Nuclear Power Fight Could Make Scana a Buy

As South Carolina politicians amp up the vitriol following

We think the swoon in Scana’s stock offers a buying opportunity below $58 per share. The stock finished last week below our fair value estimate for the first time since mid-2015 after giving up the 10% rally that briefly followed its abandonment decision. Scana is down more than 17% year to date, while the Morningstar U.S. utilities index is up 11%, excluding dividends.

Despite the political rhetoric, we think shareholders are in a good position. Our fair value estimate assumes shareholders lose $400 million pretax, or $1 per share aftertax, based on a variety of scenarios. Our worst-case scenarios contemplate about $2 billion, or $14 per share, of lost value. This implies a $54 per share worst-case stock value using a 16 times forward price/earnings ratio for the core businesses.

We think Gov. Henry McMaster’s effort to sell state utility Santee Cooper or its 45% stake in the V.C. Summer nuclear project to utilities such as Dominion Energy, Duke Energy, or Southern Co. will be unsuccessful without substantial state financial support. Santee Cooper marketed its nuclear project stake in 2010-13 with no luck, and its $8 billion of debt is an insurmountable hurdle for any publicly traded utility.

Scana shareholders will be made whole if regulators approve its abandonment plan and uphold state law allowing recovery of $2.2 billion from customers. If regulators reject Scana’s proposal, it’s uncertain whether they could compel Scana to finish the project, given the higher revised cost estimate and expiring tax credits. A federal tax credit extension or subsidized loan could be a positive for shareholders.

Efficient Scale Is Core Competitive Advantage Scana owns a difficult-to-replicate network of energy generation, transmission, and distribution assets and provides essential energy sources, natural gas, and electricity. State and federal regulators grant Scana exclusive rights to charge customers rates that allow its utilities to earn a fair return on and return of the capital it invests to build, operate, and maintain their distribution networks. In exchange, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow Scana to outearn its cost of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. Scana’s core competitive advantage is the efficient scale of its network, but in some cases regulation offsets this advantage, preventing excess returns on capital. Within this framework, the threat of material value destruction is low and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning Scana a narrow economic moat rating.

Even though Scana plans to abandon its new nuclear project, we expect regulatory and legal support will protect the company’s returns on capital. Scana will continue earning a return on and return of its capital spent through mid-2017 at an attractive 10.25% project allowed return. The regulatory mechanisms first passed in the state’s Base Load Review Act are working as prescribed, and the project has been value-accretive for Scana.

Apart from Scana’s nuclear project, we believe regulators will continue to set base rates at a level that allows shareholders to earn greater than their cost of capital on balance, in the long run. Its utilities’ current allowed returns on equity and growth prospects remain above the peer average, cushioning returns against any sharp rise in interest rates. As with all regulated utilities, we think regulatory caps on revenue and returns preclude Scana from establishing a wide economic moat.

Project Abandonment Raises and Lowers Risks Management's proposal to abandon construction of its new nuclear units raises regulatory and legal risks even if it minimizes operational risk. We assign a medium fair value uncertainty rating to account for the possibility that regulators push back against Scana's decision to abandon the project and make shareholders bear some of the incurred costs.

Regulators twice have cut Scana’s nuclear project allowed return on equity, and we wouldn’t be surprised if regulators make a similar decision to impose some cost on shareholders if they accept Scana’s abandonment proposal. Cost overruns and delays on the new nuclear project led regulators to impose a 75-basis-point reduction in allowed return on equity early on. In late 2016, regulators imposed another 25-basis-point allowed ROE cut to 10.25% from 10.5% when it approved Scana’s proposal for a $7.7 billion fixed-price contract.

Scana has historically received good regulatory treatment, and we expect these relationships to continue to support its core electric and gas business. Small rate-case decisions for its gas operations in 2016 were constructive. We expect Scana will hold off filing an electric base rate increase request for several years while it starts to collect nuclear project abandonment payments. As long as weather-adjusted usage continues to grow, we expect Scana’s earned base returns will remain near allowed returns.

Dividend Should Grow Faster Than Earnings Abandoning its nuclear project would give Scana plenty of financial stability, assuming it gets full cost recovery of approximately $2.2 billion of aftertax stranded costs. Scana should be able to flow cash from rate recovery of stranded costs into share buybacks, and we anticipate little need for new debt with the nuclear project stalled. We estimate the project would have added $3 billion of debt before accounting for the latest round of estimated cost overruns. Scana would have needed substantially more new equity and debt beyond 2019 if new nuclear project costs go much above $9 billion.

At its core nonnuclear business, we don’t expect a significant change in Scana’s capital structure as it raises financing for its growth investments based on its regulator-imposed capital structure limits.

We were surprised when Scana’s board raised the dividend 6.5% to $2.45 per share for 2017. Management also raised the high end of its target payout to 65% from 60%, a move we didn’t think would come until 2018 or 2019 as Scana started winding down its new nuclear investment. However, Scana shouldn’t have any problem achieving the high end of that range now that it has no new nuclear capital investment, assuming regulators allow Scana to recover substantially all of the new nuclear capital it has spent.

Eventually, we think Scana can target a 70% payout ratio. This means the dividend should grow faster than earnings for several years. Moderate core investment in the coming years is key to continuing Scana’s record of increasing its dividend in 62 of the last 66 years.