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Quarter-End Insights

Utilities: Under Pressure in Early 2018

Utilities sell-off presents opportunities for long-term investors.

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  • Earnings and dividend growth will be the story for utilities investors in 2018 and 2019, which now trade at a price/fair value of 0.97. Utilities across our domestic coverage universe 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. 
  • For income investors, utilities' dividend yield premium compared with interest rates has been attractive the last few years. But that premium continues to close. Since the 10-year U.S. Treasury rate climbed to 2.87% from 2.37% at the end of 2017, utilities' 3.5% dividend yield looks less attractive. However, the 63-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 regulatory hurdles. We think Dominion Energy  (DRU) has a decent chance of closing its proposed acquisition of  Scana (SCG), but we expect a tough regulatory approval process in the politically charged environment.  Sempra Energy's (SRE) management team closed the Oncor transaction, successfully receiving Texas regulatory approval, a feat several suitors were unable to secure.
  • The earnings impacts from tax reform have had little impact on utilities. Utilities with unregulated businesses benefit, but regulated utilities will simply pass tax savings to customers through lower energy bills. Renewable energy incentives remain, but falling wind and solar costs are more important to the industry’s long-term health and growth prospects. Cash flow impacts have presented near-term credit concerns but do not have a material impact on our fair value estimates.

The utility sell-off that began in late 2017 continued into 2018. On a median basis, U.S. utilities now trade in line with our fair value estimates, the cheapest they've been since 2015. This is a sharp reversal since mid-November when utilities reached a peak 1.18 price to fair value ratio. Since then, Morningstar's U.S. Utilities total return index is down 10% and has underperformed the S&P 500 by 18 percentage points. No other sector has performed as poorly. The sharp rise in interest rates, in line with our outlook, appears to be the primary factor weighing on market valuations. The 10-year U.S. Treasury yield recently rose to 2.87%, the highest since January 2014, making utilities' income properties less attractive. The spread between the 10-year U.S. Treasury yield and the utilities sector's 3.3% trailing 12-month dividend yield is the tightest since January 2003 and approaching its 25-year average (16 basis points). The spread was 118 basis points as recently as mid-November.

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

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