PSEG: A Possible Rocky Transition to T&D

It has been a year since PSEG announced a strategic review to explore divesting its fossil fuel generating assets.  Since then, management has said that it is pleased with the interest shown by potential buyers in its 6,750+ MW portfolio of mostly natural gas-fired generating plants.  The move would complete PSEG’s transition to a regulated utility (with a fleet of carbon-free nuclear generating plants).

The move to exit the fossil fuel portfolio has been precipitated by a challenging merchant power market.  Profits for merchant power generators, including PSEG Power, have been squeezed by industry overcapacity (pressured by the growth in renewables) and slow growth in electricity demand.  Declining profitability prompted PSEG to seek assistance in 2019 from the state of New Jersey for its nuclear fleet.

In what was perhaps an unforeseen response, the Federal Energy Regulatory Commission adopted a minimum price offer rule (MOPR) that set a floor on the PSEG Power’s offer price in the recent capacity auction.  This probably contributed to the 25% decline in cleared capacity for PSEG Power in the recent auction.  Combined with the decline in average capacity price, Power will receive $240 million less in capacity revenues in the 2022/2023 generating year.

The decline in capacity pricing could conceivably complicate the sale of the fossil fuel assets.  Potential buyers may now want a lower price (even though the lower capacity revenues may only last a year).  Given the already depressed prices for merchant generating assets, PSEG may not accept a lower price.

Nevertheless, I anticipate that the sale will be completed.  My projections assume a sale price of $3.5 billion or just over $500,000 per MW and 9 times estimated 2020 EBITDA.  That would result in a pre-tax loss of $1 billion on the estimated $4.5 billion carrying value of those assets.

My financial model assumes that the sale will be completed on Jan. 1, 2022.  The loss of revenues and earnings by PSEG Power from the sale more than offsets the interest savings.  In addition, I assume that operating margins for PSEG Power’s remaining nuclear fleet will be lower as a result of reduced capacity revenues in the second half of the year.  I do not assume reinvestment of the net proceeds (after debt repayment) from the sale during 2022.  Consequently , my projections show that the PSEG’s (non-GAAP) operating earnings will decline from $3.41 in 2021 to $3.25 in 2022.

If the sale is not completed, my projections show 2022 (non-GAAP) operating earnings of $3.21, only slightly below the completed sale scenario.  I use the simplifying assumption that operating margins will be the same for PSEG Power whether or not the sale is completed.  Without the sale, PSEG’s year-end 2022 projected cash balances will be lower and its interest expense and debt levels will be higher.

If my estimates are correct, the recognition of the $1 billion loss on sale combined with the reduced earnings outlook could spark some downside volatility in PSEG’s share price in the second half of this year.  2022 is therefore setting up as a reset year for PSEG.  As the company continues to invest in regulated electric transmission and electric and gas infrastructure, growth in PSE&G’s revenues and profits should begin to offset the loss of earnings from the fossil fuel portfolio and PSEG should achieve modest growth in 2023 and beyond, as long as economic conditions remain favorable.

Despite the near-term downside risk, I am setting a neutral performance rating on PSEG’s shares with a price target of $60.  The ratings assume that the any near-term decline in price will be recovered within the next 6-12 months (or so), as investors begin to price in an expected return to modest revenues and earnings growth.

July 13, 2021

Please note that this is a summary of a report published on July 5, 2021. If you are interested in receiving a copy of the full report, please reach out to me.

Stephen P. Percoco
Lark Research
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