Valuation and Leverage: Paul Fremont

Paul Fremont joined Mizuho Americas LLC from Nexus Asset Management in February 2017. Prior to that, he spent fifteen years as a managing director covering nineteen domestic U.S. utilities with the Jefferies equity research team.

PUF's Steve Mitnick: On behalf of your firm, you write frequent analyses of utilities and energy companies. What are you covering in those analyses?

Paul Fremont: Aside from covering the names in depth, we're also trying to provide a broader perspective. We want to allow investors to better understand how the sector works, and how to fit their analysis of these somewhat different companies into the bigger picture. Utility companies operate under a regulated profile compared to other sectors; they have significant differences.

PUF: You're not the only ones analyzing the companies. But you probably feel you've got some different, unique, and valuable approaches. What would you say those are?

Fremont: Let's start back in the 1980s and 1990s. Investors had initially focused on yield as their primary valuation metric. As you move forward in time, late 90s through today, investors have shifted their primary focus to pure price to earnings (P/E) analysis to value regulated electric companies.

P/E analysis makes sense to a certain degree, because the regulatory formula targets a certain level of net income. So the rate setting mechanism is really sensitized to net income. It's much less sensitized to cash flow.

One of the missing components in pure P/E valuation is that it doesn't adjust for debt. What we said in a piece that we published in mid-April, "Factoring Debt into P/E Utility Valuation," is basically that utility investors can do better.

We think they are right to focus on earnings. P/E is a very good starting point, but why not put everybody on equal footing with respect to financial risk and leverage, and therefore allow investors to make a more balanced comparison of the companies in our universe?

Since some companies use a lot of debt, and some companies use very little debt, we believe that you can account for some of the valuation differences just because some companies are more leveraged than other companies.

PUF: What you're saying is, "Sure that might be the case, but within our group the difference in how much the firms are leveraged is really significant, and needs to be accounted for?"

Fremont: The leverage differences are really not noticeable at the operating utility level because in most rate cases, the regulator will establish a fairly narrow range of allowed debt and equity levels in the cap structure.

Where the differences really kick in are those electric utility companies with holding company structures, where the holding companies can borrow. They borrow and infuse that money as equity into the operating utility.

PUF: These analyses are of course really useful for investors, but our readership includes regulators and utility leaders. How are your analyses valuable for those constituencies?

Fremont: Within the context of regulatory jurisdictions, back leverage is viewed differently by different regulatory bodies. In some jurisdictions, there is an attempt to normalize based on what the consolidated debt ratio is, versus what the specific ratio is at the regulated entity.

For those companies, or for those regulators, they believe that there is an additional cost to customers when holding companies actively use leverage as part of the equation. From a regulatory perspective, there may be some intellectual argument that looking at back leverage, or holding company debt, is a reasonable adjustment to make in the rate setting process.

With respect to the companies, I would say all the managements are very sensitive in terms of how investors make their investment decisions. Where debt has played a limited role in the past ten or fifteen years in driving valuations, that could change going forward.

Also, the company management may need to take that into consideration when they decide on what leverage structure is best for the company. If all investors look at is pure P/E analysis, you can essentially manufacture accretion by back levering at the holding company level and infusing that debt as equity. You can get four percent or so earnings accretion.

If investors knew where the markets would continue to value purely based on P/E, then there's a reward that the market would potentially put on your stock for employing more versus less leverage in your cap structure.

What we're suggesting is that if investors change their valuation approach and adjust their price target by subtracting parent debt per share, then company management may have less of an incentive to add leverage into the equation.

PUF: Before you all put these analyses out, what goes into them? Do you have sort of a generic model for all companies?

Fremont: The starting point here is, what's a reasonable valuation approach? Because the utility companies today are in many respects conglomerates. Many of them are involved in both regulated and non-regulated businesses.

When you put together a sum of the parts approach for each of them, it quickly becomes apparent that for non-regulated businesses, the starting point is usually an approach that takes into consideration the amount of debt in setting a price target.

So for instance, enterprise value to EBITDA essentially deducts out the debt per share. That would be a typical metric for what you could call non-regulated generation: for midstream gas investments, and for a whole host of investments by utility companies including retail and renewables.

When you set up a sum of the parts analysis it becomes striking. There is no adjustment that's being made for the incremental debt that sits at the holding company that one would appropriately allocate against the regulated businesses.

PUF: You must have some people helping you.

Fremont: Right now it's me and one associate. So we could definitely use more help.

But we do have detailed forecast models for each of the companies, and our coverage universe. We have separate valuation models we have built to set what we consider to be reasonable price targets.

PUF: What's your background?

Fremont: Many years ago I worked at one of the credit rating agencies, at Moody's. One of the things we did was develop a production cost model on every power plant in the country, looking at the deregulation of the generation portion of the business in many states throughout the U.S.

At the time, our standard cost report was the most requested report that Moody's had put out to date. Most of the questions on our report came from the equity side as opposed to the fixed income side. I determined early on that maybe it might be more interesting to be on the equity side, and when I left Moody's, it was to take a position at Salomon Smith Barney. Again, it was working as an equity analyst helping to cover electric utilities with Bill Tilles, who was at that time a lead analyst.

PUF: Do you have any other observations for our readers?

Fremont: After taking a two-year sabbatical on the buy side, I think that adds an entirely different perspective. I think that really has sharpened and differentiated my approach towards looking at these companies.