4 Utilities Poised to Power Through for Investors

Morningstar

Rising interest rates and investors' shift away from defensive investments left utilities with the worst performance of any major sector in 2013. Regulated utilities are the cheapest they have been in several years, although they still trade at a 6% premium to our fair value estimates. Diversified utilities are slightly more attractive. The frigid winter weather in the Eastern U.S. showed how volatile demand and energy prices can help well-positioned utilities like Calpine (CPN), NRG Energy (NRG), Public Service Enterprise Group (PEG) and New Jersey Resources (NJR).

Even though utilities produced just half the returns of the broader market in 2013 and trailed every major sector, utilities investors still had a historically good year with a 14% total return, nearly double the sector's long-term annual returns. The market's interest rate fears have weighed on the sector's absolute performance, but utilities' fundamentals remain strong for the most part, and they continue producing solid, stable returns for investors.

We expect utilities investors will continue to realize 7%-8% total returns on a normalized basis regardless of the direction interest rates move. The sector's 4% average dividend yield remains 1 percentage point higher than the 10-year U.S. Treasury yield. We think this implies the market already is pricing in near 4% U.S. Treasury yields, and we don't expect a substantial move in utilities if or when rates hit that level. If Treasury rates stabilize near 3%, utilities could outperform the market in 2014 like they did during the first quarter of 2013. Most utilities have strengthened their earnings profiles and balance sheets by taking advantage of low-cost borrowing and rich market prices, and we see no wholesale threats to dividends across the sector.

Industry-Level Insights
The abnormally cold winter weather in January and February in the Eastern United States highlighted utilities' critical role as energy producers and distributors. High heating demand sent electricity and natural gas prices to record-setting highs for the winter season. The gas and electricity demand spikes showed the inadequacies and inefficiencies of the electric grid and the gas pipeline network with gas and electricity at many times unable to reach areas with the highest demand. Most utilities were able to keep the lights and heat on, but customers paid a high price.

We think this winter will serve as a call for more investment in electricity and gas infrastructure to improve the system's integrity and efficiency. Already utilities are planning more than $100 billion of investment in 2014, according to industry estimates. For power producers, the extreme weather showed the value of having generation capacity with a firm fuel supply source that can fire at any time to meet demand peaks. Calpine's high-efficiency natural gas-fired fleet proved its value along the east coast and we expect will reward shareholders with the profits it was able to capture. We also expect New Jersey utilities like Public Service Enterprise Group and New Jersey Resources fared well operationally and financially.

In the next few months we expect to see how regulators and utilities will react to the market stresses this winter. Utilities in the mid-Atlantic region will buy generation capacity for 2017-18 in a weeklong auction May 12-16. Any upward adjustments to projected peak demand or supply constraints should show up in higher capacity prices, helping utilities such as Calpine, Exelon (EXC) and NRG Energy. Regulators in Texas also continue debating how to attract new power generation to meet growing demand spikes. Any change in policy likely would benefit Calpine and NRG Energy.

The extreme weather and recent discussion about attacks on critical electric grid components offer opportunities for investment in the transmission grid. We think ITC Holdings (ITC), the only publicly traded pure-play transmission owner, can increase earnings and its dividend more than 10% annually the next five years based on $5 billion of projects. Xcel Energy (XEL) recently unveiled a five-year, $14 billion investment plan, much of which will be dedicated to transmission spending. FirstEnergy (FE) also announced a $2.8 billion transmission investment plan.

European utilities with power generation continue to struggle with competition from subsidized renewable energy and high gas prices. RWE (RWE), E. On (EOAN), ENEL (ENEL) and GDF Suez (GSZ) have discussed closing natural gas power plants because coal is a cheaper power generation fuel even after considering carbon costs. Ultimately, we think European regulators will have to allow utilities with coal and gas generation to realize their capacity values through a market mechanism in addition to wholesale power markets. A harsh winter or scorching summer could lead to blackouts if markets neglect the value of utilities' capacity to grid stability.

Our Top Utilities Picks
The median price/fair value ratio for the utilities sector is 1.03. Industry-level valuations show a divide between utilities with significant exposure to wholesale power markets and fully regulated utilities. The median price/fair value estimate ratio for regulated utilities is 1.06, down from its peak of 1.17 in early May 2013. Independent power producers, which are exposed to wholesale power markets that remain weak, have a 0.94 median price/fair value estimate ratio.

