Description

Summary Thesis

• It is very likely that within the next 3 months Emera will need (or at least announce) a significant equity issuance in order to prevent a credit downgrade from Moody’s (Currently Baa3, Negative Outlook)
  • Moody’s has set a credit metric hurdle which EMA cannot meet without significant common equity issuance
  • EMA has stated that they will meet this target (08/10/19 Transcript), but they won’t
• Concurrently, this will likely be accompanied by a dividend cut  
  • A change to management compensation this year (2018) removes explicit language tied to maintaining the dividend
  • EMA recently reduced their dividend growth guidance, however, this does almost nothing to improve credit metrics

Recommendation

Purchase November 18 and January 19 put options.  Implied volatility on these strikes is ~12% - 15%, creating an opportunity to get fairly inexpensive exposure to a material negative equity event (either significant dilution and a dividend cut, or a downgrade to junk by Moody’s)

Risks

• Moody’s allows EMA to continue to operate with below Baa credit metrics without downgrading their rating  
• Assets sales could give Moody’s a reason to allow EMA an elongated window of time to get above the credit metric bogey
  • Given the nature of the potential asset sales (Power Generation Assets), near-term CFO pre-W/C declines more significantly than any reduction in debt
• Moody’s lowers their credit metrics after the sale of the power generation assets (EMA would derive essentially 100% of their earnings from regulated assets)  
  • This theory has been floated by current bulls, however Moody’s is unlikely to relax their credit metric because of the significant structural subordination

Dates/Catalysts

• 11/09/2018: Q318E Earnings, when EMA likely provides a, “refreshed long-term capital forecast, including financing considerations in the fall.”
• 12/2018: After Moody’s completes their 12-month review for TTM ending 09/30/2018, typically announcements are made in December.  Barring significant action taken by EMA (likely at least two of the following: significant equity raise, dividend cut, and asset sales) EMA will finish the year materially below their credit metric target and will likely be downgraded to junk.

Business Overview

Emera is a Canadian utility that owns TECO Energy (Tampa Electric Company and New Mexico Gas Company), Nova Scotia Power Inc (vertically integrated electric utility), Emera Maine (electric T&D utility), Emera Caribbean (electric utility), various gas pipelines in Canada and power generation assets in Canada and New England.  Approximately 90% of EMA earnings are from rate-regulated businesses, which enables forecasting cash flow within a relatively tight band.

EMA announced their acquisition of TECO at a 48% premium to TECO’s unaffected share price (total EV of $10.4B USD, and LTM EV/EBITDA of 11.6x) in September, 2015. This acquisition, combined with project delays and accompanying rate deferrals at the Muskrat Falls transmission lines, are the two primary contributors to EMA current credit situation.

Consolidated CFO pre-W/C <12%

Moody’s laid out the credit bogey for EMA to maintain consolidated CFO pre-W/C to debt of greater than 12% back in June of 2016.  EMA’s performance on this credit metric was 6.1% for TTM ending 12/31/2016, and improved to 10.1% for LTM ending 09/30/2017.  Moody’s placed a negative rating outlook (to junk) on 12/21/2017 after reviewing LTM ending 09/30/2017.  I believe that EMA will fall materially short of the 12% bogey for the TTM ending 09/30/2018, potentially leading to a downgrade when Moody’s completes their annual review (likely due in December 2018).  Furthermore, I don’t believe that EMA can reach the 12% bogey by even 2020, assuming that EMA is maintaining debt levels at Q22018 levels and funding a cumulative cash flow deficiency (CFO - CAPEX - dividends) or ~ negative $2.5B with common equity.

Credit Metric Calculation

The street equity research agree with this shortfall, but are ignoring the credit implications.  Shown below is one example of a street model where cumulative equity & preferred issuances of $3.6B (excluding DRIP) through 2020 don’t get EMA to a 12% CFO pre-W/C.  For the purposes of Moody’s calculation, this preferred issuance counts as 50% debt. I have made adjustments CFO to approximate the Moody’s calculation.

Example Street Model

Changes to Executive Compensation

Earlier this year in the Management Information Circular, EMA adjusted their performance metrics for long-term incentive compensation.  These metrics directly impact compensation that represented ~63% of former CEO Huskilson’s 2017 compensation. The reasons for for the change are, “The Company’s long-term focus will be on cash generation, particularly in light of the impact the acquisition had on the Company’s balance sheet and the importance of de-leveraging.”  Most importantly in this LTI compensation metric change is the removal of this clause, “In addition, dividends had to be maintained at or higher than the December 31, 2014 levels; if dividends were reduced, the second performance factor would be deemed to be zero regardless of EPS growth.”  In short, a large portion of management compensation was previously tied to maintaining the dividend - now it isn’t.

