DUKB - Pinnacle West: Highest Yield Amongst Quality Utility Plays (Rating Upgrade)

2024-01-12 16:44:19 ET

Summary

• Pinnacle West Capital Corporation has suffered from aggressive regulatory challenges and valuation compression.
• The 5% yield and the 14X P/E are supported with a solid credit profile.
• Pinnacle West Capital Corporation still has risks here, and we outline the best way to play this.

On our last coverage of Pinnacle West Capital Corporation ( PNW ), we were warming up to the utility as it outperformed our expectations. The price was still "not right" and we remained sidelined. Specifically, we said:

The company has fought back on the regulatory challenges but there is not much it can do about the risk-free rates offering a solid alternative to utility company investments. When we wrote on it in December 2021, risk-free rates were pinned at 0%. Today we can get 5.5% risk-free and 7.5% in some cases, practically risk-free. Utilities will be pressured in that environment. Last time our price target was $65.00 and we are raising it to $70 per share today. That still gets us to a "hold" rating and we would look for a big dip before we even initiate our defensive covered calls on this one.

Source: Stellar Outperformance Amongst Utilities .

PNW did not produce any contrary fireworks and went lower slowly towards our $70 mark. We go over why we are now upgrading this to a Buy and tell you how we would play it.

The Company

As Arizona's largest electric company, PNW has had the privilege of being in the fastest-growth area for utilities.

"Fastest" here means very different things compared to some other sectors, though.

Yeah, utilities are not your standard AI or revolutionary drug play, for sure. But the numbers add up. Add higher population, plus more usage per customer, plus inflation of 2%-4%, and you easily get to a 6% increase in earnings. That may not sound seductive, but these can often be "bond-like" in their returns. 6% growth plus a 3%-4% dividend is the dream combination to get equity-like returns with a fixed-income level of volatility. That is what PNW had going for it, but unfortunately, the regulatory environment can and, in this case, did throw a wrench in the works.

The regulators' decision to chop the return on equity or ROE down to 8.7% hurt really badly. ROE is a direct earnings measure, and the cut meant that the 2021 earnings of $5.26 per share would be a high watermark till at least 2026. So growth has vanished, just like that. These are things outside an investor's control unless they have spent their nights installing spyware on the regulatory board. The key lesson is of course to diversify and understand that not all outcomes are in your control. The second lesson is that high multiples for lower-growth stocks tend to produce poor results. PNW was at one point trading at 21X forward earnings in 2020. A purchase at that point ($104) likely produces negative total returns over 7-10 years.

Valuation & Outlook

PNW did successfully appeal their case and clawed back 50% of what was taken away.

That 50% was enough to stabilize the rating agencies at just negative versus cutting the actual ratings. Those ratings are actually quite sweet at the current levels and if PNW can get them to move to "stable" from "negative," there would likely be some multiple expansion in the equity.

On the flip side, PNW has decided not to take the easy path to get there, and that is by issuing equity. Equity issuance of course dilutes earnings potential, and management has taken a stance that this is not the right time to add to stock issuance.

All said and done, the stock looks modestly cheap here as we roll over our estimates into 2024-2025.

This is cheaper when you compare to other similar utilities like Duke Energy Corp. ( DUK ), NextEra Energy ( NEE ), and Consolidated Edison ( ED ). American Electric Power ( AEP ) wins by a hair, but it sports a smaller dividend yield.

The growth opportunities for capital investment remain compelling for most utilities but more so for PNW. Phasing out the coal plants, for example, will require a huge amount of new investment in renewables that create a nice earnings stream for PNW.

The key risk and one we think will almost certainly come to pass, is a higher 10-year Treasury yield in 2024. These have a large bearing on the valuation more than anything else for utilities, and we see this as a material headwind. That said, we are going to slap a "buy" rating here as amongst utilities this is as close to a compelling case as you can find.

How To Play

While we like Pinnacle West Capital Corporation stock here, we really don't see an upward acceleration any time soon. Our best case is really 10% returns, with 5% coming from the dividend and 5% coming from earnings increasing. We don't see valuation expansion on the horizon. That may sound pessimistic but for most other utilities, NEE being a prime example, we see valuation compression. Ok, so if you believe us that you are set up for 10% returns, your best play is simply going the covered call route. This way, you can set up for a 15% annualized return with a higher margin of safety.

Note that the third dividend in line has an ex-date of July 31, 2024, so you will get only two dividends. Of course, if you are stuck with the stock, as in it closes under $70 by July expiration, the next dividend should line your pockets shortly after that. We think aiming for defense here is preferable, and we would only consider a direct buy under $65.00.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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