Most electric and gas utilities are tied to the simple economics of population and income growth in their regulated franchises. A 2% growth in population usually translates into no more than 2% growth in earnings per year, at best, over a very long period of time. PPL Corporation (PPL 0.60%) seems able to break through the damper of income and population growth in the regions it serves. It does so by providing predictable, controlled, and innovative energy solutions. These are attributes that regulators trust, and PPL has enjoyed the trust of regulators in the U.K. as well as the U.S.
Can PPL continue to grow a regulated franchise?
Rate base growth
PPL has grown its rate base by 8% per year. It does this through a combination of building demand and generation services in regions poised for further economic growth, along with fast-track relationships with regulators. This latter attribute has contributed to awards of 10.25% and 10.4% return on equity, or ROE, in Kentucky and Pennsylvania, respectively.
Through its rate cases, PPL virtually eliminates volumetric risk embedded in capital expenditures. By reducing the regulatory lag between capital and operational expenditure and recovery in rates, PPL can promise on-time cash flow to investors. They are able to earn revenues almost on a take or pay basis through the two-part tariffs negotiated with the regulatory authority. One part provides real-time recovery of capital expenditures, the other tracks electric and gas usage.
In Pennsylvania, the Act 11 Distribution System Improvement Charge, or DSIC, provides timely recovery of electric distribution capital costs. PPL was able to recover $700 in safety and reliability distribution investment over five years using this regulatory vehicle. The provision allows PPL to collect a 5% surcharge on customer bills for critical infrastructure improvements.
DSIC investment also translates into increased efficiency for customers and the growing distribution system. More efficiency and reliability induces more customer satisfaction, lower rates of adverse regulatory review, and more rapid and steadier increases in regulated ROE. A similar story holds for the Kentucky Environmental Cost Recovery, or ECR, mechanism. PPL will be able to recover over $2 billion in system capital expenditure with a 10.25% ROE.
In the U.K. PPL serves over 7.8 million electric customers. Ofgem, the U.K. regulator, has challenged utilities to cut customer rates by over 11%. PPL's Western Production Division , which runs the U.K. service areas, was awarded "fast track" status along with several demand management projects. This means a fast track to earning 2.5% of expenditures in revenues during the price control period commencing in 2015. This could translate into over $30 million per year. Again, more customer satisfaction, more efficiency, and the Ofgem performance awards to boot, leads to better margins in spite of lower rates.
Hedging to protect generation earnings
PPL has been able to decrease generation capital spending in PJM and Montana while maintaining high spark margins for nuclear, gas, and coal assets. Baseload generation is projected to be over 48 GW with intermediate and peaking load at about 8.5 GW. Over 84% of baseload capacity is generated in PJM.
PPL earns capacity revenues in PJM for generation served and transmitted. Capacity prices may be dropping by up to 11% over the next year into 2015 and are expected to contribute over 500 million in 2014 and 2015. PPL actively hedges natural gas, coal, and electricity prices to ring fence generation fuel to electricity spreads, as well as maximize capacity revenues. This will help smooth the earnings impact of commodity price volatility within a $3-$4 per mwh range.
PPL has over $6 billion in credit facilities. It has committed over $900 million during 2013. PPL will be repaying over $2.9 billion in debt through 2017, with most of it coming due in 2015. Cash flow through the third quarter 2013 grew 36% year on year relative to 2012. Reflected in this rate are a $1.4 billion common stock issue, a $645 million dividend payout, and a $690 million capital expenditure increase year on year over 2012. Cash flow net of the common stock issue would not have covered both the dividend and capital expenditure increase.
PPL is paying out 60% of net income at a 4.8% dividend yield. Price to cash flow comes in at a discounted 6.6x relative to an industry average of 9.2x. The discount might be due to the $1.4 billion common stock issue. Paying down debt over the next five years should improve the debt-to-equity ratio of 1.65 against peers at 1.16. Regardless of the pay-down, PPL has more than sufficient interest coverage at 3.10x, which is greater than peers at 1.60.
PPL seems safe enough. A retention rate of 40% times a ROE of 12.90% implies a potential equity growth rate of over 5%. Analysts estimate a drop in earnings of over 8%. PPL managers have their job cut out for them to beat the analysts and achieve their own equity growth potential.