Pinnacle West Capital Corporation

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Pinnacle West Capital Corporation is an investor-owned energy holding company based in Phoenix, Arizona, with its main subsidiary being Arizona Public Service (APS). APS is Arizona’s largest and longest-serving electric company that primarily provides electricity services to approximately 1.4 million customers, and also has a strong focus on renewable energy resources.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Pinnacle West Capital Corporation is essentially a holding company, and its main operations are through its wholly-owned subsidiary, Arizona Public Service (APS), Arizona’s largest and longest-serving regulated electric utility. Here’s a breakdown of what that means:

  • Regulated Utility: APS provides electricity service to retail customers in 11 of Arizona’s 15 counties. This includes residential, commercial, industrial, and agricultural customers. As a regulated utility, APS’s rates and margins are set by the Arizona Corporation Commission (ACC), which provides a framework for their business.

Key takeaway: This means that APS’s revenues are generally stable and predictable, but also that their profit margins are tied to the agreed framework.

  • Geographic Focus: The company operates primarily within Arizona, making its performance highly dependent on the local economy, demographics, and regulatory environment.
  • Energy Generation Portfolio: APS generates electricity using various sources, including nuclear, coal, natural gas, and renewables (solar, wind, and geothermal). The company is currently transitioning toward cleaner energy, but the nature of the transition and costs to do so are heavily regulated.
  • Long-Term Contracts: The company relies on long-term contracts with its customers for their primary revenue stream. This provides stability in revenue but also limits opportunities for outsized growth.

Key takeaway: Long-term contracts help lock in revenue for long term.

  • Capital Intensive: The utility business is capital intensive because it requires ongoing investments in infrastructure, including transmission lines, distribution grids, and power generation facilities.
  • Growth & ROIC Focus: Management has a goal to achieve ROIC greater than 10% by 2025.

The utility sector faces significant challenges and transformations.

  • Clean Energy Transition: There’s a large push towards cleaner energy across the US, with states mandating more energy to be supplied by renewable sources and goals to be net-zero. APS is not an exception to this.
  • Regulatory Environment: The sector is highly regulated, and changes to federal and state laws and rules can significantly affect how utilities operate. This is extremely important for understanding their margins and revenue prospects.
  • Infrastructure Investment: Aging infrastructure and the need for upgrades will require large investments, further increasing the capital intensity of the sector.
  • Demand Volatility: Factors such as weather and economic conditions can lead to variability in energy demand, impacting utilities’ operational planning and forecasting.
  • Economic Conditions: Changes to the economy can directly and adversely affect the financial stability of the customers, which could lead to higher rates of bad debt and less usage of energy from customers.

Competitive Landscape

  • Monopoly and Oligopolistic Nature: Regulated utilities, like APS, tend to operate as monopolies within their service area, where there’s one major provider of electricity.
  • Limited Competition: While other utilities might compete with them in specific ways, it’s hard to enter into their markets directly.
  • Public Pressure: Utilities face public pressure to keep prices low while still investing in infrastructure and renewable generation.

Key Takeaway: Their moats are really based around the monopoly granted to them by regulators

  • Technological Disruptions: Disruptive technologies may make a utility’s existing assets irrelevant, or provide new ways to produce and transmit energy cheaper.

Moat Analysis: 2 / 5

Pinnacle West, mainly through APS, has some characteristics that resemble a moat. However, it is not very strong.

The reasons for it not being a strong moat and it being graded at a 2 out of 5 are:

  • Regulatory Moats: The primary “moat” for a company like APS stems from regulatory frameworks, as it operates as a regulated utility in Arizona. However, this “moat” is not impenetrable. While regulations limit direct competition, they also constrict APS’s pricing power and require it to seek regulatory approval for capital investments and expansions, limiting their ability to maximize profits compared to companies in non-regulated sectors.
  • Regional Focus: APS’ geographic concentration also weakens their moat, as this exposes them to economic and regulatory conditions in Arizona and makes them vulnerable to competition from alternative energy providers.
  • Switching Costs: While customers may be sticky due to the hassle of changing utilities, switching costs are low.
  • Lack of Scalability: The large size of APS means that they might struggle to grow revenue faster compared to its smaller peers.

Key takeaway: Overall, APS’s moat is more of a regulatory mandate, rather than a source of pricing power or cost efficiencies that can be exploited at will.

Risks to the Moat

  • Technological Disruption: The energy sector is experiencing disruptive technological changes, especially around renewable energy generation. While APS is trying to transition into renewable energy, it is still a major threat. These technologies could make APS’s existing assets obsolete. Also these technologies can be much cheaper to implement and therefore allow competing entities to undercut APS.
  • Regulatory Changes: Changes to regulations by the ACC can be a big threat to APS’s financial stability. For example, more pressure to reduce customer rates or mandated expenditure on specific technologies could affect the company’s bottom line.
  • Rising Input Costs: Fuel costs for gas and coal are significant input costs for power production, so volatile input prices could hurt the business. A prolonged spike in those commodities might squeeze the company’s profits as it is not always able to pass these costs on to consumers.
  • High Debt Levels: A reliance on debt financing means the company is more vulnerable to rising interest rates, which can decrease the profitability of current operations and make it harder for future operations.

