INVESTMENT THESIS
FirstEnergy Corp. (NYSE: FE), a diversified energy company based in Ohio, is taking steps to move on from the bribery scandal related to its nuclear operations. Late in October, FirstEnergy terminated CEO Charles Jones and two senior VPs, after an internal investigation determined that the executives violated company policies. The board named President Steven Strah as acting CEO.
In July, Ohio Speaker of the House Larry Householder was arrested in a $60 million federal bribery scandal tied to First Energy. The speaker is alleged to have diverted funds from renewable energy to bail out two nuclear plants owned wholly or in part by FirstEnergy. Following that news, we downgraded the FE shares to HOLD from BUY.
FE has long-term positives, and third-quarter results were solid. We see some risk that FE may cut its dividend (or slow dividend increases), but believe that risk is limited.
Industry fundamentals are also sound. The coronavirus has increased investor interest in utility stocks with steady dividends. People are spending more work and leisure time at home, resulting in rising demand for electricity and gas on the residential side. Utility demand on the industrial and commercial side should gradually begin to recover as more employees return to reopened work sites.
At least the bribery case issue is resolved, we continue to recommend a HOLD rating on FE. Argus has about 25 utilities in analyst coverage that are BUY-rated. Leading names include NextEra for renewables exposure and National Grid plc for international exposure. In our view, First Energy’s favorable operating environment, stable finances, and record as a steady dividend payer will be overshadowed in the near term by the fallout from the scandal.
RECENT DEVELOPMENTS
The beta on FE shares is 0.26, below the 0.38 average for peers.
FirstEnergy is seeking to recover from the bribery scandal that rocked the company in June. While it is too soon to fully understand any involvement by FirstEnergy, investors in July dumped the stock and shifted assets into other utility names.
On October 29, FirstEnergy announced leadership transition. The board of directors terminated CEO Charles Jones and two senior VPs effective immediately after an internal investigation determined that the executives violated company policies. The board appointed President Steven Strah as acting CEO. Current board member Christopher Pappas was named executive director, reporting to non-executive chairman Donald Misheff.
In the 3Q20 earnings presentation, CEO Strah laid out FirstEnergy’s plans going forward. The board is conducting a full review of governance and oversight processes and has created a new subcommittee to assess and implement potential changes as needed in FE’s compliance program. The company continues to cooperate with the DoJ and SEC investigations.
On November 2, FirstEnergy reported 3Q GAAP earnings of $454 million or $0.84 per share. The gain was due to one-time items in the year-earlier quarter. Non-GAAP EPS for 3Q20 of $0.84 was identical to GAAP EPS and rose 10% from adjusted EPS of $0.76 a year earlier. Non-GAAP EPS for 3Q20 was one cent above management’s guidance.
Revenue increased 2% to $3.02 billion, led by higher regulated distribution and transmission. FirstEnergy’s 3Q20 GAAP operating margin was 23.9%, compared to 23.0% in 3Q19; the margin gain reflected slower growth in operating expenses than in revenue.
The consensus forecast is $2.53, which has moved up from $2.43. Management lowered its GAAP EPS projection for 2020 to reflect the impact of remeasurements of pension/OPEB plans.
In February, Jersey Central Power & Light (JCP&L), a FE subsidiary, filed a distribution rate case, asking for an increase of $187 million in rates to recover general costs as well as storm costs. JCP&L requested an ROE of 10.15%. On October 28, 2020 a settlement was reached at a ROE of 9.6% and a rate increase of $94 million.
EARNINGS & GROWTH ANALYSIS
FirstEnergy has three businesses segments: The Regulated Distribution business posted 3Q operating EPS of $0.76, up from $0.69 in 3Q19. In the Regulated Transmission business, 3Q earnings of $0.21 were flat with $0.21 a year earlier. In the Corporate/Other segment, the operating loss narrowed to $0.13 per share in 3Q20 from a $0.17 per share loss in 3Q19.
We expect revenue to be 1%-2% higher over the next two years, reflecting FE’s exposure to slower-growing regulated markets in the Midwest and Mid-Atlantic states. Utility demand, which decreased on the industrial and commercial side due to the pandemic, has begun to rise again as companies reopen and employees return to work sites. We note that a portion of FirstEnergy’s industrial customers come from the automobile sector. Automobile manufacturing is doing well after a weak 2Q20. Demand for cars has been strong and auto factories may be continue to run hot into FY21. Meanwhile, residential load remains elevated as consumers have been stuck at home. We expect continued energy efficiency at the consumer level, and below-peak demand from industrial & commercial customers in the intermediate term as a result of COVID-19. However, not all industrial customers have automobile exposure, and offices still remain largely empty, prompting us to be conservative with our recovery forecasts.
We have raised our 2020 non-GAAP EPS estimate to $2.59 per share from $2.51. We have raised our 2021 non-GAAP EPS estimate of $2.68 per share from $2.62.
FINANCIAL STRENGTH & DIVIDEND
FE raised the dividend by 5.6% in February 2019 for the first time since 2014, when it reduced its quarterly payout by 35% to $0.36. The cut reflected FE’s high payout ratio and funding needs, the sluggish economy in its service territory, and weak market power prices. As such, the five-year dividend growth rate is 1.6%. We now see some risk that FE may cut its dividend (or slow dividend increases). We believe that risk is low. Starting in 2022, FirstEnergy plans to issue $600 million in equity annually to fund its regulated growth plans.
MANAGEMENT & RISKS
On October 29, FirstEnergy announced a leadership transition. The board of directors terminated CEO Charles Jones and two senior VPs effective immediately after an internal investigation determined that the executives violated company policies. The board appointed President Steven Strah as acting CEO. Current board member Christopher Pappas was named executive director, reporting to non-executive chairman Donald Misheff.
In the wake of the 2014 dividend cut, FE revised its strategy to focus on its regulated distribution and transmission businesses – which provide more predictable growth with less overall risk. Management expects these businesses to account for 80% of EPS in future years. It expects to invest heavily in its regulated operations, with a focus on improving reliability.
In an 82-page federal complaint issued on June 21, 2020, Ohio House Speaker Larry Householder and four others were accused of constructing a criminal enterprise that collected $60 million in bribes from an unnamed energy company. Though not named in the complaint, the company appears to be Energy Harbor, formerly FirstEnergy Solutions and part of FirstEnergy. While it is too soon to fully understand any involvement by FirstEnergy, investors have dumped the stock and shifted assets into other utility names. We believe that this situation remains an active risk for FirstEnergy until the federal bribery case is fully resolved, which could take years.
VALUATION
FirstEnergy shares went into freefall due to the bribery scandal, falling to the mid-$20s from the low $40s prior to the federal complaint. The shares have now recovered to the upper $20s.
The stock trades at a P/E of 11.1-times our 2020 estimate and 10.7-times our 2021 estimate. While that is at a discount to the peer group, the P/E in our view does not fully reflect risks in the stock related to the federal bribery case.
We look for FE to trade on legal developments rather than fundamentals until investors can better assess the fallout from the bribery scandal. First Energy’s favorable operating environment, stable finances, and record as a steady dividend payer will be overshadowed in the near term by the fallout from the scandal. In summary, we believe that a HOLD rating is appropriate.
On November 16, HOLD-rated FE closed at $28.50, down $1.01.
Source: Argus
