UCG's Saga

How capital markets react when a CEO changes a plan

Published on:
June 29, 2018
Last Update:

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Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

"We recently announced our decision to abandon the new nuclear project. Since making this filing, members of our senior management team and I have been meeting with a variety of stakeholders, Governor McMaster, and members of the South Carolina General Assembly, to discuss their concerns," said Kevin Marsh, boss of Scana Corporation. "We recognize that this process creates some uncertainty regarding the timing and impact of our abandonment decision."

When Wall Street analysts hear the word “uncertainty" a punishment to the stock price soon follows. Since that August 2017 earnings call, the stock price has been declining each month and now trades at a 12-month low of $37. It traded for $65 prior to that call.

The saga continued as the company surprisingly reported a loss of $172 million or $0.83 per share, for year-end 2017. I think it caught many of us by surprise because the 2008 - 2016 average earnings per share was $3.50 (during that 9-year period, earnings per share ranged between $2.95 and $4.16). Capital markets are merciless when management reports on a loss.  

The cost of abandoning a nuclear project

The 2017 loss in earnings was due to an impairment loss of $1.12 billion. The non-cash expense was directly related to the abandonment of the nuclear project as mentioned in the first paragraph. Excluding the impairment loss, I estimate that earnings would have been about $805 million, or $5.67 per share.

I was planning to purchase shares in SCG. To me, the non-cash cost (though it is a real cost for current shareholders who are looking to sell their positions) resulted in mispriced stock and, with the abandonment of the nuclear plant, would likely have freed future capital to be distributed as dividends. But the story is much more complicated.

The company had charged its South Carolina based customers much higher than average utility prices for over decade. Effectively, the consumer had paid for the construction of the nuclear plant. And Scana will not be able to charge these utility prices in the future. In short, the abandonment of the plant was a true cost, not just an accounting convention. It was a cost in the time and energy (no pun intended), the present devaluation of the stock, and for future profits.

The past

This is a story where the past is not indicative of the future.  While the company has been paying dividends to its shareholders since 2000 it is uncertain whether it will continue to do so in the future.

Second, the operating performance was adequate, but it is questionable whether it will continue; the 2017 revenue was $3.07 billion, compared to $2.84 billion in 2013; the adjusted earnings (which exclude the impairment loss) increased to $805 million from $633 million during that five-year period. But as mentioned, future utility charges will have to be lower.

2017-2013 adjusted earnings for SCG 

The present

SCG is now selling in the market place at about par. This is a relatively low valuation compared to past valuation. In 2016, with a book value of $39, SCG traded between $74 and $37, an average premium of 140%. In 2015, with a book value of $36, the stock traded between $76 and $59, a premium of 190%. 

Its earnings multiple is lower than other energy companies. Take Southern Company (SO) as an example. The company reported on $24 equity per share and the stock trades for $46, a 190% premium. Another example is Duke Energy Corp (DUK) - the stock changed hands for $79, with a reported book value of $60 per share, a premium of 130%. NextEra Energy (NEE) stock price was $167, with a book value of $60, a 278% premium.

Using the adjusted earnings of $5.6 per share, SCG trades at about 7 times the earning multiple, or 12 times the 2008-2017 earning multiple, which includes the 2017 loss. During that decade, the earning multiple was as low as 9 times and as high as 18 times. The average multiple was 13 times. 

An earnings multiple comparison between SCG and peer companies

The future

It is likely that in 2019, current SCG shareholders will own the stock of Dominion Energy (D). In December of last year, Dominion announced that it would replace all of the outstanding shares of Scana with its own stock, at an exchange price of 0.669. Dominion may be a terrific stock to own, but I know very little about the company.

What capital markets love

Capital markets often value stocks using past trends and penalize stocks when surprises occur. A 2016 investor in SCG, who had listened to Wall Street analysts, may have been tempted to purchase the stock as  earnings increased for 9 consecutive years (the annual compounded growth was 4%).

With the belief that the earnings trend must continue, the 2016 investor would have purchased the stock at a price range of $59 and $76, representing an earnings multiple of 18 to 14 times the 2016 earnings, or the 170% premium to book value. A dear valuation. 

But the nature of business is that as industries become profitable, either (1) more competition will enter the market place, squeezing future margins, or (2) the concept of diminishing return to capital kicks in.

In the energy sector there is additional risk. Energy-related businesses face constant scrutiny from regulators (read: If regulators realize that margins are abnormally high, they will likely opine that the business is a monopoly and break down its parts.)  

In sum, as earnings increase, the probability grows that future earnings will suffer. Against common convention, this is the point in time when you, the rationale investor, should be wary of the stock and less excited about where it will be.