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Stock Analyst Update

FirstEnergy Is a Bargain

The narrow-moat, soon-to-be-regulated utility is being overly penalized in the market due to the pending FES bankruptcy.

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We are increasing our fair value estimate to $40 from $35 per share, as it has now been over one year since  FirstEnergy (FE) announced its planned separation from FirstEnergy Solutions, or FES, and no major new claims or guarantees have become public. Thus, we have a high level of confidence that FirstEnergy can separate itself from FES in 2018.

However, returning to its regulated past will likely require a big move: Allowing FES to fall into bankruptcy. We estimate this could cost shareholders $1.7 billion for FES' unfunded liabilities and other cross-guarantees plus a potential $1 billion settlement with creditors to avoid yearslong litigation. We estimate the total cost to FirstEnergy shareholders could be $2.7 billion.

We recently changed our moat rating to narrow from none. Our analysis now assumes FirstEnergy is valued in our discounted cash flow analysis like the majority of regulated narrow-moat utilities using a cost of equity of 7.5% and a longer forecast period of returns on invested capital above weighted average costs of capital. Using these inputs, our discounted cash flow valuation is now $40 per share.

We think the stock is cheap as of early December, trading at a nearly 20% discount to our $40 fair value estimate and a 30% discount to fully regulated utilities. We think the market is too concerned about the pending FES bankruptcy. Even if FirstEnergy assumes all $3 billion of FES debt, our fair value estimate falls by only about $2 per share. Once FES worries subside and the market revalues FirstEnergy as the fully regulated and narrow-moat utility that it is set to become, investors should realize attractive upside.

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Charles Fishman does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.