After scorching returns during the first four months of 2013, regulated utilities have underperformed every sector except real estate since April, down 9%. Even through the ups and downs of interest-rate outlooks, the utilities sector average dividend yield continues to hover around 4%. Recent coal and nuclear plant closures highlight the competitive threats in wholesale power markets from low natural gas prices and renewable energy incentives.
Given utilities' sensitivity to interest rates, the sector continues to swing violently as U.S. monetary policy hawks and doves circle overhead. A group of the 31 largest U.S. regulated utilities--those most exposed to interest rates--outperformed every sector with a 20% total return between January and April as interest rates remained near record lows. Interest-rate sentiment then shifted sharply, Treasury yields climbed rapidly, and regulated utilities underperformed every sector except real estate, down 9% between May and August. Still, the spread between the utilities sector's 4% average dividend yield and 10-year U.S. Treasury rates remains well above its 20-year average, suggesting utilities still offer solid risk-adjusted returns even if interest rates keep rising.
Aside from interest rates, the utilities sector continues to face several fundamental challenges. Electricity demand remains stagnant in most parts of the country. Residential electricity demand, which is the primary earnings driver for many utilities, remains at 2007 levels and total demand has been mostly flat since 2006. Average household usage is down 5% the last two years. This hurts not just the distribution utilities that continue to invest more capital to upgrade their systems, but also the wholesale power producers that are stuck waiting for demand to offset the continued low natural gas prices and rapid expansion of renewable energy. We think only the prospect of tough environmental regulations will lead to a near-term rise in power prices.
We think regulated utilities face the toughest challenges in the sector. Publicly traded electric utilities have invested $400 billion the last five years and expect to invest at record levels the next few years. Gas utilities, water utilities, and municipal utilities also continue investing at a rapid pace. This has hurt returns for many utilities and required more frequent requests for larger customer rate increases. Regulators have pushed back by cutting allowed returns. The average allowed return on equity awarded during the second quarter reached its lowest level in at least 20 years at 9.8% during the second quarter.
Although the spread between average allowed returns on equity and 10-year Treasury rates remains above its 20-year average, that spread has contracted by 200 basis points in the last 18 months. We could see another 100- to 200-basis-point contraction if interest rates keep rising or regulators continue cutting allowed returns. Hawaii regulators recently cut Hawaiian Electric's (HE) Maui Electric Company allowed ROE to 9.0%, leading the utility to cut its 2013 earnings outlook. Illinois' formula-rate adjustment means Exelon's (EXC) ComEd will set rates in 2014 based on an 8.7% allowed ROE. Utilities with key pending rate cases include Xcel Energy (XEL), Piedmont Natural Gas (PNY), Exelon, Southern Company (SO), and AGL Resources (GAS).
For those diversified utilities and power producers with exposure to wholesale power markets, the wait continues for power prices to rise. Utilities continue to close and announce plans to close coal plants ahead of environmental regulations set to take effect in 2015-16. Mercury emissions caps go into effect January 2015 pending federal legal proceedings. A court challenge to the U.S. Environmental Protection Agency's caps on state-level sulfur dioxide and nitrous oxide has made it to the Supreme Court. In addition, this fall we expect a final rule from the EPA that would cap carbon emissions for new power plants at levels that would effectively ban any new coal plants.
Even some nuclear plants are at risk as wholesale power prices and electricity demand languish. Entergy (ETR) announced on Aug. 27 that it plans to close its Vermont Yankee nuclear plant, the fourth announced nuclear plant closure in the U.S. during the last 10 months. Duke Energy (DUK), Dominion (D), and Edison International (EIX) also have shut down nuclear plants, and Exelon plans to retire its smallest plant, Oyster Creek (N.J.), in 2019. These plant closures and falling utilization at operating nuclear plants last year led to the lowest U.S. nuclear generation output since 2003. However, most nuclear plants remain the lowest-cost source of reliable, carbon-free electricity generation and still post returns on invested capital that are the envy of coal and gas power producers. Aside from another half-dozen at-risk plants, we think nuclear retains its wide-moat economics.
