PPL - PPL: A Similar Story Again

2023-09-25 12:00:55 ET

Summary

• PPL made transformative moves in 2021, divesting its UK assets and acquiring Narragansett in the US.
• The company's focus on dividends has hurt its long-term prospects, with high payout ratios and increasing net debt levels.
• Second quarter results were weaker than expected, with net debt ticking up and capital spending set to rise further.

In February, I was not electrified on the shares of PPL ( PPL ) after a reasonable 2022. This came as the business made some huge transformative moves in 2021, by divesting its UK assets, while announcing a big acquisition in the US.

These moves, designed to tackle (part of the) leverage of PPL, made the business smaller and more predictable, as valuations and leverage concerns remained. As net capital spending remained elevated and mild weather caused a softer second quarter, shares have come under further pressure this year, just not enough for me yet to consider an allocation.

This comes as a relentless focus on dividends in the case of PPL has arguably hurt the long-term prospects of the business.

What Happened?

A couple of years ago, PPL was a group of utility companies which had operations in Pennsylvania, Kentucky, and the UK. The utility conglomerate steadily cranked out earnings of around $2 per share, with earnings split pretty equally between the US and the UK operations. The company paid out about 80% of these earnings, with dividends of $1.60 per share, marking a very steep payout ratio.

That only told part of the story as the company torched along a >$20 billion net debt load, with capital spending of $3 billion being roughly three times the annual depreciation charge. With shares trading in the $20s at the time, the company actually tapped equity markets at the time to manage net debt.

Since the outbreak of the pandemic, shares traded in a $25-$30 range, as the company made some decisive moves in 2021. The company sold the Western Power Distribution business in the UK at a $19.4 billion valuation, only to acquire Narragansett in a $5.3 billion deal to obtain a position in Rhode Island.

The idea behind this move was to get rid of the more volatile UK operations while reducing net debt. Hence, debt and earnings were set to fall, but become more stable (with more regulated activities) as earnings would fall a long way from a roughly $2 per share number. In fact, earnings were only seen at around a dollar ahead of the Narragansett deal, as net debt of $13 billion worked down to a 5 times leverage ratio, with absolute debt levels coming down, but the same cannot really be said by relative leverage.

The Narragansett deal closed in May 2022, as the company cut the dividend to $0.90 per share, while the company originally guided for earnings to come in around $1.30-$1.45 per share. In fact, I was quite happy to see this progress, but the issue is that net debt ticked up at $13.5 billion, as payout ratios remained high even as dividends come in far lower than before, with a high payout ratio and net capital spending pushing up net debt. Given all this, this was a very easy avoid for me, although the company's actions have worked out better than I originally thought.

Expectations Remain Moderate

With shares trading around $29 in February, shares have lost quite a bit of ground here, as they have steadily moved lower to the $25 mark here. In February, PPL posted adjusted earnings of $1.41 per share for 2022 as revenues rose substantially to $7.9 billion amidst higher electricity prices and its previous deal contributing in full. GAAP operating profits were reported at $1.37 billion, all while net debt already ticked up to $13.9 billion, with EBITDA coming in around $2.5 billion.

The reason why shares traded in the high twenties is that the company guided for 2023 adjusted earnings to come in between $1.50 and $1.65 per share, marking healthy growth, once and if achieved.

First quarter sales rose in a big fashion to $2.4 billion with adjusted earnings of $0.48 per share increasing seven cents on the year, as the company maintained the guidance after a typically stronger first quarter of the year. In May, the company announced a $0.24 per share quarterly dividend, as the annual payout ratio has increased a bit already, although that the current payout ratio of 60% is meaningfully lower than it used to be in the past.

By August, second quarter results were softer than expected, as adjusted earnings fell a penny to $0.29 per share. After electricity prices normalized, mild weather was observed as well (being the driver behind a 5% fall in volumes), while storms had an impact as well. Consequently, revenues rose just 7% to $1.82 billion, all while net debt ticked up to $14.5 billion.

This net debt load keeps ticking up with capital spending seen at $2.5 billion this year, all while depreciation charges run around $1.3 billion per annum here. While EBITDA now trends at $2.8 billion, it is needless to say that leverage numbers are demanding at just over 5 times.

What Now?

The reality is that the company sees steady growth and has become more predictable, but the second quarter has been weaker, driven by incidental items. I am quite shocked to see the company hiking the dividend, even if it is minimal, especially as net debt is actually ticking up quite quickly. In fact, net debt will tick up further as current capital spending is set to rise quickly to $3.4 billion per annum in 2025/2026, a billion increase from current expenditures, as this window is arriving rather soon of course.

Given this observation, I am quite cautious here, as I have been for a long period of time, seeing no need to get involved. While a valuation has fallen to about 16 times here, it is noteworthy that interest rates have moved higher, as net debt gradually ticks up again. Given these observations and experiences, I find it very easy to avoid the shares here.

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