Regulated utilities' weak performance since mid-2013 leaves some high-quality names at the cheapest level they've been in many years. Stalwart Southern Company (SO) was the worst-performing of the 30 largest U.S. regulated utilities in 2013 and now trades at what we think is the most attractive valuation in four years. Other high-quality regulated utilities trading at or below our fair value estimates include CenterPoint Energy (CNP), American Electric Power (AEP), and Duke Energy (DUK).

Top Utilities Sector Picks
Data as of 3-17-14.

Exelon (EXC)
Star Rating: 4 Stars
Fair Value Estimate: $42.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Yield: 4.0%
Exelon's primary business as the largest U.S. nuclear power plant owner has long been a profit machine, but power prices have crashed hard since their 2008 highs. Exelon's earnings appear stuck at these levels at least through 2015 unless there is a sharp rebound in power prices. After a 41% cut in the dividend in 2013, we think Exelon has plenty of cash cushion to sustain that dividend at least through 2015, but we don't expect that dividend to grow. Any earnings growth will probably come from the regulated utilities, which we think can generate enough earnings to cover the dividend by 2015-16. But Exelon still can't escape its overwhelming leverage to Eastern and Midwestern U.S. power prices, which are tightly correlated to natural gas prices. The low operating costs and clean emission profile of its nuclear fleet make Exelon the utilities sector's biggest winner if our outlook for higher power prices and tighter fossil fuel environmental regulations materialize. Exelon's world-class operating efficiency ensures it will be able to capture that upside.

American Electric Power (AEP)
Star Rating: 4 Stars
Fair Value Estimate: $53.00
Economic Moat: Narrow
Fair Value Uncertainty: Low
Yield: 4.0%
With its diverse operations, strong earnings growth prospects, and 4% dividend yield, we think American Electric Power is among the most attractive utilities in the sector. Ohio regulators approved AEP's revised electric security plan, allowing the company partial recovery for generation investments until deregulation in 2015 and reducing uncertainty. The deal postpones AEP's plans to close some of its coal plants, but poor economics and environmental liabilities will still probably result in a significant reduction in coal generation capacity. Despite this, we think AEP remains well positioned to benefit from a recovery in Midwest power prices. We forecast 5% consolidated earnings growth through 2017, with the regulated utilities' $14.8 billion investment plan and 9% earnings growth offsetting the near-term weakness at its Ohio generation fleet.

Calpine (CPN)
Star Rating: 4 Stars
Fair Value Estimate: $28.00
Economic Moat: None
Fair Value Uncertainty: High
Yield: NA
Calpine's natural gas power plant fleet is the largest and one of the most efficient in the U.S. With natural gas prices at decade lows, the company's fleet has captured wider margins and higher run rates than competing power producers burning coal or oil. But we think Calpine is well positioned regardless of how natural gas prices move. While the company would face reduced output and margin contraction if natural gas prices rise, its efficient fleet would still capture significant margin from higher power prices. Additionally, tightening supply and demand constraints offer upside in Texas and California. Still, Calpine's returns ultimately remain tied to volatile gas and power commodity markets. We think leveraged companies without economic moats hold high fair value uncertainty, so we would require a sizable margin of safety before picking up this stock.

Southern Company (SO)
Star Rating: 3 Stars
Fair Value Estimate: $45.00
Economic Moat: Narrow
Fair Value Uncertainty: Low
Yield: 4.7%
Southern's total return proposition remains appealing for patient investors. The stock yields near 5%, above its 10-year average yield. Although economic growth in the firm's four service territories might remain tepid, the primary driver of our 5% earnings growth through 2017 is an investment program focused on nuclear, environmental, transmission, and distribution investments. Southern is allowed to raise customer rates annually to recover much of that investment, keeping cash lag to a minimum. Investors shouldn't underestimate Southern's constructive regulatory structure, though large projects have above-average recovery risk, notably its Vogtle nuclear power plant in Georgia. Favorable regulation supports Southern's investment plan and above-average returns, justifying its premium 15 times 2014 earnings multiple at our fair value estimate.

Travis Miller does not own shares in any of the securities mentioned above.

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