by Trapping Value Contributor since 2017 / 41222 Followers
10 months ago
Summary:
On our last coverage of NextEra Energy, Inc., we suggested that pushing the bear case was likely to fail.
A strong bounce ensued.
We tell you why we are now switching to the bear side.
Klaus Vedfelt/DigitalVision via Getty Images
On our last coverage of NextEra Energy, Inc. (NYSE:NEE), we opined that bears should not get overly ambitious as the stock looked ripe for a rebound. We based that primarily on just how far the company was from the average analyst price target, a metric that often creates a temporary floor at least. We suggested cautious investors could get involved using covered calls to generate an 18.61% yield.
The defensive play worked out, though obviously not as much as going directly long the stock. But playing defense is how you win over the long run, especially when valuations as a whole are not particularly attractive. We update our outlook for NEE and tell you why we are likely to see the next leg down soon.
1) Earnings Estimates Are Optimistic
It takes time for analysts to come to grip with a broken thesis. They relent slowly and the downgrades happen over a long period of time. NEE’s near-term growth forecasts seem achievable, but beyond that, we think the higher cost of capital will begin to weigh. On the renewable side as well, the opportunities today are far lower than what they were when NEE took on projects five years back. Simply put, the best sites are gone, margin crush is already here, and insurance costs are exploding.
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Analysts have stuck with the 7%-8% growth numbers, but for a change the EPS numbers are no longer increasing. We believe these estimates are off about a year and the 2025 EPS numbers are likely to be hit only in 2026.
2) Valuation Remains Challenging
At 20X 2023 earnings, you can rest assured that the market is pricing in growth and a very benign outlook on interest rates. Historically, utilities have tended to have an inverse relationship with interest rates as their dividend yields are the strongest competitors to risk-free Treasury bonds and lower risk corporate bonds. If our outlook for 10 Year Treasury yields (US10Y) is correct, we will likely see NEE trade at a 14X P/E ratio in the next 1-2 years. Incorporating that with the above earnings outlook, we see a strong possibility of NEE trading at $45.00.
3) The Oversold Bounce Appears To Be Done
In our last article, we showed just how oversold NEE was.
One metric is favorable here and that is the analyst price target divided by the current price. This is a sentiment metric more or less but shows how quickly things have gone to the doghouse. We will note that this percentage (currently over 160%, on left hand scale) has historically topped out (stock bottomed out) at lower numbers.
TIKR, From Previous Article
Even during the COVID-19 crash this metric did not get this high. We think this should caution the bears from joining this late into the party on the higher interest rate theme. A reversal could be just as violent.
Source: ZIRP Bubble Implosion Sends The Utility All The Way To Fair Value.
The logic here is that price does not move in a vacuum. There is anchoring based on where the price has been, and moving averages and oversold conditions do matter in almost all cases. This matters, as even when analysts downgrade the stock, their price targets remain well over the current price. This adds some courage to the buying money and helps stop the slide.
But that is the past. Look how this has changed. The red dot below was where the ratio was when we wrote the last article. The blue dot is where we are today.
TIKR
Rising NEE stock price and falling price targets have essentially fixed this. The late bears have been carted out on a stretcher, and the current ratio of Analyst Mean Price Target To Stock Price is near 110%. Pretty run of the mill stuff, and unlikely to change the larger trend.
Verdict
Just simple math tells us that there is a lot more downside, even at high valuations.
Even if you assume you hit the high end of the 1990-2017 range, there is more downside here. We reach a similar conclusion if we price this at 11X EV to EBITDA or the earlier stated 14X P/E ratio. In fact, all 3 triangulate near the $45 mark, if we assume the stock bottoms in the next 2 years.
If you believe, like we do, that bubbles go from one extreme to another, you really cannot embrace NEE here. NEE was the ultimate posterchild of the ZIRP (zero interest rate policy) bubble. That unwinding will take a lot more time, and downside risks abound. Of course here, one key facet is that we believe interest rates are headed higher at the long end. Those that use the Fed Cuts to justify their stance should know that long end rates being 2% over the short end is about as normal as things get when examining the long-term history. So even if you embrace the 6 rate cuts, know that the average situation would call for 10 Year yields at 5.5% in that case. We rate NEE a Sell here.
We tend to see investors gravitate towards these kind of units as the common rallies. The rationale is that the higher position in the capital stack makes them less risky. Unfortunately, as a mandatory convertible, the risk-reward for these are almost identical to the common shares. Yes, you get a higher payout up front, but you will get a bigger haircut down the line on conversion, which we stress again, is mandatory.
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There is capital loss by converting 1 unit of NEE.PR.R into 0.5626 shares of NEE common today. Weigh that versus the higher coupon payments until conversion and that should give you the relative arbitrage opportunity, if any, that might exist. We rate these a Sell as well, as they are tied at the hip to the common shares.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
Analyst’s Disclosure:I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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