Power Players: A Closer Look at Utilities' Moats
New research lends greater insights into how utilities gain and hold their competitive advantages.
Utilities, usually a sleepy part of the stock market, have been on a tear lately. Morningstar's utilities sector index is up over 18% year to date, while the S&P 500 has increased less than 1% during that same time period.
Investors scooped up utility stocks when it became clear that interest rates would remain low--or even fall--making these firms' hefty dividend yields all the more attractive. It also helped that the prices of inputs such as natural gas decreased, helping boost demand. Add in technological advances and an explosion of interest in renewables such as solar and wind and it's easy to see why utilities have been on such a good run.
Amid that backdrop, Morningstar's utilities equity research team, led by Travis Miller, re-evaluated its approach to calculating economic moats for this sector. No longer is it simply enough to be the sole power producer in a given region or state. Miller and his colleagues now award economic moats to utilities that can generate earnings that exceed costs of capital and to utilities that are located in friendly regulatory regions. For more on this research we recently sat down with Travis. His comments have been edited for length and clarity.
Rob Wherry: Let's start with talking about the latest research your team just published. You updated the moat ratings on global utilities, right?
Miller: Late last year, we wanted to take a look at moats in utilities in terms of the investor experience. Previously, we'd thought very theoretical about moats in utilities. We primarily looked at the regulatory framework, such that if you're a monopoly and a regulated utility, you own all the wires and pipes. Then, theoretically, you should be able to earn at least your cost of capital or your business would go under and nobody would have electric or gas service or water service. So, that was the long-held framework for our moats in utilities.
We wanted to capture the more practical side of it--which utilities were good at earning more than their costs of capital in the long run. We spent four months over the end of 2015 and early 2016 and ended up downgrading 12 utilities.
This is globally, right?
Miller: Europe and the United States. Six were diversified utilities and six were regulated utilities that we downgraded. The reason for the downgrades was that these utilities had shown an inconsistent history of actually earning their cost of capital. So, the theoretical framework still holds, but the utilities that we downgraded were the ones that we just didn't have confidence that over a five- to 10-year period, the management team, regulators and the local economic conditions, would allow the company and shareholders to earn a return on capital exceeding the cost of capital.
At this point, it makes sense to define what you mean by regulated and diversified utilities and independent power producers.
Miller: Readers are familiar with regulated utilities. These are the companies that send you the electric bill every month. They own the wires, the pipes, and they actually distribute the energy that you use in your home. The way that they make money is by charging you for both the infrastructure that they've built and the operating costs that it takes to actually serve you.
On the other side of the spectrum, which people are probably less familiar with and have less touch with, are the power producers. They're a rather simple business model in that they own power plants and they buy some kind of fuel source, typically coal, uranium, or natural gas and oil, and put it through their plant to generate electricity. Then, they sell that electricity either directly to consumers or to the distribution utilities.
In between, you have the diversified utilities that own power plants selling into wholesale markets and regulated distribution utilities.
How do those three different business models affect the way you look at moats?
Miller: There are two very different businesses. People tend to think about the utility sector all as one sector. But when you start to split these two businesses apart they each have very different fundamentals. For regulated utilities, we think about the moat as a combination of management's operational expertise and regulatory conditions. The way we think about power producers is whether they are a low-cost producer.
What about the inputs? How does whether a utility uses coal, natural gas, or uranium, for example, to run its plants have an impact on your analysis?
Miller: There are a couple different competitive advantage sources. The more efficient your plant is at taking fuel and turning it into electricity can make you a low-cost producer. If you can buy a lower-cost fuel source and produce the same amount of electricity, then you could have a low-cost advantage. And electricity markets are very regional. It's very tough to transmit electricity generated in California to Chicago. So, to the extent that you have a locational advantage, you also might have a moat.
If you look across the fuel spectrum, nuclear has always been the low-cost producer. Nuclear plants generally are very large plants, very efficient plants, and uranium is cheap and plentiful. We've always considered nuclear a low-cost, wide-moat generation source.
We've reviewed that through this process and downgraded Exelon (EXC), which is the largest nuclear operator. The key point is that an interesting dynamic has developed with shale gas. Natural gas prices have fallen so much and the natural gas generation technology has improved so much, that you've now got natural gas plants that can be low-cost generators.
Lower than nuclear?
Miller: Lower than nuclear. Nuclear has low fuel costs, but they have high operating costs, too. Staffing and maintaining a nuclear plant is much more expensive than staffing and maintaining most gas plants. In some cases--and this is the first time we've seen it since the advent of nuclear generation--we're seeing in some areas gas plants running at lower all-in costs than nuclear.
There's a lot of inventory in natural gas right now. When you talk about low cost, nine out of 10 times, is natural gas usually what you're talking about?
Miller: Yes. The most interesting dynamic has been coal versus natural gas. Coal has always been about 50% of the generation base in the United States. It has always been by far a lower-cost generation fuel source than gas. But that is changing, especially in the Eastern United States.
If you look at the central Appalachian region, where coal dominates the electricity generation spectrum, that's also where you're getting shale gas. You've got some of the cheapest gas in the world coming out of the same region where you used to have the cheapest coal. And with the environmental regulations and the improvement in gas generation technology, coal has really lost a ton of market share.
Is there any good news for coal right now?
Miller: We don't think coal's going away. It's gone from 50% of the generation base just a few years ago to just about a third of the generation base this year. But there are a few things about coal plants that give them staying power.
One, they're there. You don't have to build them, and they're typically in areas that can serve good load, good demand. You can't just put up a power plant anywhere and serve load anywhere. You've got to build right there where the load is, where the demand is. So, one good point about coal is that it's there.
Second, you can easily store coal. You put it on-site. It's very, very difficult to store gas, especially on-site at a power plant. Oil is a fuel source for power generation, but it is very high cost, even with the recent drop in oil prices.
