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Summary

  • Weak power prices, excess power supply will add pressure to FE’s margins and cash flows.
  • Uncertain outcome of JCP&L rate case remains an overhang on stock price.
  • The timing uncertainty of recovering the 2012 storm costs remains a risk for FE’s top and bottom line results.

The electric utility industry has been witnessing weak demand growth due to the adoption of energy efficiency measures and soft economic conditions. A drop in the Environmental Protection Agency's (EPA) required growth CAPEX in the near future is likely to slow down earnings growth of regulated utilities. On the unregulated front, weak commodity and forward prices remain a concern for earnings growth. FirstEnergy (NYSE:FE) is among the utility companies, which have both unregulated and regulated business operations. In the recent past, the company has been experiencing difficulties in both regulated and unregulated business operations, which have taken a toll on the share price, and FE underperformed the utility industry; in the last one year, FE has witnessed a 25% drop in its share price.

I remain bearish on FE, as the company continues to face difficult business conditions in its unregulated segment due to weak commodity and forward prices. Weakness in unregulated business operations is likely to keep the company's cash flows under pressure. Also, the outcome of the ongoing JCP&L rate case is uncertain, which remains an overhang on the stock price.

Financial performance
The company reported mixed financial performance for 4Q2013. FE reported total revenues of $3.64 billion for the recent fourth quarter, up 4% year-on-year, missing consensus estimates by 25%. EPS for the fourth quarter came in at $0.75, better than consensus estimates of $0.68, down 6.2% year-on-year. The company's regulated distribution earnings decreased by $0.06 to $0.47 in 4Q2013, mainly due to an increase in operating costs and higher taxes. FE's competitive energy earnings dropped by $0.05 to $0.21, indicating higher operating costs and lower commodity margins. I believe the company is likely to experience pressures on its margins and unregulated segment's earnings due to weaknesses in commodity and power prices.

The company reiterated its full year 2014 guidance. FE expects its operating EPS to be in a range of $2.45-$2.85, as compared to $3.04 per share for the last year, 2013. The company also introduced an operating earnings guidance of $0.35-$0.45 per share for 1Q2014. The 1Q2014 earnings guidance remains slightly weak, as analysts are anticipating earnings of $0.60 per share for the quarter.

Unregulated operations remain a concern
As the company has significant exposure to unregulated business operations, the weaknesses in commodity and forward prices do not portend well for the stock price. In 2013, forward power prices in the PJM region dropped sharply as a result of lower commodity prices and excess supply. In the recent fourth quarter, the company observed a 7% quarter-on-quarter drop in liquidity mainly due to difficult unregulated business conditions. Also, the weak forward power prices have forced the company to cut its dividends. Last month, FE cut its annual dividends by 35% from $2.2 per share to $1.44 per share in order to sustain its credit rating and preserve cash flows in the difficult unregulated business conditions. In my opinion, forward power prices in the PJM region are not expected to improve considerably in 2014, as power prices are in backwardation, where 2017 prices are below the prices of 2014, and the market remains oversupplied.

Storm costs recovery
The company recently disclosed that JCP&L reached an agreement with the New Jersey Commission regarding storm cost recovery. The agreement allows the company to recover $736 million out of the $744 million total storm costs incurred in 2011 and 2012. The recoverable $736 million includes $329 million of deferred expenses and $407 million of costs incurred. The timing of the cost recovery remains uncertain. The storm costs incurred in 2011 are expected to be recovered through the current general rate case increase; however, the recovery timings of the 2012 storm costs remain unknown. The timing uncertainty of the 2012 storm costs recovery remains a risk for the company's top and bottom line results.

Conclusion
Due to excess power supply and weak forward power prices, I believe the current tough business conditions will prevail in the company's unregulated segment, which will add pressures to FE's margins and cash flows. Also, the timing uncertainty regarding the recovery of 2012 storm costs add to the company's risk profile. Due to the above-mentioned factors, I believe the stock has a limited upside price potential and I am bearish on FE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Limited Upside Potential Key In Bearish Stance On FirstEnergy