AES Corp (AES) — Q2 2016 Earnings Call Transcript

Thank you, William. Good morning and welcome to our AES's second quarter 2016 financial review call. Our press release, presentation and related financial information are available on our website at aes.com. Today, we will be making forward-looking statements during the call. There are many factors that may cause future results to differ materially from these statements. Please refer to our SEC filings for a discussion of these factors. Joining me this morning are Andrés Gluski, our President and Chief Executive Officer; Tom O'Flynn, our Chief Financial Officer; and other senior members of our management team. With that, I will now turn the call over to Andrés.

Thank you, Ahmed. Good morning, everyone, and thank you for joining our second quarter 2016 financial review call. Today, I will discuss our year-to-date performance, provide updates on market conditions and our progress on our strategic and financial objectives. Tom will then discuss our second quarter results and capital allocation in more detail. Before turning to results, I would like to highlight the most significant milestones that we achieved so far on our key objectives for 2016. To continue de-risking our portfolio, we announced our close asset sales with proceeds of more than $500 million, well above our target range of $200 million to $300 million. We brought online one-third of our capacity under construction, or 2.4 gigawatts, on time and on budget. We prepaid $300 million in current debt, exceeding our full-year target of $200 million, to accelerate our credit improvement. We are on track to achieve our three-year $150 million cost reduction and revenue enhancement goals. In Bulgaria, we received payment of all outstanding receivables and continue to collect timely payment of invoices. And we continue to make progress to resolve DP&L's pending rate case and are encouraged by recent regulatory developments in Ohio. I will discuss these achievements in more detail in a moment, but first, I would like to summarize our financial results on Slide 4. Year-to-date, we generated proportional free cash flow of $670 million, representing 57% of our full-year guidance and reflecting the collection of outstanding receivables in Bulgaria during the second quarter. Our year-to-date adjusted EPS was $0.32, representing 32% of our full-year guidance, consistent with our comments on our last call. These results keep us on track to achieve our full-year financial guidance, which Tom will cover in detail. Now I'll provide an update on macroeconomic conditions in our markets on Slide 5. First, in Brazil, although we have seen a modest improvement in energy demand since our last call, we are still projecting negative growth for the year. In the U.S., demand is essentially flat, but in most of our other markets, we continue to see robust growth in energy demand in the range of 4% to 10%. Second, while we have seen significant volatility in foreign exchange and commodity prices over the last couple of years, we are generally seeing the market stabilize, as a result, foreign exchange and commodity forward curves are largely in line with our expectations as of our last call. The one exception is that, as a result of Brexit, the British pound has depreciated by roughly 10%. However, we are largely here in the near term and, more importantly, our exposure to the pound is only about 3% of our pretax contribution. Turning to Slide 6 on our portfolio optimization activities. In Brazil, we are seeing significant consolidation of the regulated utility sector at attractive valuations. We capitalize on this trend with the announced sale of our 100% ownership interest in Sul, our most material utility business in Brazil from an investment point of view, for approximately $470 million in equity proceeds to AES. We are currently seeking regulatory approval for the transaction and expect to close before the end of the year. Including the proceeds from the sale of Sul, we have announced or closed a total of $540 million in asset sales this year. Since September 2011, we have announced or closed asset sales with $3.8 billion in proceeds. The cornerstone of our strategy in Brazil is to pursue contracted wind and solar generation, now that we are seeing the opportunity for reasonable inflation-adjusted returns. These investments will help diversify our generation mix while also allowing us to take advantage of the $300 million to $500 million in untapped debt capacity.

