Rebuilding the Utility Fortress

As income investors, we want our companies to pay us a steady stream of dividends every quarter through thick and thin.

That’s why utilities are typically among the core holdings of every income investor: the fact that utilities provide an essential service helps insulate them during downturns, thus ensuring the dividends keep on coming.

But some utilities reach for growth in ways that can impede dividend growth or even undermine the sustainability of their payout.

In the past, utilities used their stable regulated businesses as ballast to invest in what they hoped would be growthier areas. That led some electric utilities to pursue unlikely tie-ups with banks and telecommunications firms, among other entities.

Wholesale vs. Retail

In more recent decades, some utilities tried to play the wholesale power markets, with occasionally disastrous results. Others hoped to capitalize on the energy boom by acquiring exploration and production units or forming midstream master limited partnerships (MLPs).

The problem with all of these ventures is that while they often do provide a nice short-term growth kicker, utilities that venture into more competitive areas inevitably get the timing wrong. They tend to arrive at the party just as it’s winding down.

These days, market dynamics are forcing utilities to take a back-to-basics approach. The major trend has been for utilities to shed unregulated assets to improve the visibility of earnings while supporting a rising payout.

And this trend was certainly in evidence at the annual Edison Electric Institute Financial Conference.

Indeed, David Crane, CEO of wholesale power producer NRG Energy Inc. (NYSE: NRG), recently observed, “[Utilities] just finished their big conference … and the message I heard that came out of the conference is that everyone wants to do regulated, everyone wants to hide behind fortress monopoly walls.”

Of course, as the head of a competitive power producer that’s made a major push into renewables, Crane meant his remarks to be disparaging.

But we’d certainly love to hide behind “fortress monopoly walls,” while continuing to collect our dividends. After all, it’s a scary world out there.

Case in point is NRG’s share price, which has plunged 60% from its trailing-year high. The firm may be one of the most forward-thinking operators in the utility space, but the market doesn’t award points for prescience about the future of the sector, at least in the short term.

The main culprit behind NRG’s performance is the steep drop in wholesale power prices resulting from the crash in energy commodities.

Prices in the wholesale power markets are typically pegged to natural gas. And the abundance of natural gas from the prolific shale plays has caused the commodity’s price to plummet by about 50% over the trailing year.

While it doesn’t look like the competitive power markets will recover anytime soon, NRG’s decision to split into two companies–one focused on renewables, the other on conventional merchant generation–and pare debt should help restore the share price to a more reasonable level over the coming year.

Nuclear Shutdown

While NRG has always been a wholesale player–it was originally Xcel Energy Inc.’s (NYSE: XEL) merchant unit before it was spun off–Louisiana-based Entergy Corp. (NYSE: ETR) is a textbook example of a utility making an ill-timed bet on unregulated growth.

In the late ‘90s, Entergy made a conscious decision to expand into competitive power markets by investing in nuclear plants. The company hoped to leverage its expertise in running the five nukes it operates in the South by acquiring plants in other regions.

In short order, Entergy acquired five nuclear units in the Northeast over a three-year period, and then later added a sixth in 2007 in the Upper Midwest, for a total of about 5,000 megawatts of generation.

At one time, Entergy’s combined fleet of regulated and merchant nuclear generation totaled 10,000 megawatts, making it the second-largest nuclear operator in the U.S.

In the past few years, however, profits from the merchant side of its nuclear business have gotten pinched by the sagging wholesale market, while relicensing efforts have run into robust opposition from politicians and environmental groups that don’t want nukes in their backyard.

In my case, the fate of one of Entergy’s nuclear plants previously lived rent-free in my head. The nearly 2,100-megawatt Indian Point, the crown jewel of Entergy’s merchant fleet, is situated just north of New York City and provides 25% of the New York metro area’s power.

In an odd twist of fate, the company closed on its deal to acquire the second of the plant’s two operating units just two days before September 11, 2001.

Back then, I lived in the East Village and worked a block away from the World Trade Center. So I was a witness to history, though not in a way that I could have ever imagined.

In the aftermath of the terrorist attacks, there was much discussion about what might happen if a similar attack were to hit Indian Point. In fact, at least one of the 9/11 plotters had reportedly considered the facility as a potential target.

When you live in New York, part of your mental armor is to adopt a fatalistic attitude. But that changes when existential considerations are no longer theoretical.

Consequently, I wasn’t thrilled at the notion of having to trust that a nearby nuclear plant could sustain a direct hit from a hijacked jumbo jet. Thankfully, that hasn’t happened.

Fast-forward to today, and Entergy is facing a different set of concerns over Indian Point. Politicians and activist groups are opposed to relicensing the plant, and that opposition has gathered momentum following the 2011 Fukushima Daiichi nuclear disaster in Japan.

The company has already shuttered or has plans to shutter three of its other nukes in the Northeast partly due to similar pressure, but mostly because they became uneconomic to operate: the 620-megawatt Vermont Yankee plant closed at the end of last year, the 838-megawatt FitzPatrick plant in upstate New York will close by early 2017, and the 688-megawatt Pilgrim plant in Massachusetts will cease operation by 2019.

With the 811-megawatt Palisades in Michigan under a long-term power purchase agreement for virtually all of its output through 2022, that leaves the relicensing of Indian Point as the one major source of uncertainty with regard to Entergy’s merchant fleet.

Entergy’s muted earnings and stagnant dividend growth are reflected in its share price. The stock has fallen by about 28% from its trailing-year high and currently yields 5%.

That enticing yield prompted one subscriber to ask what it would take for us to restore Entergy to a buy.

Well, management allayed one of our concerns by boosting the dividend for the first time in five years. With a 2.4% bump, the payout is now $0.85 per quarter, or $3.40 annualized.

In fairness, Entergy took a feast-or-famine approach to past dividend hikes. Its last increase before the five-year hiatus was nearly 39%.

But management has vowed to adopt a different approach, with more consistent dividend growth that targets a payout ratio of between 65% and 75%.

And while we’d like to see Entergy return to fully regulated or mostly fully regulated operations, we’d also like it to wring as much economic value from its two remaining plants before that happens.

After all, the plant closures and resulting impairments have destroyed significant shareholder value.

But we can envision a day in the not-too-distant future when Entergy is once again a regulated utility fortress.

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