Description

    

Hawaiian Electric Industries (HE)

Investment Memo

Short

12/1/2008

 

								CY ended Dec.
Trading data:								2006	2007	2008E*	2009E*
	Ticker		NYSE:HE		Summary Financials ($ mm):
	Price		26.04				Revenue	2,215.6	2,460.9	2,815.0	2,689.7
	52 week high		29.75				EBIT	271.4	239.4	291.0	296.0
	52 week low		20.95				EBITDA	413.6	391.4	447.7	471.3
							EPS	1.57	1.33	1.70	1.75
	Shares outstanding (mm)		85.1				Div. per share	1.24	1.24	1.24	1.24
	Equity mkt. cap. $USD		2,216.8
					Summary Valuation Multiples:
	Debt		1,440.0				EBIT	13.3x	15.1x	12.4x	12.2x
	Cash		(38.3)				EBITDA	8.7x	9.2x	8.1x	7.7x
	Enterprise value		3,618.5				Earnings	16.6x	19.6x	15.4x	14.9x
							Lev. FCF	-7.8x	-11.8x	-	-
	3 mth avg. daily volume (mm)		0.7				Dividend yield	4.8%	4.8%	4.8%	4.8%
	3 mth avg. volume $		18.3
					Segment Detail:
	Shares sold short		6.9				Utility EBIT	166.7	130.6
	Float		85.1				Thrift EBIT	88.6	84.0
	% of float		8.1%				Holdco EBIT'	(15.9)	(10.9)
	Days to cover		9.8
							Bank Equity	559.9	594.8
							Utility Equity	535.3	680.7

Summary:

·         Hawaiian Electric Industries is a levered holding company consisting of ownership of a poorly run electric utility that is bleeding cash and a mediocre underreserved thrift (a bank consisting of mostly residential mortgages)

o        Utility bleeds cash as it has underinvested and underdepreciated for years

o        Single digit ROE mortgage bank with thin margins and low reserves

·         Hawaii is facing severe economic headwinds

o        Steep (and rising) 30%+ fall-off in tourism, indicates the state’s GDP will likely contract by over 10%

o        Hawaii’s business of selling expensive consumer discretionary items that are primarily purchased by middle class Americans using credit, often via home equity extraction, appears to be significantly impaired

o        HE appears to be the best way to express a negative view on the Hawaiian islands

·         Deteriorating macro fundamentals evident in company performance

o        Electricity unit volume beginning to decline

o        Bank regulatory filings (call reports) for Q3 show alarming increases in early stage delinquencies that should show up in higher GAAP NPAs and provisioning in the coming quarters

·         Non-bank segment of company (the utility and holding company) is highly levered at 6x EBIT and 4x EBITDA and 8 x ULFCF

o        Common equity investors seem unaware or unconcerned with leverage level

o        Cash bleed and weakening business fundamentals should cause leverage ratios to spiral upwards over next several quarters

§         Produces no FCF before interest expense!

o        Re-pricing of this debt will pressure earnings and may face difficulties refinancing this aggressive leverage

·         The stock trades extremely expensive, at a large premium to sum of parts

o        HE is 100%+ overvalued based on conservative sum of the parts analysis

o        Trades at a very high PE (16x) for either a utility or a bank, particularly for poor versions of either

o        Trades very expensive for a bank on dividend yield, but slightly cheap for a utility on a dividend yield

§         Trades at 4.6% dividend yield vs. ~4.0% average yield for the utility sector

§         Dividend yield valuation is not really appropriate since HE is paying out more capital than is generated by the business and thus has a much higher payout ratio than the utility industry (or banking industry)

§         Trades at 16x earnings multiple vs. a 10x average for the utility universe

o        Currently has below-market cost of debt, which will gradually increase as short term debt rolls and new debt is incurred to fund operations at the utility