Thanks, Andrés. Good morning, everyone. Today, I'll review our results, including adjusted EPS, proportional free cash flow, and adjusted pre-tax contribution or PTC by strategic business unit or SBU, and I'll cover our 2016 capital allocation, as well as our guidance and expectations. Turning to Slide 14, second quarter adjusted EPS of $0.17 was $0.09 lower than 2015. This decline is in line with expectations communicated on our last call. Specifically, our second quarter results reflect $0.03 lower contributions from SBU, including anticipated drivers such as timing of scheduled maintenance in ANDES and MCAC. A reduction of $0.03, because last year’s results included the favorable impact of the reversal of a liability at Eletropaulo. And the $0.03 impact from the evaluation in foreign currencies as expected, particularly in ANDES in Europe. Before moving on, I want to touch on a couple of large impairment charges we had this quarter that are not included in adjusted EPS. First, we impaired $235 million of assets at DPL, primarily at the Kelin station. This impairment impacts our quarterly diluted EPS and was largely driven by the results of the recent PJM capacity auction and our expectation of higher future environmental compliance costs under the EPA Effluent Limitation Guidelines in coal combustion. Second, as you have seen in our 10-Q, as a result of the sale, we have included Sul in discontinued operations and an impairment was recognized during the second quarter. The remaining loss on sale will be recorded at the closing of the transaction. After taking into account previously recorded cumulative transaction adjustments, the net impact on our equity will be a reduction of $100 million. Given this business is in discontinued operations, these non-cash items do not affect either diluted or adjusted EPS. As a result of placing Sul into discontinued operations, its earnings and losses are removed from our 2016 and 2015 results. Consequently, our first quarter results have been restated to $0.15 after moving the $0.02 negative impact for Sul, which brings our year-to-date adjusted EPS to $0.32.

Thanks, Tom. Before we take our question, let me summarize today's call. First, we are executing on our priorities for 2016: exiting certain businesses at attractive valuations, completing 2.4 gigawatts of projects on time and on budget, improving our credit profile, and collecting on our outstanding receivables in Bulgaria. Second, we continue to invest our growing cash flow to reduce debt and into select growth projects, as well as offer our investors a significant and growing dividend. Third, we remain confident in our ability to deliver strong free cash flow growth through 2018, which is driven by our projects under construction and our cost savings and revenue enhancement initiatives. Finally, we believe we are well-positioned to deliver sustainable growth beyond 2018 due to our strong business platforms in attractive and growing markets and our leadership position in deploying new technologies. With that, I would like to open up the call for questions.

Thank you, good morning. First question, can you give us a sense of what gives you the confidence that the Ohio issue is particularly—that's a correlation to the non-bypassable are going to be resolved favorably and what are sort of the key milestones we should be looking at to figure out how this is playing out?

We continue to have normal discussions consistent with the process in Ohio. We are obviously aware of developments with the other major utilities in the phase, especially with differing perspectives, but we think those are both constructive directions. We do continue to think that there is strong support in the state for in-state generation, given the fall of vertices diligent too far removed. The in-state jobs and in-state revenue from taxes and those kind of things lead us to believe there is strong support for that, and I apologize for saying we are encouraged by the discussions.

And secondly, Tom, so what is on that in terms of your 2016, 2017, 2018 outlook for this non-bypassable and I'm assuming you're assuming that to continue? And what if that doesn’t happen, how should we think about the sensitivities with your earnings, whether it’s for this year or for the growth in 2017, 2018 if that goes away?

I think what we would say is, I think we have been consistent here. Our most recent filing would not have a material impact, assuming we go back to the 2013 rate structure. We would not have a material impact on our financials for the remainder of 2016. Going forward, as we discussed different approaches here, we generally baked into our guidance is less than what we are currently getting, which is about $110 million a year or $9 million a month, but it’s still a material amount. We haven’t put a fine point on that, but certainly it would be a meaningful impact if there were a large fall, but at this point, we believe we will get something in that range.

Remember also, Ali, we’ve not taken a dividend out of DPL for some time and there is no parent free cash flow from DPL at least till 2018 in our forecast.

Okay, understood. Separately, Andrés, when you look at your portfolio today, can you just highlight for us what regions or assets in general you would consider to be non-core to this portfolio as you continue going down the road of streamlining your platform?

