PPL Corp (NYSE:PPL) ($27.48) is an unusual diversified utility to recommend for purchase. With earnings expected to decline from a peak in 2010 of $3.13 to a trough in 2013 of $2.45, it would seem there could be better choices elsewhere in the utility sector. However, with its 5.1% dividend yield, further expansion into regulated markets, and a potential for a turnaround in its merchant power business, PPL may offer Total Stock Returns (TSR) in line with its competitors. One of the reasons for its declining EPS estimates is the conversion of its 9.5% Mandatory Preferred Equity Units and its 8.75% Mandatory Convertible Preferred shares.
PPL is an energy and utility holding company that generates electricity from power plants in the northeastern and western U.S., markets wholesale or retail energy primarily in the northeastern and western portions of the U.S. and delivers electricity to approximately 4 million customers in Pennsylvania and the U.K. PPL owns some 10,750MW of unregulated nuclear, coal, gas and hydro generation assets in Pennsylvania and Montana.
PPL is moving to a more regulated footprint with its recent acquisition of utilities in Kentucky and the UK. Added to its historic Pennsylvania regulated business, over the next few years PPL is expected to generate about 70% to 80% of its earnings from regulated operations. As with many merchant power companies taking on higher exposure to the regulated side of their business, this move will create steadier returns and more stable cash flows. However, the transformation will come with the price of more subdued share price returns.
Currently, PPL is valued at the lower end of the scale for diversified utilities with a 2011 PE ration of 10.4, a anticipated 2012 PE ratio of 10.9 and an anticipated 2013 PE ratio of 11.3 versus an industry average of 12.4, 13.4, and 12.7 respectively. This implies a valuation discount to its competitors of at least 12%. The current dividend yield is also richer at 5.1% versus an industry average of 4.3%.
The low valuation is based on investor uncertainty concerning the regulatory environment in the U.K., substantial investments required to meet emission standards of around $2.5 bil, pending pass-through ruling in Pennsylvania, exposure to the current weak merchant power markets, and dilution from mandatory conversions of preferred stock issues in 2013 and 2014. In addition, there is a roll-off of higher merchant power contracts in 2012-2014 that are being replaced with lower current hedge market prices.
Management is looking to generate a 9.0% return on investment for its regulated business, a bit aggressive compared to an industry average of around 7.0%. Based on the focus of capital expenditure upgrades for environmental compliance being recoverable in future Kentucky rate requests and grid updates in Pennsylvania, management believe their more aggressive anticipated return is feasible. In addition, while the 2011 to 2013 East Coast merchant power market is anticipated to be weak, most analysts look for a rebound in commodity electric pricing to improve in the 2014 to 2015 timeframe. However, net margins have been higher than industry peers at 12.1% versus 9.4% for its peers.
The value of PPL is estimated at $31 to $32 per share based on the Sum of the Parts calculations. If PPL were to trade up to this level over the next three years, annual TSR could be in the 10% range. This is in line with most electric utility return expectations.
An interesting play on PPL could be either of their mandatory convertible preferred issues. The 9.5% issue uses the symbol PPL-PU and the 8.75% issue uses the symbol PPL-PW. The current yield of PPL-PU is 8.5% and the current yield of PPL-PW is 8.2%, based on market prices of $55.73 and $53.27, respectively.
The 9.5% issue is a bit more complicated than its 8.75% sliding convertible issue. Half of the distribution of the 9.5% issue is considered interest and half qualified dividends. An explanation of the 9.5% issue from QuantumOnLine.com:
“PPL Corp., 9.50% Equity Units, stated amount $50 per unit, initially consisting of Corporate Units which include a stock purchase contract and a 1/20th or 5% interest in a 4.625% junior subordinated note with a principal amount of $1000. The stock purchase contract requires the holder to purchase for $50 a variable number of shares of PPL Corp. common stock no later than 7/1/2013 and pays a contract adjustment rate of 4.875% per annum. The stock purchase settlement rate will be 1.7361 shares per unit if the then current market price is equal to or greater than $28.80 and 2.0833 shares per unit if the market price is equal to or less than $24.00. For market prices between those values the settlement rate will be $50 divided by the market value. Prior to the IPO of this security, the last reported sale price of the common stock on 6/18/2010 was $26.06 per share. The note is due 7/1/2018 and is subject to reset and remarketing in two tranches between 3/28/2013 and 6/13/2013 (see the prospectus for further information).”
A simpler preferred investment is the 8.75% issue where the mandatory conversion date is in 2014 and the conversion varies from 1.97 shares at a common price of $25.30 to 1.60 shares at a common price of $31.
For utility investors looking for steady income, the 8.75% preferred issue should be a good investment without giving up much upside to the TSR of the common until 2014.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.