Third, coal plants tend to be pretty efficient. Not quite as efficient as the newest gas generation technology, but certainly more efficient than the old gas technology and the bulk of the gas fleet out there. It can be 50% more efficient.
Coal prices are going down, too. Coal and gas are substitutes in many respects. The opportunity cost of gas is coal, and the opportunity cost of coal is gas. So, right now in most of the country you've got coal and gas trading very close to each other. Coal has always been a very stable commodity price. Natural gas is extremely volatile. So if you think that gas will continue to be volatile, then you might favor coal. If you think you can take advantage of the new generation technology and gas prices are going to remain at $3/mmBtu, then gas is definitely the way to go.
Let's turn to regulations. Is there anything on the horizon that would have an impact on the way that you view utilities, but you're still unsure because it's not clear if a Republican or Democrat is going to be in the White House?
Miller: There are two types of regulation that affect utilities: state and federal. State is the primary regulatory consideration. But at the federal level, that's where it gets a little more interesting.
At the state level, there are politics involved. But in most cases, the framework is set up, and the framework is fairly predictable. To the extent that there are changes there, then we change our opinions at a state level.
At a federal level, regulators monitor the interstate electricity markets and more specifically transmission. They monitor environmental regulations. If the federal government becomes stricter on environmental regulations, it will affect both power generation and the delivery of that power.
At the state level, how do you track regulatory changes?
Miller: We spend a lot of time looking state by state at the regulatory regime, the regulatory calendar, and the relationships that utilities have with the regulators. There is a wide range of constructive and less constructive regulatory jurisdictions across the United States. And the companies that we recently downgraded--and long have had a poor opinion about--are the ones that operate in states with less constructive regulation.
Southern (SO) is a favorable example?
Miller: Southern Co. has the reputation of having good customer service. It's been able to run its system and invest in its system in a way that benefits customers. Because of that, regulators have allowed them to earn very attractive returns on that investment. The cheaper that you can operate your company and the cheaper you can invest in the infrastructure, the less the customer pays on their bill. And customers are always happy to pay less than more.
Great Plains Energy (GXP) is more challenged?
Miller: The regulatory construct in Missouri, which is one of its primary service territories, is very poor. It just hasn't been updated in a long time, and it really punishes the utility relative to customers. Because of that, management has had a tough time controlling its costs. When you have a less constructive regulatory environment, it makes it very difficult to plan for 10- or 20-year types of investment projects.
Let's talk about renewables. Is that part of the sector still showing promise?
Miller: Renewable energy has been the biggest area of growth the past decade. Wind is by far the most profitable source in the United States, particularly in the Plains, Texas, the Southwest, and the upper Northeast. Fortunately, for some--unfortunately for others--the place where the wind blows the most isn't the place where people use the most electricity.
Two of our wide-moat companies, Dominion Resources (D) and ITC Holdings (ITC), are big players in that infrastructure development to access that renewable energy. ITC is a prime beneficiary of renewable energy growth and the need to build wires to get energy to demand centers. They are primarily located in the Midwest and the Plains, and they are a pure transmission company. However, Canadian utility Fortis (FTS) recently offered to acquire it at a substantial premium.
What about solar? How big a risk to utilities is this idea that households or factories can generate all their power needs by investing in an on-site panel setup?
Miller: Distributed generation, primarily on-site solar, is the most interesting part of the utilities sector right now. It is the largest potential game changer out there. Right now solar at current costs is not economic in 90% of the country. It's just cheaper for most consumers to get their power from coal, gas, or nuclear power stations than small rooftop solar.
As you increase the number of customers, especially the number of residential customers, using solar and, more generally, distributed generation, it will cause problems for utilities because they are no longer needed. We are several decades off from that. But it is definitely a big threat.
Let's finish up by talking about a few stocks to keep on the radar.
Miller: Utilities have had a phenomenal run since mid-2015. As the market became comfortable that interest rates were not going up, and even went down, utilities looked a lot more attractive with dividend yields in the 3% to 4% range. They have had a huge run. We think the entire sector is fairly valued or overvalued.
Utilities we cover trade at 19 times our 2016 earnings estimates and 22 times trailing earnings, well above the sector's average 15 trailing P/E during the last decade. Utilities are also trading near double their book values, higher than the 1.6 average during the last decade. The sector's 3.7% dividend yield is well below its 4.5% 20-year average.
But utilities' dividend yields have rarely been so attractive relative to interest rates. The spread between utilities' 3.7% yield and the 1.8% 10-year U.S. Treasury yield is as wide as it has been since May 2013, a historically bullish signal for utilities and bearish signal for bonds. In our valuations, a key assumption is our 4.5% risk-free rate. This is in line with long-term average rates but well above current rates. If we cut our discount rates, our fair value estimates would go up and the sector would appear less overvalued.
One of our top picks is Duke Energy (DUK). It's been around for decades. What we like about it is we think the market has focused too much on its nonregulated business. In particular, Duke has a small business in Latin America, and it has been struggling because hydro levels in Latin America have been very low. It hurts when you have hydro plants without water going through them. The market has been overly focused on that and ignoring the good growth opportunities in states it serves like North Carolina. It has a 4% dividend yield right now. It usually trades at a premium to the group. It is now trading at a discount to the group. We think that's a good buying opportunity.
What are the risks to investing in utilities?
Miller: The industry is as healthy as I have seen it in the past decade. You have very strong balance sheets. Nearly all utilities have good growth plans. Regulation has improved. Payout ratios are right in line with what you would expect. It's an attractive time to enter the space absent the interest-rate issue. If interest rates go back to historical normalized levels, investors could feel a lot of pain.
This article originally appeared in the June/July 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.
Rob Wherry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.