We have, I think, on very well in terms of focusing this company in terms of getting out of those regions where we didn’t see those markets as attractive and realizing attractive valuation from those sales. So what we are focused on in terms of growth, it’s going to be those places we can get long-term ideally dollar-denominated contracts and where we can bring something besides just money. So these are additions where there are synergies or economies of scale. So we don’t like talking about exactly those places that we are going to get out of until we do it. And you know we have very much stuck to that rule over the years. But I would say those countries, where we don’t see those opportunities. Where we see that, today, quite frankly they are either too volatile or we don’t see opportunities for growth. So what I would like to say, we will continue to grow those businesses, especially those that are cash accretive and our real focus is on creating a company where we have a strong sustainable growth in our dividend and that’s what we are focused on. So I’m not going to get into it specifically, but I think if you do it by the process of elimination, those are the places where we don’t see growth, where we don’t see long-term contracts and we really don’t have any really sort of particularly advantageous position, we will get out of. Now we won’t talk about them, until it’s actually done since obviously those can affect our operations.

Last question, Tom, just remind us why you’re not allocating special cash in terms of your priority of the use of that cash and just remind us what your priority would be on ranking your priorities?

Yes, I think across all the sectors we will look at incremental growth and I think we have said that we would expect about $300 million to $400 million of contributions into our businesses from core on a normal year. This year we are kind of right in the middle of that point. Of course, continuing to grow the dividend on a regular basis, we will continue to look to deleverage and may take some of this opportunity to accelerate the deleveraging in our balance sheet. And, of course, stock repurchases are still something we have authority for; we have done a lot. So, as we said, I think our primary focus in terms of cash to shareholders would be through the dividend.

So, perhaps a few more specific questions regarding the process here—just being very clear. How to think about the ESP-1 rate structure for 2013? What I understand is it’s mostly a regulated structure with fuel pass-throughs. How should we think about power prices and just competitive retailers under that rate structure? I know it's a bit detailed, but I’m just curious—are you still positively exposed to stock prices increasing net-net? I’m just trying to understand how that supplier recovery gets done.

In terms of the market risk and reward that we have under our restructure and one that we had or one that we are not going to revert back to is really the generation. At the end of the day, it’s about the same for us, but there was a group of people that have they not chopped then they would go to a defined rate structure. And that kind of slices it up a little bit differently, but the utility is not exposed to that; it’s a little bit different way to slice up the same amounts. In terms of going forward, we believe that what we had filed earlier in January and February, we can work under that umbrella, if you will. So we don’t need to pull that back and re-file. Remember we had a couple of different alternatives, so we feel that that umbrella gives us the flexibility to shape a solution in different ways.

Got it and just to be clear. The ESP-1, the 2013 rate structure will remain indefinitely until you get a rate outcome under the ESP-3 structure? So kind of agnostic, perhaps too strong a word there, but throughout the process whenever you eventually get an outcome in ESP-3, just to be clear?

Yes, it would remain outstanding until those are supplanted. And both of them are supportive of our financial structure.

Got it, excellent. And then just a quick question following up on the last question as well. Brazil Eletropaulo, can you comment just on what your thought process is there? Obviously, there have been some media comments there. How do you think about Brazil both with Eletropaulo and in the broader region, and how would you execute your going forward?

Okay, first given that Eletropaulo is a publicly listed company, we don’t comment on it. What we have said is that we made a significant strategic move by exiting Sul. If you look at today’s market price, the equity value we had at Sul is more than that of the value that we have in Eletropaulo, so we have made a significant shift. Second, we have been very disciplined in Brazil. We always for many years had this leverage capacity and the ability to buy new assets to grow, but we didn’t really see the valuations that were attractive for us. With the correction in prices in Brazil, we are starting to see opportunities that would make it more attractive to leverage up and buy something in Brazil. Now what would we buy? We are looking at our sort of risks, and we wouldn’t want more hydro risk in Brazil, so ideally, it would be something like solar or wind or perhaps even thermal that would not be correlated to hydrology in Brazil to make our cash flow more steady.

Sorry, and then the last quick one, any update on the assets you impaired in DPL, just curious if that has any reflection on the future viability of them in terms of retirement or whether they clearly are outlined?

