NEE: Why Oncor Can Drive $0.45 of EPS Upside at NextEra by 2019

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______________________________________________________________________________

Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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December 20, 2016

NEE: Why Oncor Can Drive $0.45 of EPS Upside at NextEra by 2019

Portfolio Manager’s Summary

  • We have analyzed the impact of the Oncor acquisition on NextEra’s earnings and conclude that the transaction will likely add ~$0.36-$0.37 to EPS in 2018, equivalent to 5.0%-5.3% of 2018 consensus EPS ($7.05), and could add $0.42-$0.46 in 2019, equivalent to 5.6%-6.1% of 2019 consensus ($7.52).
  • As EXC, DUK and SO have done in recent acquisitions, NextEra will materially increase its consolidated ratio of debt to capital ratio to fund the purchase of Oncor.
  • The terms of the acquisition require NEE to pay Oncor’s shareholders $12.2 billion and to assume $6.7 billion in Oncor debt. The Oncor deal can thus be expected to increase NEE’s current enterprise value by some $17.6 billion, or approximately 20%.
  • We understand from our discussions with the company that NEE does not plan additional equity issuance to fund the Oncor acquisition, but rather will use the proceeds from:
    • The $1.5 billion offering of equity units that closed on September 1, 2016;
    • A $1.5 billion offering of 12 million common shares announced on December 4;
    • Net proceeds of $1.4 billion from the announced sales of FiberNet and the Marcus Hook plant; and
    • An estimated $7.9 billion of additional debt.
  • We calculate that NextEra’s adjusted ratio of senior debt to total capital will rise to 55% after the Oncor acquisition from 45% as of the end of the third quarter.
    • While the acquisition will reduce the business risk of NEE, increasing the share of regulated earnings in combined segment EBIT to 68% from 60% today, the highly leveraged acquisition financing will erode NEE’s credit quality and possibly ratings.
    • We do not believe, however, that this increase in leverage will brake NEE’s long term growth. It may limit new acquisitions, but it should not constrain the organic growth that drives NEE’s 6%-8% EPS guidance, particularly at the utilities.
  • We have assessed various scenarios for rate base growth at Oncor post acquisition. Oncor has been among the slowest growing companies in the utility sector: its distribution rate base has not increased since 2010. By contrast, customer growth has averaged 1.4% p.a. over this period, and the distribution rate base of the largest neighboring utility, CenterPoint Energy, grew by 5.5% p.a. (see Exhibit 5). We believe this long period of underinvestment offers an opportunity for additional investment beyond Oncor’s current capex plans, supporting long term earnings growth at NEE.
    • If Oncor increased capex by $500 million over current plans for 2018-2020, its average annual growth in rate base over the ten years through 2020 would rise to 5.4%, in line with CenterPoint’s growth over the same period.
    • If Oncor were to allocate all internally generated cash to capex, an increase over current plans of $1.15 billion in 2018 and $1.4 billion in 2019 and 2020, its 10-year average growth rate for total rate base would be 7.1%, only a little higher than the industry average of 6.7%. While potentially achievable, this scenario would likely require significant new transmission investment opportunities, as well.
  • These higher capex scenarios could add materially to EPS growth at NEE over time.
    • A $500 million annual increase over current capex plans, we calculate, would add $0.07 to NEE EPS by 2020. (See Exhibit 6.)
    • If all of Oncor’s internally generated cash were invested, we calculate that NEE EPS would be $0.17 higher in 2020 than under current capex plans.
  •  In conclusion, the Oncor acquisition has opened an avenue for growth in NEE’s regulated earnings that we believe can offset the risk of slower renewables growth due to policy changes under the Trump administration. By 2020, every $500 million in capex at Oncor lifts NextEra’s earnings per share by 2.5 cents, adding 30 basis points to annual earnings growth.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology


Source: FERC Form 1, company reports, SNL, SSR analysis

Details

In the exhibits that follow, we set out the assumptions and calculations underpinning our analysis.

The terms of the acquisition require NEE to pay Oncor’s shareholders $12.2 billion and assume $6.7 billion in Oncor debt. Even allowing for NEE’s planned asset sales, which are expected to generate $1.4 billion in net proceeds to help fund the transaction, the Oncor deal will expand NEE’s balance sheet by $17.6 billion, increasing NEE’s current enterprise value of $88 billion by some 20%.