·         It appears there are technical reasons why the stock is so misvalued

o        Safety stock status given it is classified as a “utility“ and the market does not yet appreciate the magnitude of the likely collapse of the Hawaiian economy

o        Quant ownership, potentially a result of a dividend yield that is slightly high for a “utility”, the group in which this stock is likely classified in quant models (quant models probably overlook that this is a bank)

o        Heavy retail ownership because of the “safe” dividend

·         The most probable trigger for the stock to fall is a dividend cut and general earnings deterioration over the next several quarters

o        Currently the bank is funding the entire cash dividend – 4% yield or $20M per quarter which is 33% more than its current net income

§         Burned $37M, $38M and $40M in cash (ie negative FCF) over the last 3 quarters and that is projected to worsen

o        Utility cannot fund itself based on its operational cash flow and is bleeding cash, requiring bank cash flows in order to fund operations

§         Utility needs about $1.5B of CapEx in the coming few years in order to replace worn out facilities, consuming many years of total cash flow from operations

§         Implies the company has under depreciated the power generating assets which is troublesome not only because it would have inflated GAAP earnings but also since book value of PP&E is used for setting regulatory rates

·         Great risk/reward

o        Even if this dividend cut does not occur, there is no trigger to cause HE to rise much beyond its current price given the already extreme valuation

o        Doesn’t seem very likely at all that there can be a permanent loss of capital from this short position or even a large adverse mark

o        Seems likely that the stock will decline 30%-70% over the coming 6 to 12 months

·         Short works well in both a deflationary and inflationary environment

o        If deflation trends continue, the bank’s credit will deteriorate and this thin margin underreserved bank will be forced to slash the dividend

o        If inflation whips up, the low dividend yield will become relatively less attractive and the stock will sell off

§         Credit trends probably continue to deteriorate pressuring the dividend

§         Additionally the regulated nature of the utility means ROIC will not rise quickly if at all and since the business is levered and the cost of debt would rise, the ROE would actually fall forcing a dividend cut!

§         There is a prominent element of short long term US rates wrapped up in a short of HE

·         Hawaiian Electric Industries is a Honolulu-based holding company comprised of two distinct operating assets:

o        Hawaii Electric Company (HECO) - 60% of LTM operating income

§         Oil-fired regulated electric utility providing 95% of HI’s baseline power

§         HECO and its two subsidiaries, HECO and MECO serve the islands of Oahu; Hawaii and Maui, Lanai and Molokai respectively

o        American Savings Bank (ASB) – 40% of LTM operating income

§         $6bn thrift that is Hawaii’s third largest depositary institution (5% mkt share)

§         74% of book in residential mortgages (onshore owners), 12% commercial loans, 7% commercial real-estate loans and 7% consumer loans

·         HE is an amalgamation of worn out cash bleeding utility and a poorly run, poorly situated, underreserved, thin margin thrift

o        The utilities assets are decrepit and it voraciously consumes capital in order to maintain productive capacity

o        The bank funds not only the cash bleed at the utility but also the overall corporate dividend that inflates the valuation of the stock

 

Segment Operating Details:

·         HE is a nonsensical combination of a poorly run utility company and a poorly run bank

o Combined return on equity of 7.2% in 2007

o Only 2 of the last 5 years has HE been FCF positive

o CEO quoted a year ago as saying “we stay together because our value as a whole is higher than the sum of our parts”

o Both the bank and the utility independently run at very low margins (60-65% cost to income for the bank) and then layer in approx $10mm of HoldCo management costs

Return on average common equity by company
			2003	2004	2005	2006	2007
Electric utilities
	HECO		8.6%	8.1%	6.5%	7.9%	5.0%
	HELCO		6.4%	6.8%	6.7%	3.8%	4.4%
	MECO		9.9%	10.4%	9.6%	9.7%	5.9%
			8.5%	8.3%	7.1%	7.5%	5.0%
ASB consolidated			12.1%	8.0%	11.7%	10.0%	9.2%
Consolidated HEI			10.7%	9.5%	10.4%	9.3%	7.2%

·         HECO (Utility)

o        Serially underperforms its regulated rate of return as a result of poor management, older assets and a sluggish regulatory catch-up mechanism

