Our Outlook for Utilities Stocks

Morningstar

After a wild ride through 2013, utilities are set to post just half the full-year returns of the broader market. Fears of rising interest rates have damped investors' appetite for utilities, but we think this opens the door for total return bargains. Power markets continue running in place, extending the bleak outlook for many power producers and diversified utilities.

Utilities investors rode more ups and downs in 2013 than they have in many years while they watched the market steadily climb past them. With a 12% total return in 2013 through mid-December, utilities have returned less than half what the S&P 500 has and trail every sector except real estate. Still, the sector's 12% return is above its 8% average annual return during the past decade and shows the sector's total return staying power regardless of interest rate sentiment. We continue to think a dip on market fears about rising interest rates offers an opportunity for long-term investors to pick up high-quality utilities offering steady, positive total returns.

Adding to the sector's attractiveness going into 2014 is its average 4% dividend yield, nearly double the average S&P 500 dividend yield and more than 1 percentage point higher than 10-year U.S. Treasuries. Our analysis of returns going back 20 years suggests 10-year U.S. Treasuries could climb to 4% from 3% today with little impact on utilities' total returns. We think utilities with 4% yields and 3%-5% earnings growth prospects the next few years offer a compelling risk-adjusted total return package for any investor.

Industry-Level Insights
In 2014, regulatory developments will be the key to watch for most U.S. utilities. The average awarded allowed return on equity during the third quarter held near 10% after dipping below 10% in three of the last five quarters, based on data from the Edison Electric Institute. We estimate there are more than 20 rate case filings outstanding going into 2014, each of which could have a material impact on the earnings and dividend growth profiles for the respective utilities. Those with the largest investment plans face the most regulatory risk.

Among power producers, the countdown has begun until the first significant environmental regulations take effect for all coal power plants in the country. On Jan. 1, 2015, coal plants will have to begin limiting their mercury emissions. Sustained low power prices and the emission requirements are leading to a pickup in plant retirement announcements. The Mid-Atlantic grid operator in December approved $4.6 billion of transmission investments to help compensate for what it projects will be 20 gigawatts of power plant retirements in the coming years. Already 18 GW of coal plants nationwide have closed since 2011, and we expect that number could double by the end of 2015.

The plant closures and environmental regulations offer two opportunities for utilities in 2014: transmission investments with premium returns and margin expansion for nuclear and natural gas-fired power producers. 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.

Coal plant closures also should help margins for utilities with nuclear or natural gas generation. We think the biggest beneficiaries during the next two to three years will be Exelon (EXC), the largest nuclear plant operator in the United States, and Calpine (CPN), the largest natural gas plant operator in the U.S. We still think the power markets fail to price in the pending coal plant closures and we expect forward power prices to begin rationalizing in 2014. As that happens, we think Exelon and Calpine can realize margin expansion from more favorable power prices in the Mid-Atlantic region and Texas even with natural gas prices at current levels.

In Europe, we continue to see utilities like RWE (RWE), E.ON (EOAN) and GDF Suez (GSZ) suffer from the one-two punch of the still-weak economy and surge of renewable energy. Renewable energy incentives have raised customer bills but compressed power plant margins. European utilities now are planning to shut uneconomic power plants, probably leading to more volatile power prices. The new coalition government in Germany has made electricity policy one of its key initiatives as it tries to find a way to rein in customer bills, keep critical power plants running, and manage nuclear plant closures while keeping the lights on and factories running. In the United Kingdom, SSE (SSE) and Centrica (CNA) are feeling political pressure to slow the rapid rise in electricity prices. Not much more can go wrong for the large European utilities, so any new policies could lift their prospects.

Our Top Utilities Picks
The median price/fair value ratio for the utilities sector 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 1.02, down from its peak of 1.17 in early May. Independent power producers, which are exposed to wholesale power markets that remain weak, 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 (SO) will probably end 2013 as the worst-performing of the 30 largest U.S. regulated utilities 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 12-16-13

Exelon (EXC)
Star Rating: 5 Stars
Fair Value Estimate: $42.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Yield: 4.5%
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: $50.00
Economic Moat: Narrow
Fair Value Uncertainty: Low
Yield: 4.4%
With its diverse operations, strong earnings growth prospects, and 4.4% 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.

ITC Holdings (ITC)
Star Rating: 3 Stars
Fair Value Estimate: $98.00
Economic Moat: Wide
Fair Value Uncertainty: Low
Yield: 1.8%
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. The 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 the FERC's superior regulatory framework and ITC's higher earnings growth potential. We expect annual dividend increases exceeding 10% for the next five years.

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: 4 Stars
Fair Value Estimate: $45.00
Economic Moat: Narrow
Fair Value Uncertainty: Low
Yield: 5.1%
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 Kemper power plant in Mississippi. 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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