Skip to Content
Stock Strategist

FirstEnergy Refocuses on Regulated Operations

Several years of depressed power prices have challenged its deregulated businesses.

Our fair value estimate for  FirstEnergy (FE) is unchanged following the company's filing of a settlement agreement with the Public Utilities Commission of Ohio for the Powering Ohio's Progress plan originally proposed in August. The proposed settlement has 15 signatories, including the city of Akron, Ohio Energy Group, business groups, and universities. Changes from the original proposal included $23 million in economic development and energy efficiency grants and $7 million to help low-income customers pay their electric bills. The agreement does not change our narrow Morningstar Economic Moat Rating.

The POP plan provides for FirstEnergy's three regulated utilities to enter into a 15-year power purchase agreement with FirstEnergy Solutions for output from the Davis-Besse nuclear plant and the W.H. Sammis coal-fired power plant as well as a portion of the power from the partially owned Kyger and Clifty Creek plants. The utilities would then sell the power into the wholesale markets. Customers would receive rate credits if the power sold was greater than the purchase price. FirstEnergy has estimated that residential customer savings would be approximately $2 billion.

The POP plan also includes a distribution base rate freeze through May 31, 2019. Although the distribution rate freeze is a concern, the POP plan does provide a decent level of profitability for FirstEnergy's unregulated generation in Ohio, which has struggled financially due in large part to low natural gas prices depressing power prices.

We note that the Public Utilities Commission of Ohio staff was not a party to the settlement; its comments on the POP plan are due Jan. 9, 2015. This filing will be a key input for the likelihood of the PUCO approving the POP plan settlement.

Regulated Operations Provide Lion's Share of Earnings
FirstEnergy has revised its strategy to focus on its regulated distribution and transmission businesses following several years of depressed power prices, which have challenged the company's deregulated operations.

Management has reduced its planned capital expenditures on its unregulated coal fleet by more than $1 billion, primarily by shrinking its power plant generation fleet. Following retirements, hydro asset sales, and the transfer of a coal-fired plant to a regulated affiliate, its unregulated fleet will be about 13 gigawatts of capacity versus 23 GW following the merger with Allegheny Energy in 2011. The cost to comply with current and future environmental regulations, as well as continued low market power prices, has driven FirstEnergy's decision to shrink its fleet. Although placing less emphasis on this business, the remaining unregulated operations still provide significant upside for investors and could generate roughly 25% of consolidated earnings if power prices recover to midcycle levels.

In late 2013, FirstEnergy announced a $2.8 billion plan to expand its Energizing the Future transmission initiative. The transmission investments are allowed returns on equity approved by the Federal Energy Regulatory Commission that are typically 100-200 basis points higher than those allowed by state regulatory commissions. The increase in rate base and favorable regulatory framework should allow strong regulated transmission earnings growth. The company also plans to file long-overdue rate cases in West Virginia and Pennsylvania that should improve realized returns. We expect regulated earnings to represent more than 90% of operating earnings in 2014.

In January 2014, the board decided to reduce the common dividend by 35%. FirstEnergy's dividend yield is now in line with peers' after the cut and we estimate its payout ratio based on adjusted earnings will fall below 60% in 2014. We believe the dividend is now secure and investors could again begin to see increases, possibly as early as 2016.

Nuclear Plants' Wide Moat Offset by Other Businesses
We think FirstEnergy's combination of regulated distribution utilities, independent transmission, retail electricity marketing, and wholesale power generation results in a narrow moat. The company's 10 regulated distribution utilities and independent regulated transmission business realize economic benefits from service area monopolies and hard-to-replicate networks. However, these benefits are offset by government regulation that determines rates and caps returns.

We do not believe FirstEnergy's growing retail electricity marketing business has a moat because of the small barriers to entry, commodity product, and intense competition. Although FirstEnergy Solutions has established a brand name in its core regions and customer contracts tend to be sticky, we don't think these factors are strong enough to establish a moat.

We believe fossil fuel merchant power generation is a no-moat business because of its sensitivity to commodity prices. We believe nuclear merchant plants, representing approximately 40% of FirstEnergy's competitive power generation, have a wide economic moat because they are the lowest-cost emission-free base-load power source. Existing nuclear plants face virtually no substitution threat because no other power generation source can match the cost or scale of an existing nuclear plant. Additionally, high capital costs are a significant barrier to entry for new nuclear plant developers.

Regulatory Decisions and Power Prices Hold Risk
FirstEnergy's 10 regulated utilities and FERC-regulated transmission business have experienced, for the most part, constructive regulatory decisions. However, because of the depressed earnings contribution from the unregulated competitive energy services segment, regulated businesses now represent more than 90% of consolidated earnings, and an adverse decision from regulators would negatively affect earnings and cash flow. Unconstructive regulatory decisions are more likely in a period of rising electricity rates, an event that would probably occur with increasing natural gas prices and coal plant retirements.

The most significant risk facing FirstEnergy's CES business is natural gas and power prices remaining at current depressed levels. This would result in continued low profit margins and cash flow for the company's nuclear and coal-fired power plants. An extended period of low margins could even result in the closure of CES' two single-unit nuclear plants.

In addition to commodity price risk, FirstEnergy's coal-fired power plants face increasingly stringent environmental regulations. As a result of new Environmental Protection Agency regulations and depressed power markets making capital recovery unlikely, FirstEnergy has elected to retire almost 5 GW of generating capacity, roughly 25% of its merchant fleet. The retired units, in general, tend to be older, less efficient plants that have low capacity factors in the current commodity environment.

If the EPA were to further tighten regulations on coal-fired plants, FirstEnergy could be forced to retire newer and larger plants with higher margins and/or spend additional capital on environmental controls. These coal-fired plants represent more than 50% of the CES segment's power generation, and retirements affecting these plants would have a material impact on our estimate of future earnings and cash flow.

Sponsor Center