Public Service Enterprise Group (PSEG) is a public utility holding company whose principal direct operating subsidiaries include Public Service Electric & Gas (PSE&G), which serves 2.2 million electric customers and 1.8 million gas customers along a northeast to southwest swath of the state of New Jersey. PSEG Power LLC (Power) is merchant power producer and wholesale marketer of electricity and natural gas.
The operating environment for electric utilities and merchant power producers has changed in recent years, in large part due to the deregulation of the power generation business. Low natural gas prices and steady increases in gas-fired power generating capacity (mostly from merchant generators) have put steady downward pressure on wholesale power prices. Mild weather during the key heating and cooling seasons and sluggish economic growth have kept a lid on electricity demand. Power producers, like PSEG Power, with a higher mix of older coal- and natural gas-fired plants have especially felt the heat.
Infrastructure Upgrade Programs. The tough operating environment has sliced operating margins for power producers, but it has also helped to lower retail prices. This has provided cover for utilities to initiate (and regulators to approve) multi-year infrastructure upgrade programs, most of which allow utilities to begin recovering costs immediately before filing rate cases with state regulators.
The New Jersey Board of Public Utilities (NJPBU) approved nine of PSE&G’s infrastructure, solar and energy efficiency programs (including extensions) in the aftermath of the 2008 financial crisis. The solar programs are designed to encourage the development of solar power systems within PSE&G’s operating territory. So far, 210 MW out of a total approved 300 MW have been installed.
Superstorm Sandy was the catalyst for two other major programs, Energy Strong and Gas System Modernization, which are intended to make PSE&Gs electric and gas distribution systems more resilient.
Since these infrastructure upgrade programs were initiated, customers have seen no increase in the average monthly bills because program costs were more than offset by the decline in electricity and natural gas (volumetric) supply prices. State regulators have also supported these programs because they increase system reliability and provide a boost to local economies.
Besides these infrastructure upgrade programs, PSEG has also benefited from transmission investments, mandated under PJM’s Regional Transmission Expansion Plan (RTEP). PSE&G will spend $6 billion over the next five years on major and minor transmission line upgrades within its operating territory. When these are completed, its transmission spending will shift more towards system maintenance. The cost of upgrades is incorporated into rates charged to power producers who utilize the transmission system to deliver electricity to their wholesale and retail customers.
PUBLIC SERVICE ELECTRIC & GAS (PSE&G)
Strength in the Utility. PSE&G has delivered strong results in recent years. Since 2012, it has grown its net income at an average annual compounded rate of 10.2%, despite a 0.4% average annual decline in its electric load. Gas volumes have increased by 0.7% annually since 2012, in large part due to fuel switching by customers.
With the multi-year decreases in electric load and price of natural gas and the steady expansion of natural gas-fired electric generating capacity, retail prices for both electricity and natural gas have declined in both nominal and real terms. A typical PSE&G residential customer now pays $1,251 per year for electricity, down from $1,322 in 2009, and $861 per year for natural gas, down from $1,593 in 2009. As noted above, this has provided cover for PSE&G to ramp up its spending on infrastructure improvements. Under the agreements reach with the NJBPU, PSE&G has been able to begin recouping its costs and earning a return on these investments immediately, which has contributed to its strong bottom line performance.
2016 Results for PSE&G. Operating revenues declined $415 million or 6.25% to $6.22 billion. Gains in transmission revenues were more than offset by a big drop in “clause” revenues (mostly from the final payments that PSE&G received for splitting off PSEG Power in 1999) and also from slightly lower electricity and gas revenues.
Operating expenses, however, declined at a faster rate, by 11% to $4.61 billion, in part due to a sharp (and unexplained) drop in the amortization of regulatory assets. Thus, PSE&G’s net income jumped 13% to $889 million or $1.75 per PSEG share. PSE&G’s non-GAAP earnings equaled GAAP earnings in 2016.
