Florida Utilities: Reminds Me Of 'Jamming With Edward'

Summary

• Florida utilities are like 'Jamming with Edward' - each one is terrific as an individual but combined are quite a powerful investment selection.
• Florida is one of the top eight states for regulatory support of its utilities.
• Of the four investor-owned utilities in the state, three are rated 'A' or 'A-' for 10-yr consistency in earnings and dividend growth.

Utility investors' long-term performance is highly dependent on their service location. Most utility companies' performances are largely dependent on several vital factors including: the amount of regulated profit it can generate; underlying economic and population growth; ability of management to generate above-average returns for shareholders. Too few investors spend the time and effort to appreciate what I believe is the most important investment consideration: regulatory environment under which each utility operates.

At the top of my utility due diligence research list is a review of the regulatory environment controlling the profitability of firms in their state. The Edison Electric Institute EEI, an industry-focused organization, offers a very telling graph. The following outlines the quarterly average allowed return on equity ROE for US electric utilities. For example, in the 3rd quarter 2019, various states issued final rulings on 18 rate review requests. The average allowed ROE was set at 9.55%, down slightly from 9.58% in the 2nd quarter and about equal to rates approved during the 3rd quarter 2018.

Of significance is the downward slope of allowed returns over the past 30 years with the allowed ROE peaking in late 2000 at over an 12.6% return. The average quarterly ROE has been between 9.5% and 10.2% since 2nd quarter 2012 when it first broke below 10.0%. The saving grace for utilities in an era of declining allowed returns is an equally declining curve on the sector's weighted average cost of capital WACC. While the WACC varies by company, an "average" current range for utility WACC is between 5.2% and 6.2%.

With a declining trend in allowed ROE across the sector and a likelihood, the trend will continue, especially in light of still-falling interest rates, credit agencies review every state's regulatory posture to determine the level of financial support offered to the utilities under their jurisdiction. As the ultimate controller of utility's profitability and, hence, the utilities' ability to service their debt load, the capability to quantify the nuances of various state regulations becomes vital for the establishment of viable credit ratings.

Standard & Poor's has for decades provided an Assessment of Regulatory Environments. An explanation of the importance is in their description of the assessment:

Our view of these four pillars, regulatory stability, tariff-setting procedures and design, financial stability, regulatory independence and insulation, is the foundation of a utility's regulatory support. We then assess the utility's business strategy, in particular its regulatory strategy and its ability to manage the tariff setting process, to arrive at a final regulatory advantage assessment.

More information on the process and its importance can be found in a 2018 presentation by the National Association of Regulatory Utility Commissioners, pages 15-18. Especially revealing is the description of "challenging" state regulatory environments, including excessive delay in rate case resolution, legislative or executive branch interference with commission actions, and a penchant for prudence disallowances. The importance of regulatory environments impacts more than just the allowed rate of return, and influences decisions involving future capital investments, potential acquisitions, and strategic planning.

I have followed the work of Standard & Poor's for the past 15 years as they publish various editions of their Assessment of Regulatory Environments. Since 2006, there have been three major revisions in both the classifications and the states falling into each classification. Their most recent update is from S&P's Regulatory Research Associates and is offered as a slide in a presentation on the American Gas Association website: S&P Global Intelligence, Regulatory Research Associates RRA, Financial State of the Utility Industry, Mark Agnew, Edison Electric Institute, May 24, 2017.

If you do not think regulatory oversight and financial support is important, please review the most recent history of CenterPoint Energy (CNP). CNP owns Houston Electric, the electric utility for Houston TX, and a 53% interest in the midstream master limited partnership Enable (ENBL) which management formed through combining their natural gas gathering assets in the SCOOP/STACK. With the ongoing weakness in the MLP business, Texas PUC regulators voiced their desire for CNP to either sell this asset or to provide a financial ring around their interest to prevent negatively impacting the regulated electric distribution business. When management failed to satisfy the PUC request, the regulators not only reduced their allowed ROE but also reduced the percentage of equity used in the calculations - a double negative whammy for CNP. The credit agencies followed up rather quickly with downgrades and the CNP stock price declined from $26 to $17. The Texas regulatory environment is considered as Below Average.

In the most recent assessment, Florida is listed as one of 8 states with "Above Average" regulatory support. Florida has been one of the top states for regulatory support for at least the last 15 years. The investor-owned utilities serving the state include Florida Power & Light, Gulf Power - NextEra Energy (NEE); TECO and People's Gas of Florida - Emera Inc. (OTCPK:EMRAF); Progress Energy Florida - Duke Energy (DUK); Florida Public Utility - Chesapeake Utilities (CPK).

The map below outlines the various electric service areas by company:

The map below outlines the various natural gas service areas by company:

NextEra Energy services several parts of the state and recently purchased Gulf Power from Southern Company (SO). NEE services the largest slice of the population with 5.1 million customers, followed by Duke Energy at 1.7 million customers, non-publicly owned coops at 1.4 million, Emera at 1.1 million, and Chesapeake at 132,000. On a customer count basis, the state of Florida represents almost 100% of NEE customers, followed by Chesapeake at 53%, Emera at 46%, and Duke at 19%. By all accounts, Florida represents a substantial portion of these four utilities' overall regulated natural gas and electric exposure.

Since 2010, NextEra has earned an "A" rating for 10-year consistency in earnings and dividend growth by CFRA, two of the most important metrics for utility investors. Duke and Chesapeake are rated as A-, and Emera is considered as B+, or Average for the sector.

