Ameren's Generation Transition Provides Growth Opportunities
Ameren's Generation Transition Provides Growth Opportunities
Senior Equity Analyst
Business Strategy and Outlook | by Andrew Bischof Updated Feb 23, 2021
Ameren is a regulated utility that operates in Illinois and Missouri, two historically challenging regulatory jurisdictions that are rapidly improving. With improving regulatory environments comes significant investment opportunities, as seen with the company's most recent $17.1 billion five-year plan. Ameren has its sights set on $23 billion of opportunities during the next decade, providing a long runway of growth for the company.
Management is to be applauded for attaining constructive utility legislation in Missouri. Management's patient yet persistent years-long efforts resulted in increased investment opportunities across the territory, a stark change from the past. Numerous trackers are in place for fuel adjustments, pension, and tax positions. We consider these mechanisms attributes of a constructive regulatory environment. Usage-based rates and no guaranteed recovery of bad-debt expense are headwinds during economic downturns.
With an improved regulatory framework in Missouri, management is keeping its promise to invest in jurisdictions that support investment. Ameren is allocating $8.5 billion of its investment plan to Missouri, long the recipient of minimal investment. Projects will focus on renewable energy, upgrading aging and underperforming assets, and employing smart grids and connected grid services.
Ameren has build-to-transfer agreements for 700 megawatts of wind generation in Missouri. The $1.2 billion investment complies with Missouri's renewable energy standard. Ameren is also looking to install 100 MW of solar by 2027. Ameren will close roughly 3 gigawatts of coal generation by 2036 and expects to have no coal generation by 2045.
Regulation for Ameren in Illinois is constructive. Allowed returns on equity are 580 basis points above the average 30-year U.S. Treasury yield. This presents a headwind in the current low-interest-rate environment, but we continue to view the framework positively long-term. If rates remain low, we think management could direct growth investment away from Illinois toward Missouri, which offers higher allowed rates of return.
Economic Moat | by Andrew Bischof Updated Feb 23, 2021
We don't believe Ameren has an economic moat. What separates Ameren from its peers is a regulatory environment in Missouri that historically made it difficult for the company to earn a sustainable spread between earned returns and costs of capital. However, recent improvements in the regulatory environment are changing our view.
Shareholders have benefited under new legislation in Missouri where numerous trackers are in place for fuel adjustments, pension, and tax positions. We consider these mechanisms attributes of a constructive regulatory environment. We would like Missouri to adopt a forward-looking test year and allowed returns are slightly below regulated peer returns. Additional riders would help further reduce regulatory lag. Continued execution by management under the new legislation and support from regulators could lead us to upgrade our moat rating to narrow.
Regulation for Ameren's Illinois utility is supportive. Performance-based formula rate making almost eliminates regulatory lag by using year-end rate base and cost reconciliation. Allowed return on equity adjusts annually based on the 30-year U.S. Treasury plus 580 basis points. This framework mitigates regulatory discretion in determining Ameren’s Illinois earned return, allowing for a positive spread between earned returns and cost of capital. While we were disappointed legislators failed to renew performance-based rate making, we ultimately expect renewal given the benefits for all stakeholders.
We also believe Ameren’s transmission assets are moaty. Competitors have little incentive to build competing transmission lines if one that Ameren owns already is serving a market's full capacity. Capital costs for new transmission lines are too high and incremental benefits too low to offer sufficient returns on invested capital for two competing transmission owners. In addition, Ameren benefits from regulatory protection. The Federal Energy Regulatory Commission approves new transmission lines only if there is a demonstrated need for new capacity.
Fair Value and Profit Drivers | by Andrew Bischof Updated Feb 23, 2021
We are maintaining our $77 per share Ameren fair value estimate.
Given the regulatory shift in Missouri, we expect management will execute its capital plan and earn a fair return on that investment. This effectively removes the discount for capital investment and earned returns we previously incorporated.
Our annual average earnings-growth is at the top end of management's 6%-8% guidance. Our earnings estimates and fair value estimate incorporate recent regulatory decisions and 0.5% weather-normalized demand growth.
We forecast nearly $17.1 billion of capital investment during the next five years. We expect this investment to lead to approximately 8% rate base growth through 2025.
In our discounted cash flow valuation, we use a 6.3% cost of capital based on a 7.5% cost of equity. This is lower than the 9% rate of return we expect investors will demand for a diversified equity portfolio, reflecting Ameren's lower sensitivity to the economic cycle and lower degree of operating leverage.
Risk and Uncertainty | by Andrew Bischof Updated Feb 23, 2021
The primary risk that Ameren faces is regulatory, since most of its revenue and earnings are generated by its regulated utilities. The possibility of lower allowed returns and disallowed investments in rate base are threats to the company's earnings prospects. Recent regulatory reforms lower this risk.
Ameren also has a significant ongoing development program that is subject to potential cost overruns and political and regulatory risk. Tightening environmental regulations could require significant capital investment or added operating costs, which could have uncertain cost recovery through traditional regulated rates.
Ameren operates natural gas distribution utilities. While we think natural gas will remain the primary source for heating in the Midwest for the foreseeable future, there is risk that policymakers will expedite the shift away from retail natural gas use.
As with all regulated utilities we cover, Ameren faces the risk of an inflationary environment that would raise borrowing costs and make other investments more attractive for income-seeking investors.
Stewardship | by Andrew Bischof Updated Feb 23, 2021
We assign Ameren a Standard capital allocation rating. The rating reflects our assessment of Ameren's balance sheet strength, management's investment decisions, and plans to return capital to shareholders.
Ameren's dividend policy to pay out 55% to 70% of earnings is appropriate given the high-quality and relatively stable nature of Ameren's regulated assets. We expect the balance sheet to remain sound with the company maintaining its balance sheet in line with its regulatory requirements, supported by the company's low revenue cyclicality and operating leverage. We expect the company's investment strategy to focus on growing assets through regulated investments, which we think is a reasonable approach.
Management has impressively worked to improve the regulatory environment in Missouri, historically one of the most difficult regulatory environments for utilities. Management's patient yet persistent years-long efforts resulted in an improved regulatory environment allowing for significant investment opportunities across the territory, a stark change from when management wisely directed growth capital away from the region. Management continues to operate well under Illinois' performance base rate-making structure.
Ameren veteran Warner Baxter, who had been president and CEO of Ameren Missouri since 2009, became CEO of Ameren in 2014, bringing in a renewed focus on improving Missouri's regulatory environment by building relationships with regulators and politicians. Baxter has built trust across key constituents, to shareholders' benefit. Baxter has prior experience as CFO and numerous leadership roles throughout Ameren. He has proved to be among the best CEOs in the utilities industry.
Ameren recently rotated two key executives' responsibilities. Former CFO Marty Lyons is now president of Ameren Missouri, while former Ameren Missouri president Michael Moehn is now CFO. We think either would be a strong candidate to succeed Baxter when he decides to retire.
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