Our Top Utilities Picks
The utilities sector's median price/fair value estimate ratio is 0.98. Industry-level valuations show a divide between utilities with significant exposure to wholesale power markets and fully regulated distribution utilities. The median price/fair value estimate ratio for the regulated utilities industry is 1.03, down from its peak of 1.17 in early May. Diversified utilities, which have a mix of earnings from wholesale power generation and regulated utilities, have a 0.95 median price/fair value estimate ratio, while the independent power producers have a 0.88 median price/fair value estimate ratio.
The recent swoon among regulated utilities leaves some high-quality names at the cheapest level they've been in many years. Stalwart Southern Company has been the worst-performing of the 30 largest regulated utilities through the first eight months of 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 ITC Holdings (ITC), American Electric Power (AEP), and Duke Energy.
Among those utilities we think are best-positioned to benefit from a rebound in wholesale power markets are Calpine (CPN) and Exelon. Calpine's low-cost natural gas generation fleet is benefiting from low gas prices while taking advantage of its prime plant locations in regions with increasingly tight supply-demand conditions. Exelon, the largest nuclear operator in the U.S., remains the sector's decisive winner if coal plant closures in the eastern U.S. lead to higher power prices. European utilities such as RWE (RWE), GDF Suez (GSZ), and ENEL (ENEL) already price in the worst-case economic scenarios and offer significant upside if the European economy improves.
Top Utilities Sector Picks Data as of 9-16-13.
Star Rating: 4 StarsFair Value Estimate: $42.00Economic Moat: WideFair Value Uncertainty: MediumYield: 4.1% Exelon's primary business as the largest U.S. nuclear power plant owner long has been a profit machine, but power prices have crashed hard since their 2008 highs and appear stuck at current levels for at least the next two or three years. That has resulted in a sharp drop in Exelon's returns, a 41% cut in the dividend in 2013, and a shift in strategy that has increased earnings contributions from its countercyclical retail supply and regulated distribution businesses. Even with increased earnings diversification following the 2012 acquisition of Constellation, Exelon can't escape its overwhelming leverage to Eastern and Midwestern U.S. power prices, which drive almost half of earnings and 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 StarsFair Value Estimate: $48.00Economic Moat: NarrowFair Value Uncertainty: LowYield: 4.6% With diverse operations, strong earnings growth prospects, and a 4.6% 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 still likely will result in a significant reduction in its 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 the next five years, with 9% earnings growth at the company's regulated utilities based on its aggressive investment plans offsetting the near-term weakness at its Ohio generation fleet.
ITC Holdings (ITC)
Star Rating: 4 StarsFair Value Estimate: $98.00Economic Moat: WideFair Value Uncertainty: LowYield: 1.9% ITC’s wide moat and the Federal Energy Regulatory Commission's desire to improve the U.S. electricity transmission grid by providing incentive rates to independent transmission companies have produced healthy returns on capital and strong earnings growth for ITC since its IPO in 2005. Although returns are likely to decline as growth shifts to ITC’s lower-return projects, we believe earnings growth and returns will be higher than most utilities. FERC’s goal is driven by public policy to increase grid reliability, enhance wholesale market competition, and facilitate transmission of wind and other renewable generation to customers. We believe these trends are likely to continue for the foreseeable future. We believe ITC's premium valuation relative to peers is deserved due to FERC's superior regulatory framework and ITC's higher earnings growth potential. We expect annual dividend increases exceeding 10% for the next five years.
Star Rating: 4 StarsFair Value Estimate: $26.00Economic Moat: NoneFair Value Uncertainty: HighYield: 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 in 2012, the company's fleet captured wider margins and higher run rates than its other fossil fuel competitors--coal and 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, the company's 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: 4 StarsFair Value Estimate: $45.00Economic Moat: NarrowFair Value Uncertainty: LowYield: 5.0% 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 not remain above average, the primary driver of our 5% earnings growth through 2017 is an investment program focused on nuclear, environmental, transmission, and distribution investments, much of which closes to rates annually, keeping cash lag to a minimum. Southern has more upside to economic improvement than most peers. Investors shouldn't underestimate Southern's constructive regulatory structure, though large projects have above-average recovery risk. Favorable regulation is a key driver to the company's huge construction program and above-average returns, and supports Southern's premium 15 times 2014 earnings multiple at our fair value estimate.
Travis Miller does not own shares in any of the securities mentioned above.
- Utility Industry
- natural gas prices
- interest rates