I have two concerns about PSE&G’s recent financial performance. First, the gap between its pretax income as reported in its financial statements and that reported for tax purposes has widened in recent years, especially in 2016. (However, much of this may be due to the current accelerated depreciation provisions of the federal tax code.) In addition, PSEG has injected equity capital into PSE&G in three of the past four years in order to maintain the utility’s strong capital position and balance sheet. PSE&G has not paid a dividend to PSEG since 2011.
PSE&G’s Projected 2017 Performance. Management forecasts PSE&G’s 2017 net income to be between $945 million and $985 million or $1.86 to $1.94 per PSEG share. Using that as a guideline, I project that PSE&G’s revenues will be $6.5 billion, up 4.5% and net income will be $970 million or $1.91 per share, up 9.1%.
PSE&G will file a distribution rate case with the NJBPU by November 1. Among other things, it will seek to update its rate design and components of its return on capital and cost reimbursement formulas. It expects that new electric and gas rates will be effective in late 2018 or early 2019.
PSE&G’s Capital Spending Program. PSE&G anticipates 2017 capital spending of $3.4 billion, up from $2.8 billion in 2016. Most of the increase is due to a doubling of baseline spending on its electric and gas distribution systems to $1.2 billion. Another $0.5 billion is earmarked for the Energy Strong and Gas System Modernization Programs. All of this is part of the utility’s 5-year, $6 billion effort to upgrade or replace aging electric and gas distribution infrastructure.
PSE&G will also spend $1.6 billion on transmission system upgrades in 2016, which is about equal to last year’s spending. The remaining $90 million in its 2017 capital budget will be targeted toward solar and energy efficiency projects.
With this level of capital spending, PSE&G expects to continue to grow its rate base by 7%-9% for the foreseeable future. Growth in rate base is obviously important because it drives revenue, profits and investment returns. However, there are many different components to and factors that affect PSE&G’s revenues. I have yet to find any correlation between rate base and revenue growth.
PSE&G’s Operating and Financial Strategy. PSE&G has sought to compensate for the slow, steady decline in load growth by expanding its transmission business, upgrading its distribution infrastructure and promoting energy efficiency and solar power projects. The strategy has resulted in solid, double-digit increases in its net income since the end of the recession in 2009.
The utility promises more of the same going forward. It has received approvals for extensions of its distribution infrastructure upgrade and energy efficiency programs from the NJBPU and for its transmission upgrade projects from the Federal Energy Regulatory Commission (FERC). Although it anticipates reductions in capital spending of $800 million in each of 2018 and 2019 from the 2017 base budget of $3.4 billion, management has a record of finding additional investment opportunities. So PSE&G’s capital spending could very well remain elevated in 2018 and beyond, as long as there is no adverse change in the economic environment.
Yet, it would truly be surprising if interest rates, retail electricity prices and retail natural gas prices remain this low for the foreseeable future. If all three do move higher, customer bills will go up and PSE&G will probably begin to get pushback on future projects from regulators as they become increasingly concerned about adding to the financial burdens of New Jersey taxpayers.
As long as the adjustment process is gradual, PSE&G may be able to scale down its capital spending without disrupting its business. With capital spending now more than twice the utility’s annual operating and maintenance costs; a significant portion of that capital spending must go toward paying the direct and indirect costs associated with employees who plan and implement these projects (and not just to outside contractors and equipment suppliers). It remains to be seen, therefore, whether PSE&G can reduce its capital spending without increasing its operating costs. If it can, then PSE&G will should begin to throw off cash that can be paid regularly as a dividend to the holding company.
PSEG POWER, LLC (POWER)
PSEG’s merchant power subsidiary owns 11,681 MW in power plants having a total capacity of 16,844 MW. The plants are located in Connecticut, New York, New Jersey and Pennsylvania and serve three regional transmission organizations: PJM. New York-ISO and New England ISO. More than half of its annual output comes from its stakes in three nuclear facilities: Hope Creek (1,176 MW, 100% owned) and Salem (2,290 MW, 57%), both of which are located in Salem County, NJ, and Peach Bottom (1,251 MW, 50%), located in Delta, PA. Power also has a 23% stake in two large coal-fired units, Conemaugh and Keystone, each with 1,711 MW of capacity, located in Pennsylvania. The rest of its fleet consists of a variety of a variety of natural gas-fired, coal-fired and dual fuel (gas/oil and coal/oil) power plants, most of which are located in New Jersey.
