60, its shares are down more than 16% from the peak and are only up about 4.5% from its 52-week low.  Thomson Reuters has a consensus price target of only $73.96.

American Electric Power Co., Inc. (NYSE: AEP) is down about 4% from its recent highs, but many peers are now down over 5% from highs and some of the weaker utilities are approaching the double-digit drop level now.  AEP outlined the billions of dollars that the plan will cost ahead.  Before wondering just how much they tacked on for a total cost, the skeptics need to look at a fresh report that recently came out from the Electric Power Research Institute just for a smart grid being some $500 billion. This will be a boom for companies like Itron, Inc. (NASDAQ: ITRI) for its smart meters, but the valuation has been high there and its shares have been challenging 52-week lows of late.

American Electric Power’s figures, pleads, and complaints comes to rather long list that we chopped down so you wouldn’t have to read a tome.  The notations about the new proposed EPA rules are as follows:

• AEP’s compliance plan would retire nearly 6,000 megawatts of coal-fired power generation;
• upgrade or install new advanced emissions reduction equipment on another 10,100 MW;
• refuel 1,070 MW of coal generation as 932 MW of natural gas capacity;
• build 1,220 MW of natural gas-fueled generation.
• The cost of the AEP compliance plan could range from $6 billion to $8 billion in capital investment through 2020.
• High demand for labor and materials due to a constrained compliance time frame could drive actual costs higher.
• Retirement and retrofit costs in the plan are in addition to more than $7.2 billion that AEP has invested since 1990 to cut emissions from its coal plants.
• AEP claims that annual emissions of nitrogen oxides from its plants are down 80% from 1990.
• AEP currently owns nearly 25,000 MW of coal-fueled generation, about 65% of its total generating capacity. Coal would still fuel about 57% of AEP’s total generating capacity by the end of the decade.
• “…the cumulative impacts of the EPA’s current regulatory path have been vastly underestimated, particularly in Midwest states dependent on coal to fuel their economies.”
• “…because of the unrealistic compliance timelines in the EPA proposals, we will have to prematurely shut down nearly 25 percent of our current coal-fueled generating capacity, cut hundreds of good power plant jobs, and invest billions of dollars in capital to retire, retrofit and replace coal-fueled power plants.”
• AEP says the sudden increase in electricity rates and impacts on state economies will be significant.
• While some jobs would be created, AEP expects a net loss of approximately 600 power plant jobs with annual wages totaling approximately $40 million under the proposed EPA rules.
• Businesses will face the impact of electricity price increases by 10% to over 35% just for compliance with these environmental rules.
• The proposed timelines for compliance aren’t adequate for construction of significant retrofits or replacement generation.
• AEP’s compliance plan alone would abruptly cut generation capacity in the Midwest by more than 5,400 MW. AEP plans to keep speaking with lawmakers (i.e. lobbying) in Washington about a legislative approach that would achieve the same long-term goals with lower economic and jobs toll.
• Plants to be permanently retired are as follows:

1. Glen Lyn Plant, Glen Lyn, Va. – 335 MW (retired by Dec. 31, 2014);
2. Kammer Plant, Moundsville, W.Va. – 630 MW (retired by Dec. 31, 2014);
3. Kanawha River Plant, Glasgow, W.Va. – 400 MW (retired by Dec. 31, 2014);
4. Phillip Sporn Plant, New Haven, W.Va. – 1,050 MW (450 MW expected to retire in 2011, 600 MW retired by Dec. 31, 2014); and
5. Picway Plant, Lockbourne, Ohio – 100 MW (retired by Dec. 31, 2014).

• AEP would retire generating units at the following locations but continue operating some generation at the sites:

1. Big Sandy Plant, Louisa, Ky. – Units 1 and 2 (1,078 MW) retired by Dec. 31, 2014;
2. Big Sandy Unit 1 would be rebuilt as a 640-MW natural gas plant by Dec. 31, 2015;
3. Clinch River Plant, Cleveland, Va. – Unit 3 (235 MW) retired by Dec. 31, 2014; Units 1 and 2 (470 MW total) would be refueled with natural gas with a capacity of 422 MW by Dec. 31, 2014;
4. Conesville Plant, Conesville, Ohio – Unit 3 (165 MW) retired by Dec. 31, 2012; Units 5 and 6 (800 MW total) would continue operating with retrofits;
5. Muskingum River Plant, Beverly, Ohio – Units 1-4 (840 MW) retired by Dec. 31, 2014; Muskingum River Unit 5 (600 MW) may be refueled with natural gas with a capacity of 510 MW by Dec. 31, 2014, depending on regulatory treatment in Ohio;
6. Tanners Creek Plant, Lawrenceburg, Ind. – Units 1, 2 and 3 (495 MW) retired by Dec. 31, 2014; Unit 4 (500 MW) would continue to operate with retrofits; and
7. Welsh Plant, Pittsburg, Texas – Unit 2 (528 MW) retired by Dec. 31, 2014; Units 1 and 3 (1,056 MW) would continue to operate with retrofits.

• AEP also said that it will complete construction of the Dresden Plant (580 MW natural gas) in Dresden, Ohio, in 2012 and, in addition to retrofits already noted, it would install or upgrade emissions reduction equipment at seven other coal-fueled power plants in Arkansas, Indiana, Louisiana, Ohio and Texas.

So, as you probably deduced… this matters.  Environmentalists and capitalists will argue over AEP’s claims and figures.  It doesn’t really matter.  This is now the new risk profile and is likely a new starting point.  Our take is that AEP is still one of our top stocks to own for the next decade.  We always maintained that these shares should be bought on a pullback rather than chased.  AEP shares are only about 3.8% off the 52-week highs.  If more weakness comes in on the shares, that is when long-term opportunists should really consider positions.  Analysts from Thomson Reuters show a consensus price target of $39.69 and the stock trades now at just under 12-times a blended forward earnings estimate.

With consolidation opportunities ahead in the world of adjacent utilities, we have scribbled out that the long-term opportunity for AEP could theoretically reach $5.00 in earnings per share over the next decade. Our own multiple is a fair 10-times earnings and that generates a raw price target of about $50.00 at some point, discounted two or three years out.  That gives a five-year to seven-year parameter, but remember that AEP pays almost a 5% dividend yield as well and it has a history of dividend hikes.

Today’s news is something we are merely looking at as a starting point rather than as gospel.  The risks are many, but the reality is that electric power demand is likely to only rise over the next decade.  AEP can navigate this storm, but the real impact that investors need to consider is more of a sector risk rather than just one company’s projection of $6 to $8 billion spent over the coming decade.

JON C. OGG