With long-term interest rates stuck at historic lows, the utilities sector's 4% average dividend yield and steady growth prospects remain attractive. Power prices have ticked up following rising natural gas prices, but disconnects remain between bullish fundamentals and forward market prices. After a record-warm 2012 winter, the cold and lengthy 2013 winter offers what should be impressive first-quarter usage growth numbers.
Through the first three months of 2013, utilities have kept remarkable pace with the surging market, reaching a five-year high in early March and returning 11% year-to-date compared with 10% for the S&P 500. Utilities' average dividend yield remains near 4%, far exceeding any other sector and average dividend growth for the sector checked in at 4% in 2012. Fundamentals are holding strong and interest rates appear stuck for a while, so we see no immediate end to utilities' long cyclical run.
The supposed headwinds on the horizon for regulated utilities continue be a mirage. Low interest rates keep feeding earnings growth as utilities refinance their large balance sheets. Energy demand remains steady as housing demand rebounds, regional economies stabilize and low energy prices thwart energy efficiency efforts. Electricity demand was flat or positive in 35 of the 50 U.S. states in 2012 and the outlook appears better for 2013. For the most part, regulated utilities still have strong three-year growth prospects.
More favorable winter weather, especially in the southeast, should be a first-quarter boon after a record-warm 2012 winter. Through mid-March, heating degree days were up 11% year to date despite still averaging 6% warmer than normal. For electric distribution utilities, that weather-driven growth could moderate midyear as we lap two consecutive warmer than average summers. Still, strong cash flows should help utilities reduce the amount of new debt and equity needed to fund their growth plans and support earnings growth.
The primary earnings headwind we're watching is regulators' response to low interest rates. Regulators have been cutting allowed returns on equity below 10%, most recently in New York and several Midwest states. Average awarded ROEs are as high as they've been in at least 20 years relative to interest rates and a reversal either from lower allowed returns or rising interest rates would hit earnings and dividend growth. But until that spread starts to close, utilities could enjoy several more years of earnings growth.
Diversified utilities and independent power producers face less-certain prospects. Forward power prices, the primary earnings driver for these utilities, are up 10% in the East from their mid-2012 lows. But natural gas prices, which tend to drive power prices, are up 19% since then, reflecting what we think is a disconnect in the power markets between bullish long-term fundamentals and the market's short-term focus. In more liquid standard service and capacity auctions the last few months we're seeing signs of those bullish fundamentals, but the markets continue to ignore them.
Coal plant owners in particular face increasing uncertainty as low margins and environmental regulations hurt plant economics. Mercury emissions caps go into effect in 2015. Later this year the Environmental Protection Agency could finalize carbon caps that would virtually eliminate any new-build coal plants and the White House continues talking a tough game on greenhouse gas regulation for existing coal plants. Already, 12 GW of coal plants have closed since late 2010 and we're tracking another 34 GW of planned shutdowns, in total representing 15% of the U.S. coal plant fleet.
Our Top Utilities Picks
On a market capitalization-weighted basis, the average sector price/fair value estimate ratio is 0.93, up from 0.89 last quarter. But the utilities sector's median 1.08 median price/fair value still shows the valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities.
Based on our valuations, assuming interest rates return to historically normal levels, the 33 regulated utilities we cover on average are 12% overvalued with Wisconsin Energy (WEC), Piedmont Natural Gas (PNY), and Northeast Utilities (NU) among the richest. However, those stocks look a lot more attractive if you consider the spread between utilities' average 4% yield and current interest rates is as wide as it has been in at least 20 years, a historically bullish indicator. We think regulated utilities with the most upside include National Grid (NGG), Westar Energy (WR), and AGL Resources (GAS), all of which still sport 4% dividend yields.
We continue to see the most attractive opportunities among diversified utilities and independent power producers, although these have caught the market wave and now on average are only 6% undervalued, up from 15% undervalued late last year. We still think nuclear and natural gas power generation are set to thrive come 2015 when the first wave of coal-plant emissions regulations kick in. Exelon (EXC), the largest U.S. nuclear power plant operator, and Calpine (CPN), the largest U.S. natural gas power plant operator, should be the key beneficiaries.
We think European utilities offer the most attractive long-term valuations. German utilities E.ON (EOAN) and RWE (RWE), and French conglomerate GDF Suez (GSZ) are among the cheapest utilities we cover right now.
