Utilities: Low Rates Keep the Sector's Lovefest Raging
Only the Fed could break up utilities' M&A party.
Our worldwide utilities sector coverage trades at a median 0.94 price/fair value as of mid-September, the lowest utilities sector P/FV since the market bottom in 2009. Utilities are down about 10% year to date, and10-year U.S. Treasury yields have climbed 50 basis points since late January.
The sector continues to experience one of the most active M&A periods in history. In the U.S. there are three pending all-cash transactions, each worth at least $8 billion, and two pending $4 billion cash-and-stock deals. Low equity and debt costs are feeding the consolidation, and we expect the buyout spree to continue until rates start rising.
We expect environmental rhetoric to continue spewing from Washington, D.C., for the foreseeable future. The Clean Power Plan, finalized in August, will be the primary target for lawyers and politicians. The CPP requires states to submit carbon dioxide-reduction plans by September 2016 and implement them by 2022. We expect the CPP to survive mostly intact, but the opposition is likely to win modifications and implementation delays.
European power prices keep sinking and carbon credit prices keep going up, creating an increasingly desperate situation for fossil-fuel power generators.
The long-anticipated utilities sector consolidation has picked up speed during the past few months. We suspect large utilities that have remained on the sidelines won't want the low-rate party to end without finding a dance partner.
In the past month, Southern Company (SO) made an $12 billion bid to hook up with AGL Resources (GAS), and Canadian utility Emera made a $10 billion bid for TECO Energy (TE), including debt. Both deals are all cash and came with 30%-plus premiums. Exelon (EXC), Iberdrola (IBE), and NextEra Energy (NEE) also are moving through their own large deals. WEC Energy (WEC) recently closed its $9 billion acquisition of Integrys Energy.
With persistent, ultralow costs of equity and debt, utilities are turning to M&A for earnings growth. In particular, electric utilities facing weak demand outlooks are turning toward U.S. gas utilities. Low U.S. gas prices are driving retail demand growth, and environmental regulations are driving power generation demand growth. This secular growth and regulatory support for infrastructure investment is an appealing combination, seemingly at any price. We consider any U.S. gas utility ripe for picking, even at what we think are already inflated valuations.
In the coming months, we expect U.S. electric utilities with generation to start announcing specific plans to address the CPP when they update their three-year investment plans, typically in November. We don't expect any huge strategic shifts, but we do expect utilities to boost investment in renewable energy and gas-fired generation. More coal plant retirements could be on the way. If financing costs stay low and regulators are forced to support investment, the CPP could lift earnings growth for some utilities, similar to investments utilities made in noncarbon emissions controls.
Europe's continued move toward cutting carbon emissions and promoting renewable energy has crushed margins for fossil-fuel generators this summer. German forward power prices hit decade lows, down 8% since July. We don't see any reversal and have cut our moat ratings to none for most European utilities with significant merchant coal, nuclear, or gas-fired generation.
|Top Utilities Sector Picks|
| ||Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Electricite de France||EUR 26.00||Narrow||Medium||7.2%|
|Data as of 9-24-2015|
ITC Holdings (ITC)
ITC Holdings' wide moat and the financial incentives federal regulators offer to improve the U.S. electric transmission grid have produced healthy returns on capital and strong earnings growth for ITC since its IPO in 2005. We expect ITC's capital investments to support close to 9% average annual earnings growth and 13% annual dividend growth during the next five years, even as regulated rates of return come down. Regulators' new methodology for calculation of allowed returns following a decision in New England is a headwind, but we think any downside is more than priced into the stock as of mid-September. Long-term, ITC's transmission businesses in the central U.S. are poised to benefit from new natural gas-fired power plants and wind farms replacing coal-fired plants in the coming years.
Electricité de France (EDF)
EDF is one of the world's largest energy companies. As the French grid operator and owner of the world's largest nuclear fleet, EDF benefits from core regulated cash flows that support a dividend, most of which goes to the French state, which owns nearly 85% of shares. EDF's generation in France is regulated, so it doesn't have the same commodity exposure and upside--or downside--as most European peers. We forecast that EDF will generate core EBITDA of EUR 17.6 billion in 2016 and EUR 18.3 billion by 2018. Our growth outlook is reinforced by steady performance and investment in renewables and the company's regulated networks, a gradual expansion in power prices based on French tariff improvements, and the development of new construction projects.
Duke Energy (DUK)
Duke Energy became the largest utility in the United States after it merged with Progress Energy in 2013. Management has impressively driven significant cost savings from the transaction and is targeting 9% cost synergies, which we view as attainable given management's recent success. Duke's regulated distribution businesses make up about 90% of consolidated earnings. In 2015-19, we anticipate cumulative capital expenditures of $41.8 billion, of which nearly $30 billion is growth capital and should support our 6% earnings growth estimate. We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes.
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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.