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Sector Themes Heading into the Second Half of 2019

by on September 5, 2019

If there was ever a time for a break on Wall Street, August would be the time. Once Labor Day passes, investors dial back in and turn their attention toward company updates. Intensity increases in the months leading up to the industry’s EEI Financial Conference in November where AEP will release details on 2020 earnings targets, updated capital forecast plans and other financial indicators. This Street Wise edition summarizes current sector themes commanding investor attention for the second half of 2019, including economic uncertainty in addition to the impact of lower interest rates on pending rate cases.

Economic Uncertainty and the U.S.-China Trade War

When the economy slows and uncertainty presents itself, defensive stocks such as utilities appeal to investors.

According to Neil Kalton of Wells Fargo Equity Research, “The utility sector continues to benefit from low interest rates and economic uncertainty. The utility sector keeps chugging along boosted by declining long-term interest rates (good for valuations) and strengthening fundamentals (healthy capital expenditure visibility plus improving regulatory compacts). The sector looks attractive relative to long-term interest rates and continues to offer investors a nice anchor in the portfolio in the face of intensifying macroeconomic uncertainties.”

Slowing industrial demand has been a byproduct of the trade war between the U.S. and China and impacts utilities with industrial consumers who rely on exports.

Steve Fleishman of Wolfe Research noted the following, “Second quarter sales showed further industrial sales weakening. AEP, Southern Company and others specifically called out the impact of tariffs and related export weakness on sales. A bright spot continues to be sales to energy customers but this seems due for a pause in the second half of 2019 as we see more production slowdowns. Residential and commercial sales held up better, weather normalized, and they are higher margin customers. Job growth and high consumer confidence are helping. Nonetheless, we worry these could also trend down if the economy weakens.”

Andrew Weisel of Scotiabank also touched on the impact of lower industrial demand stating that, “A utility’s earnings per share (EPS) growth is not largely driven by load growth, but rather capital expenditures and ability to earn the allowed return on equity (ROE). Moreover, industrial sales are lower margin. Still, over time, lower demand could drive questions around affordability and/or the need to add generation, net of retirements.” However, Andrew further notes that although EPS could potentially take a hit, utilities’ Price to Earnings ratio (P/E) could trend upwards due to a macroeconomic slowdown.

Low Interest Rates Compared to Authorized ROE

A frequent question among investors is whether lower interest rates will put downward pressure on authorized ROEs in pending rate cases. While interest rates do not move in unison with the federal funds rate and ROEs tend to be less reactive when interest rates go up or down, authorized returns have generally trended in the same direction as interest rates over time.

According to Neil Kalton of Wells Fargo Equity Research, “Since 2015, average allowed ROEs for electric utilities have been very sticky in the 9.6 to 9.7% range as (1) overall customer rate increases have been modest given low gas prices, falling renewable prices and the benefits of tax reform and (2) utilities continue to invest in the local economies and can deploy capital into the state(s) that provide the highest economic incentive to do so. While we expect these factors will continue to support ROEs near the current levels, we would not be surprised to see a resumption of the pre-2016 trend of gradual reductions in the 10 to 20 basis point range.”

Julien Dumoulin-Smith of Bank of America Merrill Lynch noted, “While ROEs do not necessarily move in lock-step with U.S. 30-year treasury yields given a variety of factors (for example rate case timing), authorized returns have clearly followed the same trend as long-term interest rates. According to Regulatory Research Associates data, the average authorized ROE for electric general rate cases was 9.57% in first half of 2019 (versus 9.56% in 2018). We highlight that with 30-year treasury yields now 60 to 80 basis points below levels seen during the first half of 2019, we perceive an increased risk of a reduction in authorized ROEs in pending rate cases.”

Upcoming Events

This week, Investor Relations will accompany Brian Tierney (executive vice president and chief financial officer) and Julie Sloat (senior vice president, Treasury and Risk) in conducting one-on-one meetings with investors at the Barclays Energy-Power Conference on Sept. 4 in New York City. The following day, Tierney and Sloat will also attend meetings with S&P along with the members of the Investor Relations and Finance teams.

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Watch for future Street Wise editions discussing earnings and regulatory updates related to AEP and the electric utility industry.

The material contained within Street Wise is for informational purposes only. It is not, and should not be regarded as, investment advice or as a recommendation regarding any particular security or course of action, including actions in relation to equity or debt securities of AEP or its subsidiaries. You should consult financial advisors with respect to investments.

([View] the Street Wise archive.)

AEP closed at $91.15 Aug. 30, posting a total return of 1.02% since Aug. 16. During the same period, the S&P Electric Utilities Index total return was 2.09%, and the S&P 500 Index total return was 1.38%.

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