2023-09-11 03:39:27 ET
Summary
- One of the 3 hurdles (pension expense) is out of the way, which optimizes the cost structure.
- Uncertainties surrounding the nuclear PTC treatment and rate case remain, hindering an upgrade to a buy rating.
- PEG remains optimistic about its rate case, aligning with New Jersey's clean energy policies.
Investment action
I recommended a hold rating for Public Service Enterprise Group ( PEG ) when I wrote about it the last time , as I thought it would be safer to invest in the stock when the equity narrative is further de-risked. Namely, the progress with nuclear PTC treatment, pension changes, and the rate case back then. Based on my current outlook and analysis of PEG, I continue to recommend a hold rating. The investment case is slowly shaping up to become more certain, with one of the largest holdbacks-pension expense-now out of the way. However, the remaining uncertainties regarding the nuclear PTC treatment and rate case remain hurdles to me upgrading the rating to a buy.
Review
Since one of the three hurdles I previously mentioned has been removed, I think the storyline surrounding PEG is changing for the better. PEG's pension expense was a major headwind heading into 2023, but management has taken swift action to stabilize this item. An accounting order has been reached that will allow PEG to smooth out some of the impact of its pension. The expected impact is a reduction in volatility of 40%-50% going forward. This is very significant because it improves the predictability of FCF in the future. Remember that PEG's main business, nuclear, is a long-duration business that requires models that stretch into the future. Reducing any volatility in pension expenses should increase market confidence in PEG's earnings trajectory, which is positive for the stock. This comes on top of the excellent work that has been done so far to optimize the cost structure. The results of 2Q23 show that PEG has managed to keep O&M costs under control, with 1H23 O&M costs lower than in the prior year despite higher interest rates and general cost inflation headwinds.
What is left now is for PEG to get pass the Nuclear PTC treatment issue and rate case. As Nuclear continues to be an integral part of PEG's business, the latter is especially crucial. The uncertainty remains as the timing of IRS guidance on the nuclear PTC is currently unknown. Management has signaled that there is a chance that guidance won't be issued before FY24, when the nuclear PTC is expected to take effect. This is still the primary reason why I have not upgraded PEG to a buy, as the uncertainty surrounding the guidance could have a significant impact on future operations and hedging strategies. The good news is that PEG has continued to add hedges, and is now approximately 70%-80% hedged for 2024 at $38/MWh. This helps to alleviate some of the near-term uncertainty. However, I still see the nuclear PTC's unknowable release date and mixed results as a cloud hanging over PEG.
Despite recent shifts in New Jersey commission policies, management notes that discussions surrounding the rate case issue have consistently centered on the same topics: affordable, environmentally friendly energy sources. PEG is optimistic about its rate case in part because of the favorable billing arrangement it proposes in light of the affordability of its customers. In my opinion, this will strengthen PEG's argument for requesting higher rates in the near future. It's worth noting that New Jersey has consistently been a leader in the nation when it comes to pursuing clean energy policies. PEG should have no trouble attracting investors in light of the state's goal of transitioning to 100% renewable energy by 2050 .
Risk and final thoughts
Aside the 2 uncertainties I talked about above, the inherent risk with PEG should also be considered. Regulated earnings, such as PEG's, are indeed subject to federal and state oversight. Earnings in the future may vary significantly from current projections if the regulatory frameworks established by the NJ BPU and the FERC are altered in a materially negative way.
Overall, my recommendation for PEG remains a hold. While the investment landscape for PEG is becoming clearer with the resolution of the pension expense issue, two significant uncertainties still loom. First, the nuclear PTC treatment and its timing remain uncertain, which could impact PEG's future operations and hedging strategies. Although the company has hedged a substantial portion of its 2024 exposure, the unresolved release date for the nuclear PTC guidance adds an element of unpredictability. Second, the rate case, despite New Jersey's emphasis on affordable and environmentally friendly energy, requires careful monitoring. While PEG's proposal aligns with customer affordability, regulatory changes at the federal and state levels could potentially affect future earnings.
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Public Service Enterprise: Pension Expense Out Of The Way, 2 More Uncertainties To Clear