Reflecting management disclosures to date and our discussions with the company, Exhibit 2 presents our assumptions as to the structure of NEE’s financing of the Oncor acquisition. We begin with the two $1.5 billion financings already announced by NEE management: an offering of 50 million equity units that closed on September 1, 2016, and the sale of 12 million shares of common stock announced by management on December 4, 2016. We also include the net proceeds of the two asset sales recently announced by management, FiberNet and the Marcus Hook plant, which together contribute an additional $1.4 billion. Based on NextEra’s guidance that no further equity offerings are planned to fund the Oncor acquisition, we assume that its borrows the remainder, issuing $7.9 billion of long term debt at an interest rate of 4%.

Exhibit 2: Assumed Acquisition Financing

Source: Company reports and SSR analysis

In an appendix to its third quarter earnings release, NextEra calculated its adjusted ratio of senior debt to total capital to be 45%. Adding the debt of Oncor and the funding of the Oncor acquisition, we calculate that NextEra’s ratio of senior debt to total capital will rise to 55% once the deal has closed. This is a radical increase, and seems to represent a permanent departure from a capital structure that NEE has maintained for the last five years. While the acquisition of Oncor will reduce the business risk of NEE, increasing the share of regulated earnings in combined segment EBIT to 68% from 60% at NextEra today, the highly leveraged acquisition financing will nonetheless erode NEE’s credit quality and possibly its ratings. We do not believe, however, that this increase in leverage will act as a brake on NEE’s long term growth. While it may limit new acquisitions, but it should not constrain the organic growth that drives NEE’s 6%-8% earnings guidance, particularly at the regulated subsidiaries.

Exhibit 3: Adjusted Debt to Total Capital, Before and After the Oncor Acquisition

Source: Company reports and SSR analysis

Taking into account NEE’s 2015 issue of equity units, which remain outstanding, the financing plan outlined in Exhibit 3 results in the annual average share counts presented in Exhibit 4 below.

Exhibit 4: Forecast of Future Equity Issuance and Average Shares Outstanding

Source: Company reports and SSR analysis

In Exhibit 4, we present our estimates of the overall dilutive impact of NEE’s planned financing for the Oncor acquisition. The chart shows (i) the dilutive impact of the increase in share count, calculated based upon consensus estimates of NEE’s EPS from 2017 through 2020, (ii) the after-tax cost per share of NEE’s assumed new borrowings, and (iii) the EPS impact of the NEE’s announced asset sales to date (reflecting management guidance, these are assumed to be broadly neutral).

Exhibit 4: Estimated Dilutive Impact of Low and Base Case Oncor Financing Packages

Source: Company reports and SSR analysis

We next modeled the increase in NEE earnings attributable to: (i) the earnings of Oncor’s regulated utility business, estimated based upon the product of rate base, allowed equity ratio and allowed ROE; (ii) the tax savings to NEE of writing off over 15 years, per IRS regulations, the goodwill resulting from the acquisition (these tax savings will not be reflected as GAAP earnings but rather as an increase in deferred taxes; as such, they will reduce NEE’s financing requirement and lower interest expense); and (iii) the interest savings to NEE of having access to Oncor’s annual free cash flow after capex.

We calculate the goodwill to be generated by NEE’s acquisition of Oncor at $8.3 billion, reflecting:

  • the total consideration paid for the net assets of Oncor (equivalent to the purchase price of $12.2 billion); minus
  • the value of Oncor’s assets net of any liabilities, including interest bearing debt, deferred taxes, pension liabilities and accounts payable (we estimate the value of Oncor’s net assets to be ~$8.0 billion at the time the acquisition closes, reflecting its net assets at the end of Q3 2016 adjusted for forecast capex in Q4 2016 and Q1 2017); plus
  • any historical goodwill on Oncor’s balance sheet that was generated by prior acquisitions ($4.1 billion).

Since goodwill is amortized for tax purposes on a straight-line basis over 15 years, we estimate the tax benefit to NEE of goodwill amortization at $143 million in 2017 (assuming the deal closes at the end of February) and $171 million annually in subsequent years. These tax savings will not be reflected as GAAP earnings but rather as an increase in deferred taxes; as such, they will reduce NEE’s financing requirement and lower interest expense.

The future earnings of Oncor’s regulated utility business are of course in large part a function of how rapidly Oncor can grow its rate base. Given the timing of the acquisition, we see little opportunity to alter Oncor’s 2017 capital expenditure budget. Based on Oncor’s current rate base and Oncor’s most recent capex plans, released in the amended registration statement on December 6, 2016, we estimate Oncor’s earnings contribution in 2017 at $357 million or $0.75 per NEE share.

Beyond 2017, however, NextEra may have significant latitude to increase planned capex to offset what we believe to be an extended period of under-investment by Oncor in its distribution rate base.