§         HECO has earned an average return on equity of 7.3% over the past 5 years despite a regulated rate of return on equity of 10.75%

o        The allowed 10.75% ROE is generous relative to other regions and will be much harder for the regulator to support in the fiscal debacle that is shaping up

§         Average for similar utilities is 10% with some being pushed down to 9%

§         HECO has been at the regulators window asking for handouts for the past 3 years -> this is probably not sustainable long term

o        Financing costs likely to expand as underlying Hawaiian muni credit deteriorates

o        >$1.5bn in CapEx needs over the next 5 yrs

·         ASB (Bank)

o        History of low ROAs (<75bps) and low ROEs (9%) driven by excess capital and high (60-65%) efficiency ratios

o        Local real-estate loan book risk is compounded by $350mm asset portfolio of private AAA MBS w/ underlying assets in the mainland market -> these have not been marked down yet

§         Such assets trade at 30%-70% of par in the open market depending on underlying securitization

o        Bank doesn’t have a great deposit franchise– #3 player in a small market with only 5% deposit share

o        Lack of disclosure on loan dimensions (debt/income, LTVs etc.) is not confidence inspiring, nor is history of lax controls

o        Based on balance sheet burn-down and sources and uses analysis below indicates that the bank will likely be unable to support HE’s full cash dividend through the cycle, let alone fund the cash shortfall at the utility

§         Assumption on residential mortgages is most important in determining overall outcome

§         5% cumulative loss assumed in base case which is in-line with current prime mortgage loss expectations

§         Losses will mostly be caused by severe consumer-led credit cycle and not by weak underwriting practices

§         ASB did not apply for TARP money

Hawaiian macroeconomic environment is rapidly deteriorating due to weakening global economy

·         Tourism an estimated 30% of Hawaiian GDP

o        Visitor traffic down 20%+ year over year in the first two weeks of November and trends are accelerating

§         Based on detailed daily statistics published on government website

§         Was down 20% in September, 10% in July and 5% in March

§         Indicates that total GDP will fall 10% solely from tourism decline

§         YTD this is already the worst visitor decline in the history of the Hawaiian islands

o        Estimated that tourism impacts an additional 30% of GDP related to domestic consumption and investment

o        Vacationing to Hawaii is highly discretionary (and often a purchase made with home equity credit) and much of the consumption by tourists is discretionary

§         Tourism breakdown

·         42% from Western United States

o        Mostly CA which is one of the hardest hit economies

·         26% from Eastern United States

·         17% from Japan

o        Visitors from Japan have been in secular decline

·         5% from Canada

o        Had been taking advantage of USD weakness (though this is in the process of reversing)

·         10% other

o        Flat

·         Hotel occupancy is falling rapidly – down over 20% year over year!

o        Significant number of hotel bankruptcies are likely

·         In addition to the demand destruction created by high travel prices and impaired home equity on the mainland, Hawaii is also suffering from a structural reduction in passenger transport capacity

o        ATA and Aloha airlines have gone bankrupt, removing 10% of air capacity and Norwegian Cruise Lines has pulled two ships from the islands

·         Unemployment is up almost 50% year over year from 2.6% to 4.2% and is accelerating

o        For bank credit, the change and trend in unemployment is as or more important than the absolute level of unemployment

·         This is all likely to weigh heavily on the Hawaiian real estate market which at 10.1x median income and the highest rents in the country is massively overvalued and appears close to capitulation.

