Pinnacle West Capital Corp

The Maricopa County Superior Court on Sept. 3 issued a stay of the Arizona Corporation Commission's implementation of a new formula rate plan to set customer rates for the state's utilities, including Pinnacle West subsidiary Arizona Public Service.

Why it matters: Arizona regulators' decision in December 2024 that allows utilities to request annual rate adjustments was a significant constructive shift in regulatory policy. The state previously was one of the least constructive areas for utilities to operate. The court's stay allows time for an Arizona appellate court to rule on a similar legal challenge. The ACC, which is contesting the state-level legal challenge, also said it would contest the Maricopa ruling. APS serves Maricopa County. Pinnacle West's earned returns should improve if the ACC approves APS' proposed formula rate adjustment and the courts deny the legal challenges.

The bottom line: We are reaffirming our $87 per share fair value estimate and no-moat Morningstar Economic Moat Rating for Pinnacle West. Pinnacle West shares trade at a 13% premium to our fair value estimate as of Sept. 4, a premium to most other US utilities. We continue to assume 6% annual earnings growth through 2029, in line with management's 5%-7% target, assuming normal weather and a constructive outcome in APS' pending rate review.

Big picture: The ACC could rule by Dec. 1 on APS' $609 million rate increase request filed last year. It's unclear whether the legal proceedings will impact this schedule. Constructive rate regulation is critical to support our forecast that Pinnacle West will invest more than $10 billion in 2026-29, in line with management's plan. Our 2026 EPS estimate is in line with management's $4.55-$4.75 guidance range. Electric demand growth is trending slightly ahead of our expectations. Commercial and industrial demand was up 13.6% in the first half.

Coming up: APS plans to file its 15-year integrated resource plan in October.

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Our fair value estimate is $87 per share after including recent financial results and updates.

On a weather-normalized basis, we assume 7% average annual earnings growth in 2026-29. Customer growth, electricity demand growth, and a $10 billion infrastructure investment plan for 2026-29 support our growth outlook.

However, earnings likely will be volatile. Normal weather will be a significant earnings drag after three consecutive warmer-than-normal summers that boosted earnings. Earnings growth also will lag until customer rate increases are approved in late 2026. We expect regulators to approve about 60% of APS' $580 million annualized rate increase request.

We think the 2024 rate increase was a constructive outcome that supports future growth investments. The rate increase incorporated a 9.55% allowed return on equity, in line with most US utilities' allowed ROE and well above the 8.7% allowed ROE from the 2021 rate decision. The implementation of formula ratemaking could incentivize additional growth investments.

We use a 5.9% cost of capital in our discounted cash flow valuation, which incorporates a 7% cost of equity. This is lower than the 9% rate of return that investors are expected to demand from a diversified equity portfolio. A 2.25% long-term inflation outlook underpins our capital cost assumptions.

Service territory monopolies and efficient scale advantages are the primary moat sources for regulated utilities such as Pinnacle West's subsidiary, Arizona Public Service. State-regulated rates for electricity generation and distribution contribute about 80% of Pinnacle West's earnings. The remainder of earnings comes from federal-regulated rates for electric transmission.

Although Arizona regulators allow APS a service territory monopoly and APS benefits from efficient-scale economics, we think the state regulatory outlook is too uncertain to give us confidence that Pinnacle West can earn at least its cost of capital for at least the next 10 years, the threshold for a narrow economic moat rating.

Regulated rates are the foundation for Pinnacle West to earn a fair return on and return of the capital it invests to build, operate, and maintain its infrastructure. However, if regulators don't uphold this implicit contract between customers and investors, it will be difficult for Pinnacle West to create sufficient value to attract investment.

Demand trends, investment cycles, operating costs, and access to financing can result in earned returns that are higher or lower than the allowed returns used by regulators to set customer rates.

Long-term regulatory uncertainty is in part because Arizona utilities commissioners are elected, not appointed like in most other states. High penetration of rooftop solar is another source of potential long-term regulatory uncertainty, as it has been for the last decade.

In particular, Arizona regulators' decision to cut Pinnacle West's allowed return on equity to 8.7% from 10% in 2022, resulting in a $200 million rate cut, illustrated the potential for regulatory setbacks. We estimate the decision would have kept earnings flat for at least three years absent the subsequent rate increases. The decision also led to slowing dividend growth.

A more constructive outcome to a 2023 rate increase request and likely implementation of formula ratemaking are positive developments that strengthen Pinnacle West's economic moat.

We believe FERC-regulated high-voltage electricity transmission has an efficient scale competitive advantage. Competitors have no incentive to build a competing transmission line if a line is already serving a market’s full capacity. The costs of new transmission lines are too high and the incremental benefits too low to offer sufficient returns on capital for two competing transmission owners.

In addition, federal regulators approve new transmission lines only if there is a demonstrated need for new capacity, protecting the incumbent’s efficient scale advantage. However, transmission represents less than 20% of Pinnacle West's normalized operating earnings, not enough to change our overall moat rating.

Pinnacle West should benefit from investing in the infrastructure that will be needed to support renewable energy targets and energy demand growth in Arizona.

Arizona's population growth has historically been higher than the US average, driving usage growth and investments in generation, transmission, and distribution.

A move to formula ratemaking in Arizona would help Pinnacle West consistently earn near 9% returns on equity, in line with most peer US utilities.

Utility regulators in Arizona are publicly elected, creating more regulatory uncertainty and shareholder risk than at utilities in states with appointed regulators.

A focus on energy efficiency by Arizona regulators and incentives for rooftop solar systems could slow electricity sales growth.

As more customers adopt rooftop solar, tensions could increase between utilities, customers, regulators, and rooftop solar installers.