No, that was just at Kelin, and that was just because it had a higher carrying value reflecting the results of the latest capacity auction.

They are all cleared, Julian; all our operations are cleared.

Hi, good morning. Just wanted to check in with you on the storage business. There is increasingly talk about this business and you all are obviously very early into this business. When you think about growth potential, we are seeing reports that costs are coming down for the actual equipment. Do you see that there are sort of inflection points at which it does become a fairly large driver of spending or is it a more gradual thing where there’s ultimately a step change but it’s rather just a gradual increase as you go down the curve? In other words, do you see relatively significant changes within a year or two or three in terms of where the cost is going that’s going to allow the businesses to scale up a lot or do you think it’s probably more gradual pace?

What we are seeing in the business is a continued reduction in cost. If we look at the cost of batteries, they have come down 80% in the last five years, and we are projecting an additional 50% in the next five. This reduction is driven significantly by the massification of the production process. The more people that bring online giga factories and drive down battery prices, the better it will be for people such as ourselves. Given that, how do you see this market? This market is growing. One of the main things that are slowing it down is regulatory, since these batteries operate differently than regulatory energy plants. But we are seeing this market grow from a couple of hundred megawatts last year—some forecasts suggest it could be 10 gigawatts globally by 2020. The lower forecasts still suggest around 6 gigawatts, which is still a tremendous rate of growth. There are many applications in this regard. This is a growing market.

That's very helpful color, Andrés. And you mentioned in your prepared remarks about essentially amortizing some of these initial costs. Could you remind us just sort of how rapidly you think you would be able to break through these costs so that we can start to see significant margins on incremental sales?

Look, it's going to depend on volume. It’s all about volume. So basically think of start-up costs and such as fixed costs. The more you have, the more quickly we are not really prepared to sort of give guidance on the third-party sale, but I really don’t see this year and probably not next year as being a meaningful contributor. Finally, this is not in our guidance for that reason, but this could become quite interesting outside that time horizon.

Good morning, thank you. Tom, I have a quick question on the 15% rate of return. Should we expect the hurdle rate to go up as interest rates go up and your cost of capital go up with it?

Yes, I think the short answer is generally interest rates are coming down and our cost of capital I think has been coming down, so I think that's a good number certainly on the projects we are doing. To the extent that I think Andrés mentioned, much of our focus will be on long-term U.S. contracted businesses. Some of that may warrant some compression of that modestly, but I don’t think we see them going up.

My point is eventually the interest rates are going to go up at some point, right, whether it’s a year or two years from now. When that happens, are we going to see that 15% hurdle rate go up?

Yes, the one thing I would say is we certainly look at our cost of capital and IRRs on a real-time basis. So certainly if there is a meaningful change in macro conditions like interest rate risk or other things like inflation, we would certainly factor that into our capital allocation framework.

Lasan, I think one way to look at this is, we want to earn a 200 basis points plus over our weighted cost capital on these projects. So it’s going to depend on their locations. So for example, we will have a lower ROI for those projects that are rate-based on our regular utilities than we do on some of the other projects from different locations. But the one thing we are moving towards, I would say, is de-risking the company. That I think is an important component. So if we look at for example the Panama project, it will have significant synergies if we increase the amount of tolling we do from that facility. Once you have the two hubs operating, the return from the project will not only be from the project itself, it will also be from the existing businesses. So that’s how we are looking at it. I don’t think that if interest rates go up— it depends on how much they go up, but we are also shifting our business to less risky businesses, and the returns of the project are also tied to the existing businesses, which perhaps were not included in that ROE.

No, let me flip the question around. How much more business would you typically get if you dropped the hurdle rate to 12% or 10% even?

I think if we drop the hurdle rate, again we don’t have a universal hurdle rate. The lower the cost of capital, the more projects come into scope. We don’t use a universal hurdle rate.

Hi, good morning. Just curious, are there any issues or risks to the Sul approval process? I believe that these acquirers require shareholder approval—just may be some comment on the milestones there to get approved?