·         Likely that Hawaiian residents will leave the island as job market dries up, home equity evaporates, and income levels decline, which will accelerate losses at the bank and at the utility

Deteriorating macro environment is just beginning to challenge both the utility and the bank

·         Utility unit volumes will decline and with the operating leverage and the lag to regulatory rate adjustments, margins too and thus earnings will decline

·         The thin margin underreserved real estate concentrated bank will be forced to provision for rising portfolio loss content

o        Bank call reports are already showing a disturbing trend in early stage delinquencies

§         Q/Q, 30 to 89 day past due loans increased 3x from $5.9m to $18m, w/the majority of new delinquencies attributable to the 1st lien mortgage portfolio (2.6x increase), the construction portfolio (7.2x increase), and land loans (6.3x increase)

§         On a Y/Y basis, the rate of increase is similar to the Q/Q trends, which implies the increase is not attributable to seasonality issues

§         Total non-accrual loans increased 23% Q/Q to $9.9m, with the largest Q/Q increase attributable to C&I loans, which increased 50% Q/Q to $1.6m of non-accruals

 

Cash Flow Challenges:

·         Currently the enormous capital consumption of the utility is being funded by the bank and increased borrowings at the utility

o        Utility maintenance CapEx is much higher than its depreciation so true economic earnings are potentially quite overstated

§         The utility is voraciously consuming cash in order to maintain its EBITDA and depreciation understates this economic expense thus inflating utility reported earnings

o        Because of this, the fact the bank is paying out 133% of its net income just to fund the overall company dividend does not screen as alarming on an overall company payout ratio when the utility “earnings” are considered

o        The bank has also been making special dividends to the HoldCo which it then downstreams to the utility

o        With the deterioration in credit fundamentals, the bank will not likely be able to continue funding a high payout ratio

·         With the coming deterioration in the bank credit portfolio it is unlikely that the bank will be able to continue funding both a common equity dividend and a capital consuming utility

o        Currently the bank is funding the entire cash dividend

§         $20M per quarter which is 33% more than the bank’s current net income

§         Bank restructured its balance sheet during 2008 Q2 to free up capital and pay special dividend to the holding company

o        Utility cannot fund itself based on its operating cash flow

§         Burned $37M, $38M and $40M (ie negative FCF) over the last 3 quarters and that is projected to worsen

·         Requires a ramp in capital expenditures over next four quarters to replace the outdated equipment which should worsen the cash bleed

§         Funded by borrowing and also through special dividend distribution by the bank

§         Weakening economy will cause electricity usage to fall and cash flow to worsen further

§         Non-bank (utility + holding company) is highly levered at 6x EBIT and 4x EBITDA and 8xULFCF and has CapEx in excess of D&A as well as sizeable working capital requirements

o        Bank’s capital base is stretched thin and will ultimately be unable to fund the dividend and/or support the utility

§         As stated above it is already paying out 133% of its generated capital (ie net income) just to fund the overall dividend to common equity

§         Deteriorating macro environment will lead to greater provisioning and thin bank margins leaves no room to absorb deteriorating credit trends

·         Provision as % of loans has been at an incredibly low at around 10bps to 20bps per quarter

·         Reserve as % of loans relatively low at 76bps which should lead to reserve build

·         TCE ratio currently at a reasonably comfortable 8.2% but credit losses and provisioning will cause drop

·         Ultimately regulators should force a dividend cut / capital raise to prevent bank TCE ratio from plummeting

·         Most recent call reports show alarming trends in early stage delinquencies

·         HE also had an underfunded pension that will likely require $40M of cash over the coming quarters

o        Equal to a full year of net income at the bank and unclear how they will fund

·         Cash flow summary

Below is a summary of the historical quarterly cash flows and the cash flows projected over the next several quarters for HE assuming no dividend cut. The key driver is the expectation for loan provision and reserve build, as well as the continued cash bleed at the utility:

	3/31/07	6/30/07	9/30/07	12/31/07	3/31/08	6/30/08	9/30/08	12/31/08E	3/31/09E	6/30/09E
Cash flow summary
Bank recurring FCF	11.6	12.6	11.7	17.2	14.6	17.9	15.4	13.4	10.1	6.9
Utility recurring FCF	(38.0)	(36.2)	50.1	13.3	(38.8)	(40.2)	(42.1)	(35.3)	(37.9)	(15.6)
Total recurring FCF	(26.4)	(23.6)	61.8	30.5	(24.2)	(22.2)	(26.7)	(21.9)	(27.8)	(8.7)
Less: cash dividends	(20.2)	(20.3)	(20.5)	(20.6)	(20.7)	(20.8)	(21.0)	(21.0)	(21.0)	(21.0)
Total recurring FCF less cash dividends	(46.5)	(43.9)	41.4	10.0	(44.9)	(43.0)	(47.7)	(42.9)	(48.8)	(29.7)
provision as % of loans	0.00%	0.12%	0.27%	0.18%	0.09%	0.11%	0.19%	0.50%	1.00%	1.50%
allowance as % of loans	0.80%	0.81%	0.84%	0.74%	0.74%	0.74%	0.76%	0.84%	0.84%	0.84%