Prior LTI Compensation Metrics

Current LTI Compensation Metrics

Recent Actions/Statements

Comments on Dividend

• 05/11/2017 EMA Q117 Transcript:  “In the first quarter, we continue to make good progress on our growth initiatives that we expect will grow earnings and allow us to continue to target our 8% annual dividend growth rate through 2020.”
• 08/11/2017 EMA Q217 Transcript:  “We continue to make good progress our growth initiatives that we expect will grow earnings and allow us to continue to target 8% annual dividend growth through 2020”
• 08/11/2017 EMA Q217 Transcript: “In 2015, we raised the dividend twice, April and October. In 2016, we raised the dividend in July, coincident with the closing of the TECO acquisition. Prior to those two years, the board historically addressed the dividend at its October meeting, and we expect that the board would return to that normal pattern this year.
• 09/29/2017 EMA Press Release:  Board of Directors approves 8% increase in annual dividend payment
• 11/13/2017 EMA Q317 Transcript: “So, at this point in time, we remain confident that our 8% dividend growth profile is -- remains our target. We remain comfortable with that.”
• 02/12/2018 EMA Q417 Transcript: “So our view is, we've talked about our target dividend growth rate of 8% through 2020 that we remain committed to that target”
• 05/11/2018 EMA Q118 Transcript: No comment on dividend growth rate of 8% commitment.  1 Question refers to its reference in the MD&A, but management never mentions the dividend growth rate target explicitly.
• 08/09/2018 EMA reported Q2 Earnings:  Lowered dividend growth guidance from +8% to +4% - +5%.  Declares dividend increase of +4%.

Comments on Capital and Rating Agency

• 05/11/2018 EMA Q118 Transcript: “As part of our regular planning cycle, we will be refreshing our long-term capital plan during the third quarter and providing an updated forecast in the fall.”
• 05/11/2018 EMA Q118 Transcript: Q: “Are you guys at 12% right now or…” A: “We wrapped up both, I think – I don't know, probably both the rating agencies have this just north of 10% at the end of last year, and we are targeting 12% by the end of the year.
• 08/10/19 EMA Q218 Earnings Transcript:  Q: “Relative to your debt and the targeted, I think it's a 12% target you'll have. Have you socialized the expected cash flow growth with the – and where you'll end up as a ratio with the rating agencies and where are you with the sort of managing the outlook on the credit rating?” A:  “Yes. So, Robert, it's Greg. We have regular dialogue with rating agencies on all of our plans in terms of both forward-looking as well as year-to-date results. And again, we are confident and I believe they are equally confident that we will achieve the targets that we've set for ourselves both in 2018 and 2019.”
• 08/10/19 EMA Q218 Earnings Transcript: “As we highlighted on our Q1 call, we're in the midst of completing our regular strategic planning process and we anticipate providing a refreshed long-term capital forecast, including financing considerations in the fall.”
• 08/10/19 - EMA Q218 Earnings Transcript: “But as far as we are for 2018, we don't have any additional common equity requirements”

Appendix:

Moody’s Rating History & Detail

06/01/2016: Moody’s Assigns new Baa3 ratings to Emera Inc.

Rating Outlook

Emera's stable rating outlook incorporates a view that Emera will successfully execute on its permanent financing plans to finance the TECO Energy acquisition in a consistent manner with what has been stated publicly. The stable outlook also reflects our expectation that Emera's consolidated financial metrics improve, such that consolidated CFO pre-W/C to debt approaches 14% over the next 3 years.

Factors that Could Lead to a Downgrade

Emera's rating could be downgraded if regulatory support of its operating utilities deteriorates; or business risk profile increases through investments in its non-regulated activities; or holding company debt increases further; or if financial metrics do not improve as expected and consolidated CFO pre-W/C to debt remains below 12% on a sustained basis.

12/21/2017: Moody's changes the rating outlook of Emera Inc. and Emera US Finance LP to negative

Factors that Could Lead to a Downgrade

“Emera's rating could be downgraded if regulatory support of its operating utilities deteriorates; or business risk profile increases through investments in its non-regulated activities; or holding company debt increases further; or if financial metrics do not improve as expected and consolidated CFO pre-W/C to debt remains below 12% on a sustained basis.”

Commentary: Over the next 12-18 months, we expect Emera will continue to exhibit financial policies that emphasize holding company debt reduction and improving cash flow generation across its portfolio of subsidiaries.  Our negative outlook will focus on the company’s execution to improve its financial metrics.

Over the 12-month period ending 30 September 2017, Emera generated approximately CAD1.3 billion in cash flow from operations, invested about CAD1.5 billion in capital investments and made CAD 388 million in dividend distributions resulting in negative free cash flow of about CAD560 million.  Emera used asset sales, equity issuances and short-term borrowings to supplement the shortfall in cash flow. Going forward, we expect Emera’s cash flow from operations will approximately cover planned capital expenditures.

Catalyst

• 11/09/2018: Q318E Earnings, when EMA likely provides a, “refreshed long-term capital forecast, including financing considerations in the fall.”
• 12/2018: After Moody’s completes their 12-month review for TTM ending 09/30/2018, typically announcements are made in December.  Barring significant action taken by EMA (likely at least two of the following: significant equity raise, dividend cut, and asset sales) EMA will finish the year materially below their credit metric target and will likely be downgraded to junk.