Portland General's Capital Investment and Growth Potential Keeps Rising
Portland General's Capital Investment and Growth Potential Keeps Rising
Business Strategy and Outlook| by Travis MillerUpdated Mar 09, 2021
With an expanding customer base and a service territory with rich renewable energy resources, Portland General Electric has found plenty of investment opportunities.
After completing the $600 million Carty gas plant in 2016, management continues to invest heavily. Despite the COVID-19 pandemic uncertainty, PGE invested $774 million in its system in 2020, its second-largest annual investment during the last decade. Large projects included the $160 million Wheatridge wind-solar-battery project and a $200 million operations center.
We think PGE will continue to find new growth projects as policymakers support renewable energy growth and infrastructure upgrades. In February 2021, management increased the company's 2022-24 annual investment run rate by 10% to $550 million.
Regulatory support for this growth plan will be critical. Oregon regulation is mostly constructive with forward-looking rates and timely decisions. The state's 20-year integrated resource plan and related four-year action plan give PGE and regulators clarity on potential growth investments. Its usage-decoupling mechanism limits annual earnings volatility in normal circumstances.
PGE's 2019 rate-case settlement keeps 2018 rate structures mostly in place, including a 9.5% allowed return on equity and rate decoupling through 2022. Although this is among the lower allowed ROE in the sector, the consistent rate-making is a positive, especially after challenging results in 2015 and 2016.
PGE will take a brief break from regulatory activity, which is good timing given the pandemic-related economic stress and fallout from 2020 energy trading losses. We expect the next round of regulatory activity to start in late 2021.
The board made income investors nervous when it skipped a dividend increase in April 2020 before raising it in July 2020, keeping PGE's 14-year dividend growth streak intact. We think PGE can grow the dividend 6% annually, in line with peers, given the growing economy in its service territory, investment opportunities, and cash flow to support up to a 70% payout ratio.
Economic Moat| by Travis MillerUpdated Mar 09, 2021
Service territory monopolies and efficient-scale advantages are the primary sources of economic moat for regulated utilities such as Portland General. State and federal regulators grant PGE exclusive rights to charge customers rates that allow it to earn a fair return on and return of the capital it invests to build, operate, and maintain its system.
In exchange for PGE's service territory monopoly, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.
This implicit contract between regulators and capital providers should, on balance, allow PGE to earn above its cost of capital in the long run, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. Recent regulatory decisions have been positive, and public policy supports most of PGE's investments.
The risk of future adverse regulatory decisions precludes PGE from earning a wide economic moat rating. However, the threat of material value destruction is low, and normalized returns exceed costs of capital as capital investment falls to normalized levels, leaving us comfortable assigning a narrow moat to PGE.
Oregon's power-cost sharing regulation creates the potential for more volatile earned returns, but we don't think it's enough to change PGE's moat rating.
Fair Value and Profit Drivers| by Travis MillerUpdated Mar 09, 2021
We are raising our fair value estimate to $44 per share from $43 after incorporating 2020 results in line with our expectations and time-value appreciation.
We continue to estimate 6% annual average earnings growth beyond 2020 based on PGE's infrastructure investment plan. This is at the high end of management's 4%-6% annual growth target primarily because of our bullish outlook for the company's growth investment opportunities.
We continue to assume that PGE averages $650 million of investment annually through 2025. This is in line with management's 2021 investment plan but about $100 million higher than management's annual investment plan beyond 2021. We remain confident management will continue to find incremental investment opportunities and increase their long-term investment plan, as they have the last few years.
The outcome of regulatory proceedings related to PGE's integrated resource plan update and likely general rate case filing during the next two years will be critical factors that will determine PGE's earnings growth potential.
Our discounted cash flow valuation incorporates a 6.4% weighted average cost of capital and a 7.5% cost of equity. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio, reflecting PGE's lesser sensitivity to the economic cycle and lower degree of operating leverage.
Risk and Uncertainty| by Travis MillerUpdated Mar 09, 2021
Portland General's ability to expand its rate base and achieve rate increases depends on its relationship with Oregon regulators as well as access to capital markets. Both of these factors have become more favorable for PGE based on recent regulatory activity and falling market costs of capital. That could reverse if capital markets tighten or regulators cut allowed returns on equity. PGE's 2019 rate-case settlement maintains its 2018 rate-making structure, reducing that regulatory risk likely until 2022.
Fluctuations in annual stream flow also might alter Portland General's mix of energy available from its low-cost hydro plants. Reliance on fossil-fuel generation and wholesale spot market purchases could impact earnings because of its cost-sharing mechanism. Shareholders experienced the huge downside risk when the company suffered large power trading costs in summer 2020.
Portland General's $130 million settlement in July 2018, related to contract disputes with the Carty power plant, eliminated an overhang on the stock and a drag on earnings. After completing the Wheatridge facility and new operations center, we expect PGE's investment plan for the next few years will focus on smaller projects related to the distribution grid. These are lower-risk investments more likely to finish on time and on budget.
Stewardship| by Travis MillerUpdated Mar 09, 2021
We assign Portland General management a Standard capital allocation rating.
Shareholders should watch carefully how management rebounds from several concerning developments in 2020. The most notable was the energy trading loss unveiled in August 2020. We think investors should be most concerned about the size of the loss, which was about one quarter of PGE's typical annual purchased power costs. We believe shareholders are best off if PGE is exceptionally conservative with power costs since Oregon requires shareholders to pay for the bulk of power costs when they are unusually high.
In April 2020, management cut guidance by 9% and the board paused dividend increases for the first time since PGE's former parent, Enron, declared bankruptcy. The board raised the dividend 6% in July 2020, in line with our estimate and management's guidance, but the off-cycle decision should concern investors. Management also has moved around its capital investment outlook, which makes it difficult to determine long-term earnings growth potential.
On the positive side, management has done a good job achieving constructive relationships with regulators and consumer advocates. Its 2018 and 2019 rate case settlements were generally constructive for shareholders and customers. Management likely faces another regulatory test in late 2021 for new rates in 2022 to recover its planned investments during the next two years.
PGE has followed a smart blueprint and aligned investment programs with state policy while not being overly aggressive with rate cases. Management has spent considerable effort addressing rate design changes with good success. Management also has pursued renewable energy growth, which fits well with state policy and customer demands. The company's regular integrated resource plan filings provide good long-term clarity for all stakeholders.
The board has been aggressive about raising the dividend in recent years but also appears mindful of management's 60%-70% payout target. On a normalized basis, we think PGE's strong financial position supports a dividend at the high end of management's 60%-70% payout ratio range. The board only recently raised the bottom end of its payout target from 50%, a low threshold among regulated utilities.
CEO Maria Pope took over in 2018 from Jim Piro, who retired after 37 years with PGE. Pope's top task is to maintain the constructive relationship Piro fostered with Oregon regulators and his efforts to implement more investor-friendly rate mechanisms. CFO Jim Ajello joined in 2020 from Hawaiian Electric, replacing retired CFO Jim Lobdell.