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PPL Corporation (PPL)

PPL has been a big disappointment to shareholders over the past year. Read our thoughts on PPL's recent underperformance here (June 16, 2018).

Founded in 1920, PPL Corp is a pure-play regulated gas and electricity utility serving more than 10 million customers in the U.S. and the U.K.

PPL’s largest customer base, as well as most of its sales, earnings, and cash flow, are derived from the U.K., where regulators have historically allowed for superior returns on equity compared to most U.S. utilities.
Source: PPL Investor Presentation

Business Analysis

PPL has transformed its business mix over the past decade to reduce its earnings volatility and improve its return profile. Through a series of strategic divestitures and acquisitions (most notably PPL's $5.7 billion acquisition of the U.K.'s second-largest electricity distributor in 2011), the company shed its exposure to the highly competitive power generation business and increased its mix of regulated utility revenue from 27% of company-wide sales in 2010 to 100% today.
Source: PPL Investor Presentation

Regulated utilities are essentially monopolies because they have exclusive rights to sell electricity and/or gas in their service territories. To protect customers from price gouging and ensure they have continuous access to reliable service, state regulators determine what a utility can invest in and how profitable its operations can be.

When evaluating a regulated utility, it's therefore very important to get comfortable with the regulatory frameworks it operates under. Allowed rates of return can vary significantly from one state to the next as each regulatory body operates independently. Other important factors are the demographics of a service territory (population and business growth drive power demand) and a company's growth projects, which need to be delivered on time and on budget.

PPL's confidence in its service territories and regulator relationships is demonstrated by its plans to invest $16 billion from 2017 to 2021. Approximately $5.4 billion is earmarked for the company's Pennsylvania and Kentucky electrical transmission businesses at a healthy weighted average return on equity near 10%.

Another chunk of the investments are for the company’s aggressive push into renewable energy in the U.K., where the utility is already connecting consumers to 20 GW of green energy, a figure that is likely to soar in the coming years.

PPL expects its U.K. regulated segment to generate a strong return on equity between 13% and 15% through 2020. No equity is needed from PPL to fund its U.K. operations, and the current regulatory framework in effect has set base revenues through 2023, providing solid visibility as long as no major revisions are made. PPL also believes it has some levers to pull with its planning process to mitigate lower allowed returns after 2023 should that occur.
Source: PPL Investor Presentation

Overall, the company expects these investments to compound its rate base and earnings per share by 5% to 6% annually over the coming years. If successful, PPL's investments should translate to impressive (for a regulated utility) dividend growth of 4% a year, which marks a nice acceleration from the 1% to 2% annual payout growth PPL has recorded in recent years.
Source: PPL Investor Presentation

PPL's sensitivity to changes in regulatory frameworks and capital market conditions will be elevated during this aggressive investment phase. Fortunately, about 80% of its planned capital expenditure spending has no regulatory lag, meaning that the company can pass on the cost of its new investments fairly quickly to customers. PPL also enjoys a very strong credit rating (A- from S&P), which provides it with some additional financial flexibility. 

Overall, PPL appears to be a durable business that generates predictable earnings, operates in geographies with historically supportive regulatory bodies, and is poised for somewhat faster growth in the years ahead. Management has increased PPL's dividend in 15 of the last 16 years, and that trend seems likely to continue.

Key Risks

While PPL’s growth plans make it appealing for conservative income growth investors, there are several risks to keep in mind. First, as with all regulated utilities, there is political risk because a utility’s profitability comes directly out of the pocket of customers.

Populist political attacks against “greedy utility monopolies,” especially during economic downturns, could sour regulatory relationships between PPL and its regulators, especially in the U.K. where PPL’s allowed return on equity is among the highest in the industry.

While PPL’s U.K. utilities currently operate under a regulatory framework that runs through 2023, providing a predictable rate of return on its projects, it's possible a mid-period review is initiated that could impact the profitability of the company's projects. PPL says any review is not expected to materially impact its plans, but it's important that investors appreciate the increased political tension in the U.K. and the uncertainty it creates, especially once this current framework expires. 

PPL’s U.K. energy transmission business, while providing attractive rates of return, also acts as a double-edged sword because it potentially exposes the utility to long-term currency risk after 2019, which PPL’s current hedges do not fully cover. The uncertainty about Brexit’s effects on the U.K. economy mean that when those hedges roll off, a much weaker pound could result in a decline in PPL’s overall earnings growth potential.

Fortunately, management has stated that even if the market rate for the pound hit parity with the dollar, PPL has the ability to achieve the low end of its EPS growth rate through 2020 due to the value of its hedges above the budgeted rate of $1.30/£. Regardless, investors should be aware of the unique risks stemming from PPL's international operations.

Next, while PPL’s growth plans are impressive and seem to provide a long runway for rising earnings and dividends, there is no guarantee that management can deliver those projects on time and on budget, especially as the industry evolves. Advancements in energy efficiency and distributed generation (solar, wind farms, etc.) have caused per-capita electricity generation to stagnate and decline in recent years, for example. When combined with the aging power grid, which is very costly to maintain, the industry could face real long-term challenges.
Source: Bloomberg

Furthermore, because of the capital intensive nature of the utility industry, PPL depends on raising debt and issuing equity to fund its projects (the company expects equity issuances of $350 million annually through 2021). As a result, PPL, like many fast-growing utilities, could find its growth ambitions watered down if interest rates rise too fast and/or investor demand for its shares dips, effectively raising its cost of capital.

PPL has benefited from the lowest interest rates in history, resulting in low debt costs and high demand for its shares to keep its cost of equity low. That’s because low bond yields have forced many income investors into a desperate hunt for “bond alternatives."

Low volatility regulated utilities have been some of the biggest beneficiaries of this trend, but their favorable environment could reverse itself as the Federal Reserve continues on its interest rate increasing program. That could cause PPL’s shares to stagnate or fall, which would bring the utility’s dividend yield up to a level that makes it more competitive with risk-free U.S. Treasuries.

Closing Thoughts on PPL

Thanks to their steadier margins, predictable cash flow, and defensive qualities, regulated utilities often make for attractive income investments. From an improved business mix consisting purely of regulated activities to its generous yield and diversified growth plans that are expected to double the company's dividend growth rate going forward, there is certainly a lot to like about PPL. 

However, the company is not your bread-and-butter U.S. regulated utility. The U.K. accounts for over half of PPL's profits and is facing unprecedented economic and political uncertainty. While the current regulatory framework in place appears favorable and seems unlikely to be materially revised through 2023, these situations should still be approached with greater caution. 

Based on what we know today, PPL still seems like a reasonable source of current income and income growth over the coming years. The stock is certainly not without its risks, more so than many pure-play U.S. utilities, so maintaining a well-diversified portfolio can be especially prudent in these situations. 

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