Top Utilities Sector Picks Data as of 3-18-13.
Star Rating: 4 Stars Fair Value Estimate: $42.00 Economic Moat: Wide Fair Value Uncertainty: Medium Yield: 3.8% Weak power prices continue to drag down Exelon's earnings prospects for the next three years. Faced with trough EPS near $2.50 in 2014-15, management in January cut its full-year dividend 41% to $1.24. But leverage works both ways, and Exelon is the utilities sector's biggest winner if our outlook for higher power and natural gas prices materializes. Coal plant environmental regulations are tightening and utilities are shutting down plants, all supporting our bullish outlook. With this view, we think Exelon's midcycle earnings power is $4.25 per share, nearly double our 2014 mark-to-market earnings estimate. For power market bulls, we think Exelon is among the cheapest utilities in our coverage universe, trading at just 8 times our 2015 midcycle earnings estimate and offering a 4% dividend yield even after its second-quarter planned dividend cut.
Star Rating: 4 Stars Fair Value Estimate: $27.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Yield: 0.8% Ormat's geothermal plants offer utilities a more appealing renewable resource than wind and solar generation, which are less reliable and more expensive--provided you can find the geothermal resource. Ormat's growth from development at more proven geothermal sites will be impressive, but we expect a bumpy ride as growth becomes more dependent on exploration. The company's portfolio provides a consistent profit stream and should grow at a rate unmatched by its peers without dependence on fossil fuels, supporting consistent cash ROICs. Reservoir issues at Brawley caused fears about the land portfolio that we think are overblown, despite the hit to recent profits. New projects will help ease concerns. Investors looking for an established, pure-play renewable energy developer should find Ormat enticing. Ormat also has significant exposure to emerging markets, supporting cash flow growth.
Star Rating: 4 Stars Fair Value Estimate: $24.00 Economic Moat: None Fair Value Uncertainty: High Yield: NA Calpine is uniquely positioned among its independent power producer peers as the industry's only predominant natural-gas generator, with the most efficient fleet in the U.S. This positions Calpine to benefit from tightening supply-demand conditions in many U.S. power markets, particularly in Texas and California. Both regions are struggling to provide market incentive for new-build expansion and pending emissions regulations we estimate could force 53 GW of coal plant capacity offline throughout the U.S. We expect this to create supply constraints across Calpine's core operating regions, allowing it to capture significant margin expansion independent of natural gas prices. While we view Calpine positively, we urge investors to maintain a high margin of safety given Calpine's no-moat position in a commodity-sensitive industry.
American Electric Power(AEP)
Star Rating: 3 Stars Fair Value Estimate: $46.00 Economic Moat: Narrow Fair Value Uncertainty: Low Yield: 3.9% With diverse operations and strong earnings growth prospects, we believe American Electric Power's 4% dividend yield is attractive. In August 2012, Ohio regulators provided regulatory clarity by approving most of AEP's revised electric security plan, allowing AEP partial recovery for generation investments until deregulation in 2015. The deal postpones AEP's plans to close some of its coal plants, but poor economics and environmental liabilities still likely will result in a significant reduction in its coal generation capacity. Despite these plant retirements, we think AEP remains well positioned to benefit from a future recovery in Midwest power prices. We see 6% consolidated earnings growth the next four years, with near-term weakness at its Ohio generation fleet offsetting our projected 9% earnings growth at the regulated utilities based on the company’s aggressive capital investment plans. As of early March, its 14 P/E is among the lowest of its regulated utilities peers.
Great Plains Energy(GXP)
Star Rating: 3 Stars Fair Value Estimate: $23.00 Economic Moat: Narrow Fair Value Uncertainty: Low Yield: 3.8% Great Plains for years has suffered from a challenging regulatory environment that depressed earned returns and contributed to a 50% dividend cut in 2009. But we believe regulatory conditions are improving in Missouri (home to almost 70% of the company's rate base) based on recent rate cases and passed and proposed legislation. With a large capital investment budget, including attractive investments in renewable energy and transmission, we think Great Plains offers a transparent and underappreciated opportunity for earnings and dividend growth during the next three to five years. Great Plains' shares are trading at 14.7 times our 2013 estimate in mid-February, a discount to the average P/E of the peer group of regulated utilities of 15.3 times. In our opinion, the stock is undervalued and no longer deserves to trade at a discount to its peers.
Travis Miller does not own shares in any of the securities mentioned above.