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Quarter-End Insights

Utilities: A Weak December Could Foreshadow a Tough 2018

Utilities valuations appear to have peaked, but investors should remain cautious.

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  • Earnings and dividend growth will be the story for utilities investors in 2018 and 2019. Utilities across the world have aggressive investment plans with mostly constructive public policy support. As long as energy prices remain stable, we expect 5%-7% annual earnings and dividend growth across the sector during the next few years.
  • On a global basis, the utilities sector had a 1.08 market-cap-weighted price/fair value ratio as of Nov. 30, unchanged from the third quarter. A swoon in December brought down U.S. utilities' valuations, but prices remain rich.
  • For income investors, utilities' dividend yield premium to interest rates has been attractive the past few years. But that premium is closing. Since the 10-year U.S. Treasury rate climbed to 2.4% from 2.1% in late 2017, utilities' 3.4% dividend yield looks less attractive. However, the 100-basis-point premium remains historically attractive and should cushion the sector's sensitivity to future rate increases.
  • Utilities involved in M&A are still trying to secure regulatory sign-offs. We expect  WGL Holdings (WGL),  Great Plains Energy (GXP), and  Westar Energy (WR) to close their deals in the first half of 2018 but still face challenging regulatory hurdles. Likewise,  Sempra Energy's (SRE) bid for Texas utility Oncor will face tough regulatory scrutiny in early 2018. We think rumors about an acquisition of beleaguered  Scana (SCG) are unrealistic.
  • The new U.S. tax regime shouldn't affect utilities much. Utilities with unregulated businesses should benefit, but regulated utilities will simply pass tax savings to customers through lower energy bills. Lower rates could provide headroom for utilities to accelerate capital investment, leading to earnings growth. Renewable energy incentives will remain, but falling wind and solar costs are more important to the industry’s health. 

 

Winter has come in like a bear for utilities, and we expect it to stick around at least into 2018. The major indexes and all other sectors blew by utilities in December as the market turned a cold shoulder to the sector.

After hitting an all-time high in mid-November, the Morningstar Utilities Sector Index came under pressure while the rest of the market continued setting new records. We think 2018 could be a tough year for utilities investors facing pressure from still-elevated valuations and the potential for rising interest rates that will suppress returns.

Although market factors don't look good for utilities in the short run, most of the companies have exceptional fundamentals. Balance sheets are strong, dividends are well covered, and many have investment plans that lock in better than 5% earnings growth. Utilities in general are taking advantage of fundamental energy market opportunities to invest considerable sums in their electric and natural gas networks. U.S. investor-owned utilities plan $350 billion of investment in 2017-19, according to tabulations from the Edison Electric Institute.

We think 2018 and 2019 will be the years when that investment turns into impressive earnings and dividend growth. If earnings growth outpaces utilities' stock prices, the current elevated valuation multiples will come down to more reasonable levels. That means we think investors should focus on utilities with solid dividend yields in the 4% range and growth opportunities that can produce 5% or better earnings growth. That combination of yield and growth should help cushion weak stock price performance.

Developing energy market trends could support continued growth beyond 2019. Electric vehicle penetration won't help overall power demand, but it offers utilities the opportunity to invest in upgrading and installing new distribution equipment to support widespread charging infrastructure.

Renewable energy growth should continue as prices for wind and solar come down and utilities invest to meet state mandates and corporate demand. And we see no end in sight for natural gas infrastructure development to improve safety and expand regional access to cheap and plentiful shale gas.

Top Picks
The last time the utilities sector traded at a discount to the median fair value was in mid-2015. But the sector pullback in December has created a couple of attractive buying opportunities for income investors willing to take a little extra risk. 

 Scana (SCG)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $60.00
Fair Value Uncertainty: Medium
5-Star Price: $42.00

Scana's new nuclear project has weighed on the stock for several years. A brief relief rally followed management's decision to cancel the project, but now investors are scared that Scana faces $5 billion of sunk capital. We think the market is too pessimistic.

In our fair value estimate, we assume Scana returns $130 million to ratepayers, equivalent to writing off its last two years of investment in the project. However, the current market price implies Scana writes off nearly all of its investment and pays another $2 billion in refunds and penalties. This is far out of line with similar industry precedents. Management has shown good shareholder stewardship through the decadelong project, and we think it has good legal and regulatory backstops. As nuclear project concerns ease, Scana's 30% discount to peers should shrink.

 FirstEnergy (FE)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $40.00
Fair Value Uncertainty: Low
5-Star Price: $32.00

FirstEnergy's discount to our fair value estimate is primarily due to concerns that FirstEnergy Solutions will file bankruptcy and creditors will make claims against its parent. FES' three nuclear plants--two in Ohio and one in Pennsylvania--and several coal plants are struggling because of cheap shale gas. We assume these states do not provide financial support and that FES files for bankruptcy. Our fair value estimate includes $1.7 billion of parental guarantees and $1 billion of settlement payments from FirstEnergy to FES creditors to avoid years-long litigation. After FES' bankruptcy, FirstEnergy would be a fully regulated utility with solid growth from its distribution and transmission businesses. We estimate a fully regulated FirstEnergy will have operating earnings growth of roughly 5.5% over 2018-21, driven by the transmission segment growing at more than 7% annually.

 PPL (PPL)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Uncertainty: Low
Fair Value Estimate: $37.00
5-Star Price: $29.60

PPL has attractive regulated growth opportunities that could produce 5% annual rate base growth through 2021, supported by its operations in constructive regulatory jurisdictions. Some 70% of PPL's planned capital expenditures will have little or no regulatory lag. During the next five years, PPL plans to spend $15.9 billion at its regulated utilities and on additional transmission opportunities, supporting our projected 5.5% annual earnings growth through 2021. The U.K. distribution utility continues to be the focus of investor concern. The first concern is currency volatility, which we think management has addressed through its conservative hedging program. The other concern is the U.K. political environment, where much of the political focus has been on electric suppliers, to which PPL has no exposure.

Quarter-End Insights

Stock Market Outlook: A Dearth of Opportunity Amid the Rally
Credit Market Insights: Flattening Yield Curve Impacts Performance
Basic Materials: The Most Overvalued Sector We Cover
Energy: A False Sense of Security for Oil Markets
Communication Services: A Deal Eludes Sprint and T-Mobile
Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All
Consumer Defensive: Hungering for Top-Line Gains
Financial Services: Asset Managers Are Forced to Adapt
Healthcare: Pick Carefully as Valuations Head Higher
Industrials: Pockets of Uncertainty Present a Few Opportunities
Real Estate: Slow but Steady Climb Continues
Technology: Most Bellwethers Are Overvalued
Venture Capital Outlook: Dry Powder for Late-Stage Deals
Private Equity Outlook: Eyewatering Acquisition Multiples
Crypto Asset Outlook: Installation Phase

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