Key Takeaway: These are all risks that could very well harm PNW’s moat in the long run.

Business Resilience

  • Stable Demand: Despite economic and regulatory risks, electricity demand in the state is relatively stable due to population and economic growth, which supports baseline operations.
  • Regulatory Frameworks Regulatory frameworks allow the business to recover a large percentage of costs and guarantees a minimum level of profitability.
  • Efforts to Diversify: APS is moving to diversify its generation and resources and transition to clean energy to lower risks associated with fuel and power prices.

Key takeaway: This will likely help maintain a reasonable level of profitability, even in times of economic distress or regulatory changes.

Financial Analysis

Here’s a summary of Pinncale West’s financial health based on latest filings:

  • Revenues:
    • In the nine months ended September 30, 2023, Pinnacle West’s consolidated operating revenues totaled $3,701 million
    • This was an increase of 12.1% compared to $3,299.1 million from the same time period in the previous year
  • Earnings:
    • Pinnacle West reported a net income of $492.2 million for the nine months ended September 30, 2023, compared to $504.5 million for the same time period in 2022
    • Earnings per share were $4.40
  • Operating Expenses:
    • The consolidated operating expenses totaled $2,935 million for the nine months ended September 30, 2023, compared to $2,547.5 in the same time period last year
  • Debt:
    • Long term debt including current maturities of long term debt was around $7,500 million
  • Credit Ratings: The company’s credit ratings range from Baa2 to BBB+, showing the company has maintained a healthy credit rating in its debt.
  • Moodys: Baa2, Standard & Poors: BBB, Fitch: BBB+
  • Dividends: They have maintained a steady dividend payout to shareholders.

Key takeaway: Based on these factors, the financials are reasonable, although the business could be doing a bit better.

Balance Sheet Health: 3 / 5

  • Debt: As mentioned above the company has a substantial amount of debt, especially considering that interest rates are on the rise. A higher amount of debt compared to equity may create problems. Therefore, we will assign them a 3 on balance sheet health.
  • Assets: The company’s main asset is property, plant and equipment, which is a stable form of asset. However, a good proportion of the assets are in other assets, which include intangible assets that do not produce much value
  • Equity: The company has a stable amount of equity and has continued to be profitable and increase equity year on year.
  • Cash: Cash and equivalents are relatively low

Understandability: 2 / 5

  • Complex Regulatory System The heavily regulated nature of the industry in Arizona requires a strong understanding of the complex regulatory proceedings of the Arizona Corporation Commission.
  • Complex Energy Markets: The energy sector can be a challenge to understand for ordinary people and its complexities regarding sources and their cost, regulations and demand/supply curves.
  • Financial Instruments: The large scale usage of derivatives and complex financial instruments further increase the complexity and make it harder for an average investor to make a judgement.
  • Lack of Transparency: The lack of transparency of the inner workings and strategic choices of APS due to the nature of it being a private entity makes understanding and judging its financial decisions much more complicated.
  • Technical terms: The various technical terms specific to the electric generation and distribution sectors makes it harder for investors to know if its a good or bad business.

Key Takeaway: Due to all the complexity surrounding the company and its financials, this business scores only 2/5 on the understandability metric.

Recent Concerns and Controversies

  • Rate Hikes: There’s an ongoing debate about the rate increases APS has been requesting. The argument revolves around the trade-offs between cost recovery and affordability for consumers, creating some challenges for customer satisfaction.
  • Navajo Transition: The transition from coal to renewable energy resources and the closure of the Navajo Generating Station has posed some risks with potential job losses, economic dislocations, and cost implications for decommissioning and other related issues.
  • Rising Debt: Investors have been concerned about the company’s growing debt, due to increased investment in infrastructure, which could lead to lower returns.
  • Transparency There are concerns regarding transparency of financial dealings and investment strategies of the company due to a lack of information disclosure from the private entity.

Key takeaway: These are all ongoing issues that must be tracked.

Conclusion

Pinnacle West Capital Corporation, a regulated utility, provides stable and predictable revenues, but is not immune from risks, especially stemming from regulatory changes, high debt and technological advancements in the sector. The main source of moat is regulation which is not very strong. However, its long-term prospects are largely stable due to its presence in Arizona. An investor can consider this company, but be wary of the complexity of the business and that management performance is judged by the ability of the utility to operate efficiently under constraints imposed on it by regulatory bodies.