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Quarter-End Insights

Utilities: Roller-Coaster Ride Continues, but Fundamentals Are Strong

Stock price volatility offers opportunities for investors committed to holding utilities for the long run.

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  • The median price/fair value estimate for our global utilities coverage is 1.05 through Sept. 15. The median price/fair value estimate for the 47 U.S. utilities we cover is 1.04. The median price/fair value estimate for the 24 non-U.S. utilities we cover is 1.07.
  • As 10-year U.S. Treasury rates fell from 3% at the beginning of 2014 to 2.6% in June, U.S. utilities outperformed every sector with an 18% total return. Since interest rates began climbing again, utilities have been the worst performers.
  • In Europe, there is increasing chatter that Continental countries might follow the United Kingdom and most of the Eastern United States into capacity markets. The first-ever auction in the U.K. is scheduled for December.
  • We continue to be bullish on U.S. power and natural gas prices, a boon for most diversified utilities and power producers. In Europe, gas prices have collapsed and government support for renewables is waning, offering some relief for power generation margins.

Since 2011, utilities have been on a wild roller-coaster ride, far outperforming the market for six to nine months, then far underperforming the market, then far outperforming. Fundamental performance has been steady, and we think most utilities are in as strong financial health as they have been since the U.S. and European recessions began. But investors seem to be rushing in and out of the sector with every whiff of interest rate policy shift. We think this offers opportunities for investors committed to holding utilities for the long run.

The spread between U.S. utilities' median 3.7% dividend yield and 2.6% 10-year U.S. Treasury yield still gives investors a historically attractive 110-basis-point premium yield spread. During the past 20 years, utilities' dividend yield on average has been equal to the 10-year U.S. Treasury yield. This suggests interest rates could rise to 3.6% before we see any meaningful deterioration of long-term returns for utilities.

Alternatively, if utilities' dividend yields fell to current U.S. Treasury yields, investors could realize some impressive returns in the next two or three years. In fact, even as U.S. Treasury yields doubled from 1.5% in mid-2012 to 3.0% in fall 2013, utilities were up more than 5%. In the two years following the interest rate bottom, utilities averaged a 13% annualized return, well above the sector's 9% average annual return since 1992.

In Europe, we suspect the U.K. general election in May 2015 will reduce some of the rhetoric from politicians calling for energy price freezes and the breakup or privatization of large energy companies. Renewable energy continues to wreak havoc on power markets, particularly in Germany. European utilities' profit margins are stabilizing, but at much lower levels than three years ago.

In the U.S., utilities fundamentals are generally strong. Our forecast sector average 59% payout for 2014 is in line with historical averages, and credit metrics are stronger than the past three years. With sustainable payout ratios, we think dividends could grow as much as 5% annually, better than the median 3% earnings growth during the past three years. Those utilities with a favorable combination of constructive regulation and critical infrastructure projects should provide investors the best long-run returns.

Top Utilities Sector Picks

Star Rating Fair Value
Fair Value
RWE EUR 41.00 Narrow Medium 3.3%
Exelon $40.00 Wide Medium 3.8%
TransAlta $13.00 None Medium 6.5%
Data as of 9-15-2014

RWE's status as the largest electricity producer in Germany and the third-largest electricity supplier in Europe leaves the firm heavily exposed to regional power markets. RWE benefited as electricity demand outpaced supply in the previous decade. But the economic recession, a collapse in energy prices, and renewable energy saturation have depressed profits. Weak power markets and energy demand mean earnings will probably continue to fall at least through 2015, but RWE's concentrated exposure to Central and Eastern Europe could reward investors if the economy accelerates.

 Exelon (EXC)
As the largest nuclear power plant owner in the United States, Exelon long has been a profit machine and an industry-leading source of shareholder value creation. But power prices have crashed hard since their 2008 highs and appear stuck at current levels for at least the next two years. Even with increased earnings diversification, 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.

 TransAlta (TAC)
We believe investors' focus should remain on Alberta power prices. The company's earnings are highly leveraged to power prices in this region following the roll-off of the power purchase agreements. The good news is that we believe increasing electricity demand due to the power requirements associated with oil sands and liquefied natural gas in western Canada could result in higher Alberta power prices and strong long-term earnings growth. We believe TransAlta's decision to cut its common dividend to an annual rate of CAD 0.72 per share from CAD 1.16 beginning with the 2014 first quarter is in the best long-term interest of shareholders to conserve cash and avoid continued share dilution.

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Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.