Hot Weather, Regulatory Outlook Support Portland General's Growth in 2021 and Beyond
Hot Weather, Regulatory Outlook Support Portland General's Growth in 2021 and Beyond
Analyst Note| by Travis MillerUpdated Aug 27, 2021
After reviewing recent regulatory filings and incorporating exceptionally hot summer weather in Oregon, we are reaffirming our view that Portland General has some of the best growth potential in the utilities sector. Our 6% annual long-term earnings growth forecast is at the high end of management's 4%-6% target. We expect similar dividend growth.
Portland General trades at a slight premium to our $45 per share fair value estimate as of late August. We are reaffirming our narrow moat and stable moat trend ratings.
Unusually hot summer weather is set to boost 2021 earnings and provide extra cash Portland General can use for its growth investments in future years. The company set a peak electricity demand record in June, and the heat has intensified during the third quarter. Cumulative cooling degree-days in Oregon this summer are nearly 3 times higher than normal and more than double last year through last week.
Last month, management raised its 2021 EPS guidance to $2.70 to $2.85 from $2.55 to $2.70. We raised our 2021 estimate to reflect higher demand but maintained our estimates in 2022 and beyond, assuming normal weather.
Earnings growth in 2022-23 will depend on the outcome of the company's $59 million base rate increase request in July. We think management took a conservative approach by basing its request only on capital invested during the last two years with no change to its 9.5% allowed return on equity or allowed capital structure. This could lead to a settlement that supports management's $2.2 billion investment plan during the next four years and other rate changes to smooth earnings growth.
Portland General's growth rate could climb above 6% beyond 2023 if it wins renewable energy projects during its long-term resource procurement process starting late this year. New Oregon legislation requires Portland General to eliminate carbon emissions by 2040, requiring a large buildout of renewable energy and infrastructure.
Business Strategy and Outlook| by Travis MillerUpdated Aug 27, 2021
With an expanding customer base and a service territory with rich renewable energy resources, Portland General Electric, or PGE, has found plenty of investment opportunities. New Oregon legislation that requires PGE to eliminate carbon emissions on its system by 2040 will require an even bigger step-up in investment during the next two decades.
Despite the coronavirus 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 expect PGE will invest $700 million in 2021 and could continue investing at similar levels for many years as policymakers support renewable energy growth and infrastructure upgrades.
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 paused its regulatory activity in 2020, which we think was a good decision given the pandemic-related economic stress and PGE's 2020 energy trading losses. In July, PGE asked for a $59 million rate increase in 2022. We think regulators likely will approve the request since it is based on PGE's current 9.5% allowed return on equity, one of the lowest in the sector.
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 with cash flow to support up to a 70% payout ratio.
Economic Moat| by Travis MillerUpdated Aug 27, 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 Aug 27, 2021
We are raising our fair value estimate to $45 per share from $44 after incorporating time-value appreciation since our last update. Year-to-date results are running ahead of our earlier expectations primarily due to exceptionally hot weather in Oregon, but we are reaffirming our long-term outlook, assuming a return to normal weather. The 2021 weather benefit does not have a material impact on our fair value estimate.
We continue to estimate 6% annual average earnings growth during the next four years 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 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 2021 general rate case, integrated resource plan, and likely rate cases in 2023-24 will be critical factors that will determine PGE's earnings growth potential.
Our discounted cash flow valuation incorporates a 6.2% 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 Aug 27, 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. PGE's 2019 rate-case settlement maintains its 2018 rate-making structure. Its 2022 rate increase request is also based on its current allowed rate structure, raising the likelihood of another settlement.
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.
Portland General faces several environmental, social, and governance, or ESG, risks, however it is one of the few utilities that has no direct exposure to fossil fuels or greenhouse gas emissions since it owns only electric distribution and transmission assets.
Wildfires, extreme summer and winter weather, and stream flows that affect hydropower availability can affect PGE's operations and finances. Reliance on fossil fuel generation and wholesale spot market purchases to supplement intermittent renewable energy could affect earnings because of its cost-sharing mechanism. Oregon legislation requires PGE to eliminate carbon-emitting energy sources by 2040. Other ESG risks include cybersecurity, energy reliability, and safety.
Capital Allocation| by Travis MillerUpdated Aug 27, 2021
We assign Portland General management a Standard capital allocation rating.
PGE management has followed a smart blueprint and aligned investment programs with state policy while not being overly aggressive with rate cases, resulting in constructive relationships with regulators and consumer advocates. Its 2018 and 2019 rate cases ended up with generally constructive settlements, and management's 2022 rate increase request is structured in a way that makes a settlement likely.
Management's recent regulatory success is due in part to its considerable efforts over many years addressing rate design to smooth earnings volatility related to customer usage and electricity costs. Management has also pursued renewable energy investments, which fit well with state policy and customer demands. The company's regular integrated resource plan filings provide good long-term clarity for all stakeholders.
Several unusual developments in 2020 should make shareholders a bit cautious. 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 three months later raised the dividend 6%, 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.
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.