D - Pinnacle West: Stellar Outperformance Amongst Utilities

2023-09-11 05:34:51 ET

Summary

• Pinnacle West has outperformed the broader utility index ETF by 25% over the last 20 months.
• The stock even shrugged off the poor earnings in Q2-2023.
• We examine the setup and tell you whether this is worth buying today.

Our last coverage of ( PNW ) we gave a neutral rating to the utility, noting the quality of the company offset the regulatory headwinds. We explained our defensive play to generate a high amount of current income while reducing risks.

With PNW down to $66.36, we sold the $65 Cash Secured Puts and $65 Covered Calls in the second portfolio. That strike gives us a comfortable buffer and net cost of $60.50 is an acceptable entry point should the stock get put to us. There are certainly bulls on this stock, but we fail to see any probability of this moving back to the highs, outside an overzealous bidder. We rate this at neutral at the present price and have a fair value of $66.30 (17X 2022 EPS).

Source: High Yielding Utility Faces A Challenging Time

That worked out as we made dough on the option play. The stock has however really done well relative to our outlook. It has also handily beaten the Utilities Select Sector SPDR ( XLU ) by a whopping 25% over the last 20 months.

At least that chart and performance shows that our relatively cautious outlook was unwarranted. We were wrong. We examine the recent results and tell you what we got wrong here and whether it calls for a change in tune.

Recent Results

Q2-2023 was heavily impacted by mild weather, but literally every factor went against the company. Earnings per share were down from $1.45 to $0.94 per share.

The result was a $0.21 miss, which has to be one of the bigger GAAP misses that we have seen on the utility side. That would have normally caused a very big drop in the stock, but the company actually raised guidance for the year to $4.10-$4.30 from $4.05 (midpoint).

Volatile weather has been the name of the game this year. We saw the impact in both Q1-2023 and Q2-2023. July and August have been quite hot in comparison to the milder weather that squashed Q2-2023 earnings. But the ace this year for the earnings has come from the favorable regulatory ruling.

Last quarter, I spoke about the appeal of our last rate case and the favorable Court of Appeals decision. The commission directed its legal staff to enter into negotiations with the company. And in June, we reached an agreement with the commission legal staff on how to implement that decision.

The joint resolution was then approved at the June open meeting, and it created a court resolution surcharge that started on July 1. We're pleased that we were able to reach an agreement with the commission in a reasonable and expeditious manner to resolve this issue. And as I've mentioned previously, the Four Corners Power Plant is a critically important reliability asset for the entire Southwest. And the investment in SCRs was required to keep that plant running under federal law.

This is the key reason guidance is moving up, despite weather related challenges. The company started collected $52.5 million annualized starting in July and what we are seeing is just the half-year impact for 2023. This was enough to offset some big negative headwinds and will be a substantial boost to 2024 and 2025 earnings.

Outlook

Analysts were extremely optimistic on the company in 2021 and had to backtrack after the big regulatory setback where Arizona regulatory body capped the ROE number. With the recent July results and relatively constructive talks on the appeal of that decision, we are seeing the see-saw moving to the other end as upgrades are coming in fast and furious. This is also what is driving the massive (well massive for a utility at least) jump in earnings per share.

The feedback loop has been that it has allowed PNW to not issue any equity as earnings have been sufficient to support the credit ratings for now.

Investors should still observe that all the credit ratings have a negative watch on PNW.

But the two counterpoints here are that the ratings are quite high to being with (deep into investment grade) and favorable resolution on the regulatory front likely removes the "negative outlook" from all three.

This is the critical piece of news that will drive volatility around the stock. Most analysts expect a 50% reversal of the hit that broke the stock down in 2021.

Verdict

We think that 50% reversal should happen and is priced into earnings estimates.

The stock is about in line with the utilities index and the outperformance has come as earnings estimates for 2024 and 2025 have increased substantially.

If you compare these versus what we see with the underperformers in the XLU, like Dominion Energy ( D ), you can get why earnings estimates remain the biggest driver of stock prices.

But at this point we see the numbers well priced in , thanks to the outperformance. 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.

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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