Pinnacle West: Bare-Bones Upside, Time For Some Calls (NYSE:PNW)

Dear readers/followers

Utility plays are probably one of the safest income generators you could go for in terms of overall dividend safety and stability/growth. At least, that’s generally the case. Because a utility’s income is dependent on rate bases that are regulated by the relevant regulators (usually state or national, depending on the utility you invest in and where) when there is a disagreement the potential for company-wide earnings (and dividend) impacts is considerable.

That’s what happened with Pinnacle West Capital (NYSE:PNW), which is why we’re in the situation we’re currently in, with expectations lowered by 10-20%, and as a result, a share price that’s going up and down quite a bit. Naturally, there is opportunity in this – but also risk.

So let’s see what the latest results bring us.

Pinnacle West Capital – An update & Review

Look, in my latest article, I made it very clear. You can even review my track record for most of 2022 to see where I stand with this company. Since my latest article, what I do own is up double digits while the market is up 2%, showcasing quite excellent trends.

But you can also see that as soon as that share price breaks the $ 70-$75 mark, I grow as cold as PNW as water on the rocks in a highball. There are some extremely narrow trends at work here, and the margin for error isn’t high. However, in my articles, I’ve managed to skirt and navigate these dangers and risks quite admirably, both buying cheap and trimming at good levels.

I intend to continue doing just that.

Active conservative portfolio management is, to my mind, one of the reasons I outperform most comparative broader indices for 2022. Though far from perfect, it’s nonetheless what allowed my Non-native portfolio (Scandinavia) to outperform NASDAQ by more than 45% during the year.

There is a lot of “risk” talk about Pinnacle West – but what hasn’t changed, despite their current dividend and earnings issue, are the core fundamentals. The company still sports a rock-solid balance sheet, BBB+, and a yield that’s currently at 4.55%, despite a share price that’s above $75.

I can understand why some of you might think now is the time to get back into PNW, but I would respectfully caution you that you should reconsider such a target.

Yes, 3Q22 targets were good, all things considered. By that, I mean considering the weather, interest effects, and other things, the EPS and gross margins were actually decent. The company also delivered FY22 EPS guidance, currently calling for a $4.35 with a potential 15-cent negative range on the downside ($4.20). Either way that goes, it’s a double-digit decline in EPS YoY, and one that’s likely to stay at around that level for 2023-2024E for the time being, all things considered.

Yes, the company is going to see retail customer growth annually between 1.5-4% for the next few years, and as a result, electricity growth will go up as well. However, costs will increase as well, and the time has come to submit the next APS rate case application, after the veritable doozy that came in the last time the company tried to fight the APS on one of its decisions.

Without having reviewed the entire request, the company’s request looks very reasonable given the environment that we’re currently in, and I’m hoping (yes, hoping at this point), that the APC won’t have too much of an issue with it at this time.

We need remember that PNW still needs to deliver its transition to cleaner generation and hardening/fixing existing infrastructure, transmission, and distribution networks – that is a multi-year, multi-billion plan, and the company has taken too many punches already to its plans to be able to absorb many more.

That’s another reason I’m hedging my bets here. I’m not disbelieving PNW or its targets – but a disagreement between regulation and applicant is not something I like, because it typically indicates a potentially deeper conflict at play. This somewhat defeats the purpose of the stability that utilities are supposed to provide.

So, I’m hedging my bets not only through clear sell or “BUY” targets but also by introducing options into the mix here (more on that later).

Still, the rate case issues actually simplify the thesis for PNW a great deal. Why? Because it really caps the potential upside, we can get from this investment for the coming few years. This means that our visibility for what the company is about to make in terms of EPS is very good.

The combination of the company-forecasted required capital investments, combined with PNW’s clear statement that it won’t be tapping equity as a funding source until the end of the next (not this recent) rate case, means that the business needs to fund these costs from operational cash flow and debt either from holding or PNW itself.

I have a small position still in PNW which I held onto after my reinvestment into Enel, and that position combined with what little I bought after is what forms my current position in PNW – not even 100 shares in total at this point, truth be told.

But still enough to continue to follow and be interested in where the company is going. Pinnacle West is a good example of why utilities are indeed stable investments that warrant your money if you’re looking for conservative cash flows. Despite the heavy impact of the rate case, PNW has recovered nicely. PNW’s plan to support its growth, reliability and ESG transition is on track.

The rate base growth that’s already approved is a decent case for why PNW will continue to deliver quite decent results overall.

