Utilities: Bloody February Brings Valuations Back In Line

• U.S. utilities' 10% drop in February was the sector's worst performance since the late 2008 market crash and was one of the top 10 worst months in at least 50 years.
• After Morningstar's utilities sector valuations hit an all-time high at the end of January, the sector's February swoon and our internal recalibration of underlying interest rate assumptions have brought market valuations nearly in line with our estimates. 
• Outside of the eurozone, utilities' fundamentals remain strong with moderate payout ratios, solid balance sheets and a bevy of high-quality growth opportunities.
• Utilities' 3.6% dividend yield as of mid-March is still historically attractive relative to 10-year U.S. Treasury yields at 2.2%. However, utilities' dividend yields remain well below their 4.5% 25-year average.

Getting a handle on utilities the past few years has been as hard for investors as predicting when the Federal Reserve will blink. Utilities were the best-performing sector in 2011, the worst-performing sector in 2012-13, and the best performing sector in 2014. The first part of 2015 is proving just as erratic with utilities trouncing every sector in January before falling 10% in February, the sector's worst stretch apart from the 2008, 2001, and 1974 market crashes. We don't see an end to this atypical volatility until interest rates rise back toward historical norms.

After more than a year of waiting for the utilities bubble to burst, February was the needle that opened some attractive investment opportunities in the sector. In late January, the median U.S. utilities valuation hit the highest level ever since Morningstar began covering utilities. The February swoon cut that premium in half. We also cut our cost of capital assumption in our discounted cash flow valuations to reflect historical inflation and real interest rates, bringing valuation premiums down another 10%. As of mid-March, utilities' median valuation was only slightly above market prices and in line with valuations in late 2013 before the 27% run in 2014.

  - source: Morningstar Data 

U.S. utilities' fundamentals remain strong. We're forecasting median 5% dividend growth for the group during the next three years, with some utilities such as  Edison International (EIX),  ITC Holdings (ITC),  NextEra (NEE), and  Dominion Resources (D), well above that. Infrastructure replacement and efforts to maximize the value of low-cost natural gas supplies support this growth. A sharp uptick in interest rates could stall some of that growth as financing becomes dearer, but many of these projects have government support and the growth trajectory is quite transparent.

European utilities continue trying to find ways to manage through persistently weak power markets and tough government oversight. E.On (EOAN) has gone so far as to announce plans to spin off its competitive generation assets by 2016. Fellow German utility RWE (RWE) closed its sale of its upstream energy unit, RWE Dea, for EUR 5.1 billion despite objections from the U.K. government. E.ON, RWE, and fellow European diversified utility GDF Suez (GSZ) continue to be the most leveraged to an economic rebound but also most exposed to near-term energy market weakness that will keep dividends flat for the foreseeable future.

Among European diversified utilities, we think EDF offers the best combination of valuation, yield, and dividend stability, with modest growth during the next three to five years for patient investors in the downtrodden space. Other diversifieds have more upside to power prices and similar competitive advantages, but none has EDF's cash flow consistency and near-term visibility to support a narrow economic moat and a strong dividend with a 5.1% current yield. EDF stands far above peers in upside potential from new European capacity markets, as the inaugural U.K. capacity auction clearly demonstrated. EDF also could realize significant incremental value from newbuild nuclear in the United Kingdom.

Top Utilities Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
RWE		EUR 41.00	Narrow	Medium	EUR 28.70
Electricite de France		EUR 28.00	Narrow	Medium	EUR 19.60
Calpine		$26.00	None	High	$15.60
Data as of 3-26-2015

RWE AG (RWE)
RWE is one of Europe's five largest utilities, with vertically integrated generation, transmission, and distribution operations serving 16 million electric customers and 8 million gas customers. It also owns and operates power generation and supply in the United Kingdom and the Netherlands, and renewable energy assets in Europe and North Africa. About half of its profits are earned in Germany. RWE's low-cost power generation assets are difficult to replicate and earn high returns when costs rise for alternative power generation sources; however, the surge of renewable generation and nuclear phaseout in Germany have crushed profitability for its fossil-fuel generation. That said, we think RWE can sustain its EUR 1 per share dividend for the foreseeable future while retaining upside to an improving European economy.

 Electricité de France (EDF)()
EDF is one of the world's largest energy companies, controlling the French transmission and distribution grid along with other pieces of the European grid and a massive global generation fleet. Its French nuclear fleet comprises 58 plants. It also operates the largest unregulated supply business in France, which acts as a broker between generators and retail end users, and holds stakes in numerous other energy-related businesses throughout the world. EDF spans the globe, but France and renewable energy investments will drive growth through 2018. EDF's investments and French electricity market reforms could drive 3% annual EBITDA growth through 2018, supporting dividend growth. EDF's concentrated exposure to French electricity regulation makes it less attractive than more-diversified European utilities if power markets improve, but provides a stronger backbone for cash flows.

 Calpine (CPN)
Calpine is an independent power producer with 25.4 gigawatts of generation capacity throughout the United States and Canada, assuming it closes its sale of six power plants in the Southeast. The company operates in three regions: West (7.5 GW), Texas (9.4 GW), and East (9.6 GW). Its fleet is 97% natural gas generation. The rest of its portfolio comprises 725 MW of California Geyser geothermal plants and 4 MW of solar generation. Calpine's natural gas fleet is one of the most efficient and lowest-cost in the United States. We think this cost advantage positions Calpine well regardless of how natural gas prices move. Although the company would face reduced output if natural gas prices rose, its efficient fleet would still capture significant margin from higher power prices. In addition, Calpine's fleet is well-positioned in regions where electricity supply/demand conditions are tightening.

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