Weakness in Merchant Power. A decade ago, PSEG’s fleet of merchant power plants was positioned well to meet the needs of its service territories. The fleet had operating scale and a favorable carbon footprint, even with coal-fired units that accounted for 25% of its total output.
Since then, however, the price of natural gas has fallen sharply and Power’s fleet has lost much of its competitive advantage to newer, natural gas-fired plants that produce electricity more efficiently at lower heat rates. Renewables have also captured a meaningful slide of demand. As a result, Power’s smaller, less efficient load-following coal-fired units and natural-gas peaking fired units are now called into service much less often. With forward wholesale power prices still bouncing along the bottom, management recently announced that Power’s nuclear plants, which generate more than half of Power’s annual electricity output, may not earn their cost of capital when existing hedges roll off over the next two years.
2016 Results for PSEG Power. The competitive pressures faced by Power are reflected in its 2016 financial performance. Power’s revenues declined 18.4% or $905 million to $4.02 billion and its net income fell from $856 million to $18 million.
About two-thirds of the revenue decline was due to lower generation revenues, driven by a negative swing in mark-to-market adjustments on hedging positions, milder weather, lower sales prices and lower capacity payments (due to peaking plant retirements). The rest was due to lower revenues from supplying natural gas to industrial and commercial customers (which was also driven by milder weather and lower natural gas prices).
Despite the decline in revenues, Power’s 2016 operating expenses increased by about $500 million to $4.0 billion primarily because of the absence of two unusual benefits that had lowered 2015 operating expenses (i.e. gains on financial transmission rights and insurance recoveries from Superstorm Sandy). Power also recorded additional costs (including higher depreciation) associated with the planned closure of its Hudson and Mercer coal-fired power plants.
Adjusting for certain unusual items, such as the mark-to-market adjustments and coal plant retirements, Power’s non-GAAP (after-tax) operating income was $514 million or $1.04 per share, down from $653 million or $1.29 per share in 2015. Thus, the drop in Power’s non-GAAP operating earnings was not nearly as steel as the decline in its GAAP earnings.
Power’s Projected 2017 Performance. Based upon management’s guidance, Power is expected to deliver non-GAAP earnings of $435 million to $510 million or $0.86-$1.00 per PSEG share in 2017. My projections, which are exactly in the middle of that range, anticipate operating earnings of $0.93 per share. I also expect that Power’s revenues will be flat at $4.0 billion. Thus, Power’s (non-GAAP) earnings are expected to be down again in 2017.
My projections assume that there will be no major unusual items, such as additional plant closures, and a lower level of non-business-related mark-to-market adjustments in 2017. With those assumptions, I project that Power’s 2017 GAAP earnings will rebound to $523 million and $1.04 per share from $18 million and $0.04 in 2016.
Power’s Capital Spending Plans. Power’s 2017 capital spending budget is $1.2 billion, which is down 10% from $1.34 billion in 2016. The bulk of 2017 spending, $825 million, is earmarked for the continuing construction of three new natural gas-fired power plants at Bridgeport Harbor CT, Sewaren NJ and Prince George’s County MD. The Bridgeport and Sewaren units will replace an existing load following coal unit and gas-fired peaking units at those locations. Besides new construction, Power’s capital budget includes $190 million of maintenance capex, $130 million for new solar facilities and $60 million of environmental and regulatory spending and nuclear upgrades.
Management anticipates that Power’s total capital spending will fall to $670 million in 2018 (with $405 million earmarked for new power plant construction). Both the Sewaren plant and Keys Energy Center in Prince George’s County are scheduled to be completed in mid-2018. Power’s capital budget drops further to $370 million in 2019, with the scheduled completion of the Bridgeport Harbor plant at mid-year. More than half of the 2019 capital budget has been allocated to maintenance expenditures.
