Regulation is the straw in my Quality Grade system that most often stirs the drink. And when the result is an increasingly volatile mixture, it’s usually best for investors to stand clear, asserts utility sector expert Roger Conrad, editor of Conrad's Utility Investor.
In the case of FirstEnergy (FE), however, investor worries stemming from an Ohio bribery scandal have run well ahead of actual developments.
Now selling for less than 11 times next 12 months earnings, the stock reflects a highly unlikely worst case on the political front, and utterly ignores the utility’s still solid economic underpinnings.
Earlier this year, FirstEnergy paid a steep price of $1.1 billion cash and $2 billion in lost claims to enable former power generation unit Energy Harbor (ENGH) to exit its two-year bankruptcy. But it was the last legal hurdle to being a pure play regulated transmission and distribution utility, on track for 5 to 7 percent annual earnings growth from rate based investment.
FirstEnergy’s Q3 results showcased its resilient business model, with operating earnings per share surging 10.5 percent and management affirming full-year guidance of $2.40 to $2.60. The company also met operating cost targets and affirmed its policy of low single digit annual dividend increases.
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The bear case is this strength will melt under increased scrutiny from Ohio regulators following the resignation of the Chairman of the Public Utilities Commission, including a possible end to revenue decoupling that’s shielding earnings from the pandemic’s worst effects. And the uncertainty led all three major credit raters to cut FirstEnergy to junk status.
What raters’ drastic moves haven’t done is meaningfully increase the company’s cost of debt capital, as 30-year bonds still yield only around 3.5 percent to maturity. One reason: Ohio is only 25 percent of distribution operations’ rate base, roughly the same as Pennsylvania.
That means it contributes only about 16 percent of total earnings power, since federally regulated transmission makes up a third. And the Buckeye state’s pull diminishes going forward, with transmission rate base growth projected at 10 percent versus 4 percent for distribution.
Bottom line: FirstEnergy can weather a toxic relationship with Ohio a lot longer than the state. That makes compromise far more likely than any company-breaking punishment. FirstEnergy is a buy under $32.
