Charles Fishman: Over the past couple of years, the market has not been kind to unregulated power plants, or what is referred to in the industry as "merchant generation." Weak electricity demand, falling natural gas prices, and tremendous growth in wind and solar energy have squeezed margins. Many utilities have reduced or eliminated their exposure to this commodity-sensitive business, and we are confident that FirstEnergy will soon follow this path.
By 2019, we expect FirstEnergy's earnings will come entirely from fully regulated businesses in Ohio, Pennsylvania, West Virginia, New Jersey, and Maryland, many with wide and narrow moats. As such, we upgraded our moat rating from none to narrow.
Before power markets were deregulated, FirstEnergy was a fully regulated integrated utility. However, returning to its regulated past will likely require a big move: allowing FirstEnergy Solutions--or FES, its unregulated merchant unit--to fall into bankruptcy. We estimate this could cost shareholders a total of $1.7 billion for FES' unfunded liabilities plus a potential $1 billion settlement with creditors to avoid years of litigation.
Still, we think the stock is cheap, trading at nearly a 20% discount to our $40 fair value estimate and a 25% discount to fully regulated utilities. We think the market is too concerned about the pending bankruptcy, and, although costly, we are confident FirstEnergy can separate itself from FES. Once the market revalues FirstEnergy as the fully regulated and narrow-moat utility that it is set to become, investors should realize attractive upside.