A little over a week ago, NextEra Energy
NEE
NEP
The reason: Adverse capital market conditions had made the deal impossible to finance on economic terms. So rather than push it through anyway, management announced it would wait until the macro environment did improve.
To cover the lost sale proceeds from the drop down, NextEra instead announced the sale of its Florida natural gas distribution utilities to Chesapeake Utilities
CPK
During the accompanying analyst call, NextEra management took pains to reaffirm its long-term guidance for 6 to 8 percent earnings growth. That includes prospective guidance ranges for 2023 through 2026, based on projected asset additions at its Florida electric utility (75 percent of earnings) and unregulated NextEra Resources. And management also stated it “will be disappointed” if actual results don’t come in “at or near the top end” of those ranges.
Nonetheless, the announcement set off a series of big daily declines at both NextEra Energy and NextEra Energy Partners. And as a result, once premium valuations for both have completely collapsed. Partners, for example, as of today’s trading yields more than 16 percent. And parent NextEra now trades for 16 times expected next 12 months earnings, roughly half of where it was earlier this year.
That’s still a premium to the Dow Jones Utility Average, which has sold off to its lowest level since the pandemic and now trades at 12.3 times expected earnings. The reason: Investor fears that what’s affected NextEra—America’s leading producer of wind, solar and energy storage with a 20 percent market share—is affecting the rest of the sector, very likely in a worse way.
Not surprisingly, I’ve answered quite a few emails over the past week about NextEra Energy and NextEra Energy Partners, ranging from whether both are headed to oblivion to whether it’s time to “double down” on the family. So to clear up where things stand, here’s an update in Q&A form in advance of the October issue of Conrad’s Utility Investor due out Monday. I’ll have much more on all of these issues and other recommended stocks in the issue.
Are dividends at risk at these companies?
Unlike bond interest, which requires a default to cut back on, equity dividends are entirely at the discretion of management. So no one can 100 percent rule out a dividend cut at either NextEra Energy or NextEra Energy Partners.
That said there are two main catalysts for a dividend cut. One is downward pressure on revenue and earnings. The other is balance sheet, mainly the need to reduce debt. Neither is the case currently at the NextEras.
Partners is smaller with fewer assets to generate cash flow. And it’s also rated just below investment grade. So logically it would be most at risk to an actual cut. This week, however, credit rater S&P affirmed Partners’ BB rating with a stable outlook. It further stated the company’s portfolio of assets is “credit supportive,” liquidity is “adequate” with availability of $1.95 billion and the discontinuation of convertible equity portfolio financing, suspension of incentive distribution rights and reduction in the dividend growth rate “could be favorable.”
Partners turned some heads this week with a deal to actually increase its ownership interest in its Texas natural gas pipeline business to 75 percent ahead of a planned sale. But that hardly seems the action of a desperate company.
It’s pretty clear that capital market conditions affect NextEra Energy Partners’ effectiveness as a fund raising vehicle for NextEra Energy. And with the Federal Reserve increasingly likely to keep interest rates higher for longer—barring a recession—management has decided to basically put Partners on a shelf for now. But again, all we’ve seen so far on the business side is a reduction in planned growth.
We may indeed get more bad news at NextEra when the companies announce Q3 results and update guidance at the end of this month. Then again, management’s track record has been to pull off bandaids in advance of releasing results. And it’s hard to argue prices don’t already reflect much, much worse than we’ve seen so far.
Will NextEra Energy take advantage of the low current price to roll up NextEra Energy Partners as we’ve seen major oil and gas companies do their MLPs?
It’s certainly possible. Partners is right now trading at 56 cents per dollar of book value. And no one knows these assets like the parent, which continues to operate them and receives 55 percent of the economic interest already as general partner.
There are three reasons I think NextEra Energy won’t. First they didn’t take that step in 2015 when Partners crashed along with the MLP universe. At that time, “the market” obviously doubted the viability of the “growth from drop downs” business model. But by not buying it back in then, NextEra has been able to drop down assets worth more than $23 billion. That’s a lot of growth financed on the cheap, and without giving up control of the assets.
Second, NextEra is well aware that Partners’ shares have been highly cyclical over their now 9-year plus lifetime. Mainly, the model is a virtuous cycle when real interest rates are low enough to spur investment. It’s a vicious cycle when capital markets basically rule out financing drop downs on economic terms.
Partners’ shares have surged in the good times, more than the parent’s in fact. And they’ve cratered when market conditions have become as they are now. It seems likely to me NextEra will be patient with Partners, on the belief it will be a good financing vehicle again.
Third, regardless of what some in the investment media are claiming, the massive demand for solar, wind and energy storage projects hasn’t diminished—higher rates have reduced the ability to finance them. But if NextEra is going to be successful expanding its now 20 percent U.S. market share, it’s going to need all the potential financing vehicles it can get hold of.
They’ve put a lot of work into growing Partners and taking the balance sheet toward investment grade. Rolling up Partners may be accretive near term. But it would also remove a source of capital that’s been very successful in the past. And good luck if they try to convince investors to fund another vehicle after buying in Partners, unless it’s at a substantial premium to the current price.
This is actually a big difference with the MLPs. Mainly, demand for new midstream basically stopped cold in previous decade. And though I would argue we need more infrastructure in the worst way now, expansion is still stalled due to regulatory hurdles. Bottom line: There’s no need for oil and gas companies to fund rapid growth in midstream assets as there was early in the previous decade. So there’s no need for separate funding vehicles as there was early in the previous cycle.
Assuming you’re right about the NextEras’ underlying business health still being strong, when will the selling end?
Unfortunately, it could go on for quite a while longer. The technical picture is wrecked for much of the utility sector right now. And this is very much a stock market where daily trading is directed by big money—much of is governed by algorithm—where individual company nuances are not really a factor in decision-making.
We’re at a point where a favored few stocks—mostly big technology—are driving the S&P 500. Dividend paying stocks are hugely out of favor. Renewable energy as a sector is even worse. And utilities, which combine the two, have been in literal freefall.
When momentum goes this fast and far in one direction, it’s difficult for we investors to envision what will eventually brake and reverse it. My guess is the Federal Reserve is pretty pivotal here. And though they are crushing the very investment needed to tame long-term inflation—energy, infrastructure, housing etc—they seem pretty self-satisfied with continuing to push up borrowing rates. In fact, only a recession is likely to convince them to ease up. And that’s almost certainly what it’s going to take for investors to come back to utility stocks.
The most important thing for us as investors is to keep tabs on the companies we own. If there is real weakening—and cutting back a dividend growth rate from 12 percent to 6 percent does not qualify—we want to take our losses and move on. Otherwise, we want to hang in. The opportunity to hold or fold will be Q3 earnings and guidance updates the next several weeks.
We also want to start taking advantage of prices where they are now but only with incremental buying, a little here and a little there. And we want to make sure we’ve still got a decent amount of cash to take advantage in case prices go still lower, as well as to preserve principal.
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