Yes, the milestone requires shareholder approval. We believe that they are very confident of getting it. Then there would be an approval from the regulatory body. That’s why we are targeting this close for the fourth quarter of this year, but given all that’s happening in Brazil, we don’t expect any issues. Furthermore, it’s a transaction that makes a lot of sense, consolidating the distribution company into state entities and Sul. There is a lot of logic and many cost savings from bringing these together, so we think the fundamentals for the transaction for the acquirer are very strong.

Okay, thanks. And then just on the TPO, Ohio process. I'm just curious what was the thought process to file to revert back to the pre-2014 rate structure? I mean did you have discussions with the staff, or what made you choose that route versus any of the other alternatives?

Yes, we did have some consultation. I’d better not go into the specifics, but following the Supreme Court, we wanted to look for something that had the same provision of stability and supported the overall financial viability of the company while staying away from the specifics of the Supreme Court. Additionally, appreciating there was strong motivation for the reason I mentioned earlier to keep the utility stable and keep our generation viable.

Got it. Thank you.

Hi, good morning. I have a question on the effluent requirement and the coal combustion residual requirements. How much extra CapEx is that going to necessitate?

Yes, we haven’t disclosed that specifically. I believe DPL has the three-year forward CapEx table that is in their K. We are still reviewing it, but we did have some preliminary numbers that were baked into our impairment analysis and it was really the combination of those numbers. They really be out—I believe it’s a 20 to 21 times zone, as well as we did have to take note of the recent capacity auction that went down much from 160 to about 100. We think 100 is low; we did have to factor that most recent data point into our long-term forecast.

Brain, this is Ahmed. The deadline for these requirements is 2022, and as Tom mentioned, I mean we did have a number in our forecast, but based on the revised forecasts, the projections are slightly higher. But the real impact for this impairment is the capacity prices, which came in lower than what we were expecting. So that was the bigger driver than the CapEx.

Got you. And then just going back to your prepared comments on Sul. You mentioned that you had re-classed Sul into discontinued operation and there was a $0.02 sort of swing on year-to-date adjusted EPS. I'm just assuming that you haven’t changed guidance because $0.02 is relatively minor or immaterial versus the guidance range, is that right?

That's fair. To be honest, when we talked last time, we did say when we had a slower first quarter, we did say there were some things that we were working on, and this is at least one of the things in the bucket.

Thank you. Andrés, could you discuss Slide 12, on the third bar? In the 8% to 10% new construction that I get and you have laid that out very well. The 5% from existing business, I wonder if Andrés or Tom could give a little more color on that. Is that like just a full-year of IPL for instance improving Brazil, or what plays into the 5% over the two years?

That is our cost savings and revenue enhancement initiative, which is well underway. We have a three-year $150 million cost savings and revenue enhancement initiatives in three chunks of $50 million each. This is an annual run rate. Prior to this, in the previous four years, we did a $200 million cost savings and revenue initiative. So we have a lot of experience in this. Perhaps Bernerd, our Chief Operating Officer, can make a few comments on what that consists of.

Yes, thanks, Andrés. I think we are very pleased that we are on track with the $50 million that was what we committed for the first year in 2016. We also have a - we thought the initiative that we have underway well tracking on into 2017 and into 2018. And just as a reminder, those are the initiatives that we were disclosing as our synergies and economies of scale; that is one area we are working in sourcing. The service centers we have in lower-cost locations and what they can achieve between the labor cost that we have and efficiencies of standardization we have in those places. We are also doing standardization improvements in our fleet, sharing or replication of the lead practices of our thermal plants across the rest of the fleet. So with that, we actually have identified largely the $150 million that need to be delivered, and we are confident to deliver those.

Okay, so a lot of the 5% is these cost savings. So we can bank on that—sounds pretty solid. That’s good. Okay, that was all I had. Thank you very much.

Thank you everybody for joining us in today’s call. As always, the IR team will be available to answer any questions you may have. Thank you and have a nice day.