Why are these stocks like "Jamming with Edward"? "Jamming with Edward" is a fascinating musical collaboration between slide guitar aficionado Ry Cooder, studio pianist Nicky Hopkins (whose nickname is Edward), and 3/5s of the Rolling Stones (Mick Jagger, Charlie Watts, Bill Wyman). Recorded in 1969 during sessions leading up to the "Let It Bleed" album, "Jamming with Edward" was released in 1972 as one of the first offerings of the then-newly formed Rolling Stones Records label. Much like the four stocks above, each participant is an outstanding selection on their own, but in combination, the total becomes more formidable than each is individually. Within the construction of a diversified utility sector portfolio, inclusion of these stocks should provide exposure to one of the best eight states for regulatory oversight.

Part of the diversification task for utility investors is not only to establish positions in different utility types, such as water, electric, and natural gas but also to diversify in geography. Using the table above as a guide, finding utilities with "better" regulatory environments becomes fairly easy.

The importance of regulatory support will become very apparent over the next few quarters. Most utilities are currently suspending service terminations and letting customer's payments slide on their due date. Like other economic slumps, there will be a spike in write-offs of account receivables as being uncollectable. In previous downturns, regulators have allowed utilities to recoup these losses during future rate case reviews. For example, the Wall Street Journal reported the State of Michigan and others have suggested utilities closely track these delinquent bills, which will get worse as the billing cycles usually lag by a month or more, as to allow for easier account and reimbursement. Investors should not be surprised to find those utilities supervised by "Above Average" PUC commission will have better support for these recoveries than states listed as "Below Average".

Over the past few months, I have been buying preferred stocks in utility companies. Two that are of interest and dovetail with these four companies are NextEra Cumulative "Collared" Mandatory Convertible Preferred Series O (NEE-PrO) and Emera Reset Series C (EMA-C.CA) (OTCPK:ERRAF).

The NEE Series O is a preferred stock that will convert to shares of common stock on Sept 1, 2022. The conversion ratio is collared with a minimum and maximum conversion ratio, based on the share price of the common. The settlement rate will be 0.1785 common shares per preferred share if the then-current market price is equal to or greater than $280 and 0.2231 common shares per preferred share if the market price is equal to or less than $224. For market prices between those values, the settlement rate will be $50 (Par Value) divided by the market value. The current value of NEE is $230. The preferred pays a cumulative dividend of $2.43 a year for a current yield of 5.1% based on a trading price of $47.71. The dividend is non-qualified and has a par value of $50. The sweet spot for this issue is for NEE to trade between the collar of $224 and $280 in 27 months.

Canadian-based Emera offers an interesting Reset Preferred Series C. Popular north of the border, the reset feature means the dividend is reformulated on a predetermined basis. For the Series C, the reset is every 5 years at a rate equal to the sum of the then five-year Government of Canada bond yield plus 2.65%. The next reset date is Aug 15, 2023. During the last reset in 2018, the annual dividend was increased from C$1.02 (US$0.72) to C$1.18 (US$0.84). The quarterly distribution will remain constant for the next 40 months, at which point the distribution will be reset again. The par value is set at C$25 (US$17.72) and was originally designed to yield 4.1%. As a foreign dividend, it is considered as Qualified but carries the usual 15% Canadian dividend withholding tax that is recoverable through the Foreign Tax Credit when IRS taxes are filed by the investor. It should be noted the threshold of $600 in foreign dividend taxes paid before additional IRS paperwork is needed.

In a world of lower interest rates and negative sovereign rates in many countries, there is the fear that Canada could experience negative rates at the time of the next reset in 2023. The fear of negative rates has caused the current price to collapse to C$15.11 (US$11.15 price for ERRAF) and is offering a 7.5% yield. For the current price to reflect the initial 4.1% yield at the time of the 2023 reset, 5-yr Canadian sovereignty rates would be to be in the -0.5%, equal to the negative interest rate leader Germany. I bought a position expecting the 5-yr rates in Canada will be better than negative one-half of one percent in mid-2023. If rates are around those in 2018, or 2.0% to 2.5%, Series C share prices could rebound 30% and more. In addition, any weakening of the US Dollar against the Canadian Dollar improves both cash income and share prices for US investors. However, this is low liquidity stock with a few hundred shares trading per day in the US and 10,000 a day on the Toronto Exchange, so limit orders are strongly suggested.

Investors looking to add quality utilities in a state known for its support of the utilities under their jurisdiction should review these stocks.

Addendum: Unlike any other Stones album, "Jamming with Edward" is just as the title suggests: a jam session with free-flowing music, mixing a combination of slide guitar, bluesy piano, and a soulful harmonica. A relatively unknown recording, there are different versions of how it came to pass. The album producer claims Keith Richards stormed out of a "Let It Bleed" recording session, refusing to play with Ry Cooder as a supporting guitarist, leaving the other musicians to record the jam. Others have said Richards left the session to take a call from his girlfriend and Jagger is quoted as saying Richards could not get out of bed in time to make the session. While most of the album is in the Grateful Dead style of free-flowing musical jamming, the 1940 blues anthem "It Hurts Me Too", first recorded by Chicago bluesman Tampa Red, is an overlooked gem. The mix of Hopkins' piano, Cooder's slide guitar, and Jagger's harp rivals the recordings by Elmore James and Junior Wells. Enjoy the 5:14 video of "It Hurts Me Too".

Author's Note: I/we are long NEE.PrO, ERRAF, EMRAF, DUK, NEE, SO, CNP-PrB. Please review the disclosures found on my profile page.

Analyst’s Disclosure: I am/we are long NEE, EMRAF, ERRAF, DUK. 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.