Perhaps one of the more important parts of the company’s plan is that there will be no issuing of equity prior to the next rate case. That plan is still in the works, with operational cash at $3B, $1B in APS debt, $300M from PNW, and $500M from equity alternatives. That in itself is enough to fund the $4.7B capital plan that’s currently laid out until 2024E.

This, combined with a stellar balance sheet is what lays the groundwork for a positive PNW thesis – at $65/share or below, at the very least.

Let’s see where this takes us for this coming year and the initial valuation thesis for PNW.

PNW Valuation

The issue with PNW’s valuation remains the impact of the rate case. The current forecast calls for a mid-point sort of EPS forecast of $4/share, which is a 26% YoY EPS decline from the levels pre-rate case adjustment. This is also why I am no longer positive on PNW at anything approaching a $70/share price or above, which I was before that rate case response.

Here is the set of current PNW forecasts together with what we could expect at a premium, which is where PNW tends to trade.

A 9% annualized RoR based on a premium P/E-valuation of around 17-18x P/E, with a 4.55% yield and the potential for significant volatility, which is what we’ve seen since the impact became clear over a year back. That’s not something I’m willing to work with.

I’m willing to “HOLD” PNW at this price, at least as I’m writing options, but I’m far from willing to “BUY” it here. I said in my last neutral article that I’m not thrilled about investing in PNW at the price it was – which was well over $70/share, due to the expected EPS decline and what that meant in terms of multiples for that specific price. That stance still remains here.

Still, some safeties to PNW do remain. Forecast analyst accuracy remains at 100% – no change there. So that 9%, that’s pretty much in the bag, unless we see a severe disconnect to premium multiples, which I view as unlikely, all things considered.

PNW also – still – has very positive targets at this time. S&P Global analysts, while lowering their targets by more than $12/share in less than a year, now are at an average of $73. That means since my neutral article, these analysts have been bumping it up again and again, with 12 analysts at ranges from $56 to around $91/share.

Even more analysts than before are leery after the rate case cut, and consider the company a “HOLD” or underperform at these multiples despite the rather favorable average of only 4% overvaluation – but only 2 analysts are at “BUY” here.

My own target is far lower. Based on volatility, forecasts, and what’s available on the market (I’ve already spent an article talking about Enel (OTCPK:ENLAY) as a better alternative here), I believe a bigger discount rate is warranted. It doesn’t mean panic-sell your shares of PNW, but it does mean being careful that you’re not buying too expensively.

To my mind, anything with a “7” or above as a first digit here, is too much. A “good” price is a 5x discount to premium 18x P/E, going down to 13-14x, indicating a $65-$68/share PT.

That means I’m shifting my official PT by $2/share, and contrary to the market analysts am moving down, not up for the company.

Here’s my thesis for PNW.

Thesis for PNW’s common shares

• There is no easy way for PNW to turn or twist the current circumstances about, because it’s a regulator-bound utility, meaning its growth potential is very capped, and what else remains is simple math. The simple math of growing demand and need for servicing of infrastructure not being possible at the same RoR/profits without an increase in rate – which the company hasn’t gotten due to the rate decision.
• That’s what I typically like about quality companies such as this. It comes down to simple math. And the simple, current math for PNW is that the future, unfortunately, isn’t as rosy as it once was.
• In the most positive of cases, this is now an 8-9% annualized RoR investment. That’s not high, nor is it the best on the market. Taking the quality and fundamentals into account, I’m shifting to my PT of $68 – but I’m not going lower unless something else in the fundamentals changes
• Based on the price action I’m seeing, this is now a very clear “HOLD” as opposed to a “BUY”

Remember, I’m all about:

• Buying undervalued – even if that undervaluation is slight and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
• If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
• If the company doesn’t go into overvaluation but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
• I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria, with the fulfilled demands in italics.

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic attractive upside based on earnings growth or multiple expansion/reversion.

Options for PNW

PNW is interesting because there are options both ways. While I don’t exactly own 100 shares, it’s close enough to where I consider writing a covered call valid. Because I’m actually interested in selling PNW, I can go fairly long and collect a high premium from what would be considered a risky close-to-ITM option.

Here’s one such possibility.

And those July options were pretty heavily traded – also keep in mind this was during a negative day for the company (I’m working with after-hours market data here), and the premiums are likely to be higher if you wait for the company to be green or at least flat for the day. A 6-8% potential annualized RoR, which is over 1x the dividend is not uninteresting to me here, because I would be interested in rotating at $80/share if offered (or $82.75 including premium).

I haven’t written this one yet – but I may.

As for buying PNW, what options I found were not attractive at this time? All of the $65 strikes for the 30-90 day period annualized less than 4-5%, which is a no-go for me.