Power’s annual capital budget could then drop below $300 million in 2020 and beyond; unless management finds new growth opportunities.
Power’s Operating and Financial Strategy. With the addition of new, efficient natural-fired plants to the fleet, management expects that Power’s competitive position and financial performance will improve. It believes that it will be able to increase its generation and sales volume from a projected 51 Terawatt hours (TWh) in 2016 to 61 TWh in 2021 without any net increase in the capacity of its fleet.
While Power’s performance depends upon the fleet’s ability to turn a profit, management has other levers, including its hedging strategy, trading in electricity and natural gas physical and futures markets, development of new solar plants and others, that can help compensate for the pressure on fleet profitability. Power’s fleet also benefits from stable capacity payments, which it receives from the regional transmission organizations (PJM, New York ISO and New England ISO), for pledging the availability of its fleet to deliver power as required to ensure the reliability of the power grid. Power is also entering the retail electricity market to develop direct relationships with end-users.
Power has traditionally paid large annual dividends to the holding company; but its dividend payments have decreased sharply in recent years. In 2016, Power paid $250 million in dividends, down from $400 million in 2015 and about $900 million in 2014. If Power’s profitability improves after 2017, as management hopes, and capital spending declines, Power will generate more free cash flow, which would allow it to increase its dividend to PSEG.
Improving the competitive position and financial performance of its generating fleet is a top priority. A stronger competitive position will ensure that its plants will operate at higher capacity factors, which should serve to improve operating margins.
Yet, it may not be easy for Power to achieve significant improvement in its operating margins until there is a better balance between supply and demand in the power market. A significant amount of older and less efficient capacity probably still needs to be retired in order for power producers to see a meaningful improvement in spark spreads (i.e. the difference between electricity revenue and fuel costs).
Low interest rates make it easier for other power producers with sufficient financial capacity to seek to improve their competitive positions in the same way as PSEG by building new efficient plants. This could conceivably keep downward pressure on power prices and delay a meaningful improvement in the balance between power supply and demand.
A quick scan of EIA data shows planned capacity additions of 1,700 MW for New Jersey (including PSEG Power’s 540 MW Sewaren project), 3,873 MW for Maryland (including Power’s 755 MW Keys Energy Center) and 881 MW for Connecticut (not including Power’s 485 MW Bridgeport Harbor project). Many of these projects are still seeking regulatory approvals, so construction on them is not yet underway. A large number of natural gas-fired plants are also on the drawing boards in and around the Marcellus shale region.
The downward pressure on power prices is also being felt by nuclear plant owners, like PSEG Power. As noted above, management has recently said that its nuclear fleet will not be earning its cost of capital when current hedges roll off over the next couple of years, if forward rates for power remain at current levels. PSEG is therefore seeking to work with both regulators and New Jersey legislators to develop a workable long-term solution.
The closure of PSEG’s nuclear plants would make it nearly impossible for the state to meet its carbon emission goals. It could also conceivably reduce the reliability of New Jersey’s electricity supply. Legislation has been proposed to direct the NJBPU to study whether subsidies in the form of zero emission credits might be a viable solution to this problem; but, unsurprisingly, this legislation is opposed by the Electric Power Supply Association, which supports a level playing field for all electricity providers.
PUBLIC SERVICE ENTERPRISE GROUP (PSEG)
2016 Results for PSEG. The growth in PSE&G’s earnings and the decline at Power combined to produce a sharp drop in PSEG’s GAAP earnings in 2016, but flat non-GAAP earnings. Overall, PSEG’s net income fell from $1.68 billion and $3.31 per share in 2015 to $889 million and $1.75 per share in 2016. Non-GAAP EPS was essentially flat ($2.91 in 2015 vs. $2.90 in 2016).
While the consolidated company was profitable in 2016, PSEG’s cash performance showed further weakness (extending and accelerating a recent trend). The company’s cash flow after operating and investing activities (excluding changes in available-for-sale investment securities) turned sharply negative in 2016. Meanwhile, PSEG’s debt-to-total capitalization rose from 43.2% to 47.3%, as its total debt increased from $8.17 billion in 2015 to $8.87 billion in 2016.
