From regulatory headwinds to industry consolidation, the risk inherent in utilities is greater than what many expect. Utilities have a mix of low betas, low multiples, and high dividend yields. However, this is the result largely of poor growth opportunities. With many of these companies trading high relative to free cash flow, value opportunities may also appear limited. That said, the multiples are well below historical levels in some instances and thus lend support to the bull thesis.
In this article, I will run you through my DCF model on PPL and then triangulate the result with a review of the fundamentals against Exelon (EXC) and Duke Energy (DUK). I find that all three of these companies have attractive upside despite the above-described limitations.
First, let's begin with an assumption about the top-line. PPL finished FY2011 with $12.7B in revenue, which represented a 49.5% gain off of the preceding year. Analysts model a 4.6% per annum growth rate over the next half decade or so.
Moving onto the cost-side of the equation, there are several highly-variable items we need to consider: operating expenses, capital expenditures, and taxes. I model OPEX hovering around 77% of revenue versus 18% for capex. Taxes are estimated at 27% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to et free cash flow. I estimate this figure hovering around the historical levels over the explicitly projected time period.
As it turns out, PPL is trading at roughly 14.6x my 2015 free cash flow estimate. This appears expensive, but there is still reason to be optimistic about the firm's prospects.
All of this falls within the context of risk mitigation:
Today we announced reported first quarter earnings of $0.93 per share, up from $0.82 in the first quarter of 2011. Earnings from ongoing operations for the quarter were $0.70 per share compared with $0.84 a share in the same period last year. Our first quarter earnings from ongoing operations reflect $0.14 per share of dilution from our April 2011 common stock issuance to finance our acquisition of the Midlands utilities in the U.K. As you can see in our segment results for the quarter, we had very strong performance in the U.K., including the successful integration of the Midlands operations. These quarterly results demonstrate the value of our expansion and into diversified regulatory jurisdictions and the attainment of a more predictable earnings profile.
From a multiples perspective, PPL is also overly cheap. It trades at a respective 10.1x and 11.4x past and forward earnings. To put this into perspective, consider that PPL's historical 5-year average PE multiple is 15.7x. Exelon trades at a respective 10.3x and 12.6x past and forward multiples versus 16.8x and 14.4x for Duke.
Consensus estimates for Exelon's EPS forecast that it will decline by 26.9% to $3.04 in 2012 and then grow by 0.7% and 7.2% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $3.02, the stock would hit $45.30 for 17.6% upside. This is highly attractive when you consider that the company offers a 5.8% dividend yield.
Consensus estimates for Duke's EPS forecast that it will decline by 2.7% to $1.42 in 2012, and then grow by 4.9% and 6.7% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $1.43, the stock would hit $22.88. The merger with Progress Energy (PGN) solidifies Duke's market share in the industry but the regulatory concessions have limited value creation. Despite a challenging business environment in 2011, Duke's performance still held its own.
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