·         HE runs a high level of leverage

o        Non-bank portion is 6x EBIT and 4x EBITDA

o        Net debt excluding all bank funding is about $1.4B

o        That level of debt is very high, but when you consider the fact that the utility needs another $1.5B of CapEx to maintain productive capacity, it is alarming

o        After CapEx there is no FCF to service debt, much less amortize it

·         The maturity schedule on this debt is not immediate but should not be ignored

o        Refinancing this level of leverage on a business with these financial characteristics will not be easy

o        The rate the company currently pays on this debt (5.5% pretax, 3.5% post tax) is very low and will likely rise sharply on refinancing which will further impair earnings

·         Unclear how company will fund operations over the next several quarters

o        $87M of undrawn line of credit capacity at the end of 2008 Q4 should provide enough liquidity for 3 to 6 months

o        Any incremental leverage will cause leverage and cash flow metrics to deteriorate at the same time that fundamentals get significantly worse

o        Equity issuance a possibility given recently shelf filing, though this would dilute existing shareholders and not solve the operational cash burn issues

Bank balance sheet burn-down analysis:

										Base				Low				High
						Balance		% of Total		% Loss		$ Loss Content		% Loss		$ Loss Content		% Loss		$ Loss Content
Loan Portfolio (as of 12/31/07)
	Investment properties
		Commercial				276.7		6.5%		10.0%		27.7		3.0%		8.3		10.0%		27.7
		C&D				137.5		3.3%		20.0%		27.5		10.0%		13.8		50.0%		68.8
	Total real estate					414.2		9.8%		13.3%		55.2		5.3%		22.1		23.3%		96.4
	C&I					471.6		11.2%		7.0%		33.0		3.0%		14.1		12.0%		56.6
	Total C&I					471.6		11.2%		7.0%		33.0		3.0%		14.1		12.0%		56.6
	Consumer
		Mortgage				3,065.1		72.5%		5.0%		153.3		3.0%		92.0		10.0%		306.5
		Other				278.1		6.6%		12.0%		33.4		7.0%		19.5		15.0%		41.7
	Total retail					3,343.2		79.1%		5.6%		186.6		3.3%		111.4		10.4%		348.2
	Total loan portfolio					4,229.0		100.0%		6.5%		274.8		3.5%		147.6		11.9%		501.2
Investment portfolio (as of 12/31/07)
	U.S. Treasury					607.0				0.0%		--		0.0%		--		0.0%		--
	MBS					280.0				5.0%		14.0		0.0%		--		15.0%		42.0
	Total Remaining					887.0				1.6%		14.0		0.0%				4.7%		42.0
Total Loss Content												288.8				147.6				543.2

o        We are using what we consider reasonably conservative loss content estimates given the overall macro deterioration in Hawaii

·         These losses will have to be recognized through higher provisions and reserves over the next two years

·         The Pretax Pre Provision Profit (PPP) of the bank (the earnings able to absorb losses) is about 100M,

o        The loss content is about 2-3 years of bank PPP earnings which means the bank will generate no earnings for 2-3 years

o        Because the bank is paying a dividend, in order for the bank to fund the losses, it must stop paying dividends to equity or raise additional capital

Bank capital deficit / (surplus) analysis:

	Sources:					Base			Low				High
		Tangible common equity				429.4	7.9%		429.4				429.4
		Reserves				30.4	0.7%		30.4				30.4
		PPP credit				250.0			250.0				250.0
			PPP (avg fwd)				100.0				100.0			100.0
			Pref div				-				-			-
			PPP				100.0				100.0			100.0
			Multiple				2.5x				2.5x			2.5x
		Total				709.8			709.8				709.8
	Uses:
		Loss Content				288.8			147.6				543.2
		Required equity				300.0			300.0				300.0
			% of assets				6.0%				6.0%			6.0%
		Reserves				21.0			21.0				21.0
			% of loans				0.7%				0.7%			0.7%
		Total				609.8			468.6				864.2
	Capital needed pre-dividend					(100.0)			(241.2)				154.4
	Cash dividend over period					200.0			200.0				200.0
	Capital needed post-dividend					100.0			(41.2)				354.4

·         HE appears to be about 100% overvalued using conservative assumptions

o        Dividend cut assumed to conserve capital and preserve book value at the bank

o        Assumes no sum the of parts discount

·         Recognize that valuation metrics are less important than the perceived safety of earnings and dividend because of heavy retail ownership, but helps to have cushion and when the dividend can no longer be funded, the market will take a close look at traditional valuation metrics for these two businesses

·         $1.4B of non-bank debt currently costs just 5.5%

o        Given the 6x leverage on EBIT and the fact that it is hemorrhaging cash, an interest cost of 8% to 10% seems more appropriate in this environment

o        $231M is short term which will reprice higher, and company currently borrowing around $40M per quarter just to fund its operations and capital expenditure requirements

Bank valuation
	Base	Conservative	Comment
TA	$5,500.0	$5,500.0
ROA	1.00%	1.25%	Gives management benefit of doubt in its ability to improve ROA -- historically is ~80bps
Net income	$55.0	$68.8
P/E	10.0x	12.0x	Reasonable multiples for a mediocre thrift
Valuation	$550.0	$825.0
Share count	84.7	84.7
Bank value / share	$6.49	$9.74	Current TBV is $5 per share so implies valuation range of 1.2x TBV to 1.9x TBV
Utility asset valuation
NTM Utility NOPAT	$118.7	$118.7
HoldCo Opex	(9.6)	(9.6)
NTM non-bank NOPAT	109.1	109.1
Multiple	8.0x	12.0x	Industry average multiple is 8x -- seems generous given utility cannot fund itself
Valuation	$872.6	$1,308.9
Share count	84.7	84.7
Utility value / share	$10.30	$15.45
Total asset value	$16.79	$25.19
Net non-bank debt	(1,403.1)	(1,403.1)
Share count	84.7	84.7
Non-bank debt / share	($16.56)	($16.56)
Total value / share	$0.23	$8.63
Current market value	$26.50	$26.50
Upside for short	(99.1%)	(67.5%)

·         ASB’s new CEO, Tim Schools, is tackling the thrift’s underperformance, slashing costs and revamping products in an effort to boost ROEs and curb deposit flight to the mainland (big problem last year)

o        Early signs were that he was making some headway with cost / income ratios decreasing to 60% in Q2 from 69% in Q2 2007

o        Marginal improvements will be harder and without incremental leverage or aggressive lending practices it is hard to envision ROEs climbing much above 12%

·         Hawaiian regulatory environment is becoming more favorable with more dynamic ROE recapture mechanisms that will bring actual ROE closer to regulated

o        This would effectively result in significant price increases and heightened volatility for the end consumer which will be tough to pass through in the current environment

o        The current proposed revision which is due for vote in the regulatory commission over the coming months comes with large alternative energy capital expenditure requirements – this heightens financing risk and management has proven unable to earn economic ROEs on their past development projects

·         Risk free rates fall further and the dividend yield becomes relatively more attractive

·         Yield curve steepening could improve profitability at the bank since it funds long term fixed rate assets with short term funding

Catalyst

*Dividend cut and additional dilutive equity raises

*please note that this memo was written several days prior to the equity raise announced after yesterday's close. Given that this amounted to just 7% of the outstanding shares the thesis remains unchanged