PSEG’s Projected 2017 Performance. Based upon management’s guidance, PSEG forecasts non-GAAP EPS of $2.80-$3.00 in 2017. Roughly 66% of that total, or $1.85-$1.98, is expected to come from PSE&G and 32% or $0.90-$0.96 from Power. The remaining $0.05-$0.06 has been allocated to PSEG Energy Holdings, which invests primarily in energy-related leveraged leases.
PSEG’s Capital Spending Plans. PSEG projects total capital expenditures of $4.66 billion in 2017, up from $4.2 billion in 2016. PSE&G’s capital budget is $3.4 billion; while Power’s is $1.2 billion. Capital spending is expected to decline in 2018 and beyond. However, PSE&G could identify new project opportunities, which could keep spending elevated. Power’s capital spending should decline in 2018 and 2019, as its three new power plants are completed, unless it too identifies new investment opportunities.
PSEG’s Operating and Financial Strategy. With the expected increase in capital spending and flat earnings performance, my projections suggest that PSEG’s consolidated debt will increase by another $1.8 billion in 2017, provided that it receives a tax refund similar to 2016’s. If so, its debt-to-total capitalization would increase to 49.6%, according to my estimates.
That would still leave PSEG with a fairly strong balance sheet, but the company’s leverage would continue to trend higher. The company borrowed nearly $1.9 billion in 2016 to cover its cash flow shortfall (after capital spending) and the entire dividend payment. According to my projections, it will likely have to do the same in 2017. PSEG obviously cannot borrow to cover a $1.7 billion annual cash deficit indefinitely. Consequently, I was surprised that its Board of Directors authorized a 4.9% increase in the annual dividend (from $1.64 to $1.72) for 2017.
Nevertheless, management speaks confidently about PSEG’s ability to navigate the current rough patch. It expects high single-digit rate base growth for the foreseeable future at PSE&G. It also predicts that Power will generate significant free cash flow after the three new gas-fired power plants are placed into service in 2018 and 2019.
Management asserts that PSEG has the financial strength to support current and future capital spending without the need to issue additional equity. It also claims that growth in the company’s dividend is sustainable.
Confidence is important, but management has so far offered little tangible evidence to support its assertions. It has not addressed directly the deterioration in the company’s cash flow performance or trend of increasing leverage. Furthermore, it has not offered specific cash flow or balance sheet targets; nor has it offered even a preliminary indication of its earnings expectations beyond 2017, which I think is warranted under the circumstances.
Based upon my analysis, I see the company’s financial performance over the next two years as critical to its longer-term outlook. I am more concerned about the sustainability of the $1.72 annual dividend than with PSEG’s ability to grow the dividend or earnings over the next few years. Earnings of $2.90 per share are sufficient to support a $1.72 dividend, as long as the company’s rate of free cash flow conversion is roughly in line with its earnings.
Stock Price Performance and Valuation. PSEG’s stock (NYSE:PEG) underperformed the Dow Jones Utility Average, of which it is a member, in 2016 and so far in 2017. In 2016, PEG rose 13.4% in price (with a 17.8% total return), slightly below the DJUA’s 14.2% gain (and 18.2% total return). So far in 2017, PEG is up 1.4% in price (2.4% total return), but its underperformance gap with the DJUA has widened, with DJUA up 6.6% in price and 7.5% on a total return basis. Given the concerns that I have noted about its 2016 financial performance, I am not surprised that the stock has underperformed so far this year.
PEG has a dividend yield of 3.8% and a forward (2017) P/E multiple of 15.2. The compares with an average dividend yield of 3.5% and forward P/E of 17.9 for DJUA constituents. Given the make-up of the DJUA, both relative yield and P/E multiples seem to correlate well with the market’s performance expectations for individual companies. In PSEG’s case, the discounts suggest greater than average concern about its ability to achieve (and sustain) its forward earnings guidance. Of course, that discount also suggests that PEG has better than average upside potential, if PSEG can address its current business challenges successfully.
March 29, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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