Oncor has been among the slowest growing companies in the utility sector: its distribution rate base has not increased since 2010. By contrast, customer growth has averaged 1.4% p.a. over this period, and the distribution rate base of the largest neighboring utility, CenterPoint Energy, grew by 5.5% p.a. (see Exhibit 5). This long period of underinvestment offers an opportunity for additional investment beyond Oncor’s current capex plans. If Oncor increased capex by $500 million over current plans for 2018-2020, its average annual growth in rate base over the ten years through 2020 would rise to 5.4%, in line with CenterPoint’s growth over the same period. If Oncor were to allocate all internally generated cash to capex, an increase over current plans of $1.15 billion in 2018 and $1.4 billion in 2019 and 2020, its 10-year average growth rate for total rate base would be 7.1%, only a little higher than the industry average of 6.7%. While potentially achievable, this scenario would likely require significant new transmission investment opportunities, as well.

Exhibit 5: Customer and Rate Base CAGR for Oncor, CenterPoint and all Electric Utilities

Source: SNL, Company reports and SSR analysis

We have therefore modeled three scenarios for capex and rate base growth at Oncor. These are (i) the continued implementation of Oncor’s recently announced capital expenditure plan through 2020, driving 5.4% compound annual growth in rate base from 2015 through 2020; (ii) an increase in Oncor’s announced capex plan by $500 million per annum for 2018-2020, driving 7.2% compound annual growth in rate base from 2015 through 2020; and (iii) a scenario where Oncor reinvests all internally generated cash during 2018-2020, driving 10.0% compound annual growth in rate base from 2015 through 2020.

We believe the second scenario represents realistic upside to Oncor’s current forecast, as this level of capex only catches up to the 5.3% annual growth in distribution rate base achieved by CenterPoint’s growth over 2010-20. While the third scenario is very aggressive and unlikely to occur, we include it to show the potential upside beyond 2020, when we believe Oncor can continue to grow rate base rapidly to rectify the underinvestment under Energy Future Holdings’ ownership, address continued customer growth, meet new transmission needs as renewables in Texas continue to grow, and integrate distributed generation and energy storage onto its grid.

Exhibit 6 presents the results of our accretion analysis for each year from 2017 through 2020 in our three capex cases. Given Oncor’s current capital expenditure plans, we calculate that by 2020 the Oncor acquisition could add $0.44 per share to NEE’s earnings, or the equivalent of 5.5% of 2020 consensus. This would be enough to achieve, and possibly exceed, the 8% compound annual growth off of the 2014 base year that NextEra is currently using for the high end of its guidance. Under our second scenario, with $500 million of additional distribution capex from 2018-20, the acquisition would add $0.51 in 2020, or 6.3% of 2020 consensus. Finally, under the most aggressive scenario, where all internally generated cash is reinvested at Oncor in 2018-20, EPS would increase by $0.61 in 2020, or 7.6% of 2020 consensus.

Exhibit 6: Estimated Increase in NEE’s EPS Due to the Oncor Acquisition

Source: Company reports and SSR analysis

Conclusion

We find NEE an attractive investment, especially after its underperformance since the election, with strong earnings growth that should continue through the end of the decade and beyond.

NEE’s recent underperformance appears to reflect concerns about what might happen to renewable energy development under the Trump presidency, fears that we believe are exaggerated. The economics of utility-scale renewable energy continue to improve, and in some regions of the country renewable generation is already competitive without subsidies, specifically wind in the best areas of the Midwest and solar in the Southwest. In addition, utilities are continuing to sign PPAs for new projects to comply with the renewable portfolio standards of the states in which they operate. A change in administration at the federal level of government is unlikely to change the direction of these state policies; indeed, a number of states are looking at raising their renewable mandates. Finally, large corporations like Google and Facebook are increasing their demand for renewable power. We see these factors continuing to drive growth in wind and solar development over the next several years.

We would also note that not of all of the Trump administration’s proposed initiatives are adverse for NextEra. Among utilities, NEE is one of the biggest potential beneficiaries of the Trump tax plan, with $0.50 of EPS upside at their competitive businesses and the potential to keep some of the benefits at their Florida utility through the end of their rate settlement in 2020.

Finally, the analysis of the Oncor transaction presented here indicates that it will provide material support to NEE’s long-term EPS growth, with upside beyond current guidance, and can offset much of the risk of slower renewables growth due to policy changes over the next four years. The transaction will materially increase holding company leverage, but we do not expect this to act as a brake on NEE’s long term growth. It may limit new acquisitions, but it should not constrain the organic growth that drives NEE’s 6%-8% earnings guidance, particularly at the regulated subsidiaries.

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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