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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.

Utility fundamentals continue to look very strong for the long run despite the sell-off. Balance sheets are strong, dividends are well covered, and many utilities 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.

Utilities' key fundamental risk is a potential cut in regulated returns, which would reduce our earnings growth outlook. Generally, regulators have been slow to pull back allowed returns in a persistent low interest rate environment. While we think rising interest rates and tax cuts will take some pressure off regulators to cut utilities' allowed returns, regulators in Virginia recently reduced rider returns highlighting the potential risk to utilities.

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 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 since mid-November has created a couple of attractive buying opportunities. 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.

 Scana (SCG
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $60
Fair Value Uncertainty: Medium
5-Star Price: $42

In January, Dominion stepped in as a potential savior for Scana investors who have been punished since management abandoned its new nuclear project in mid-2017. The market remains skeptical that Dominion and Scana have the charm to win over South Carolina politicians, regulators, and customers despite what Dominion called the largest proposed financial giveaway to utility customers in U.S. history. We think the companies have a 75% chance of winning support for the all-stock deal. The market appears to be pricing in a much lower probability with a 30% merger spread. The alternative is a long legal and regulatory morass as Scana tries to recover some $5 billion of sunk capital and avoid potential bankruptcy if regulators and politicians deny cost recovery and force refunds. We don’t think regulators will go that far and we like Scana’s core business, so we think this is a good risk-reward trade-off for investors.

Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $35
Fair Value Uncertainty: Low
5-Star Price: $28

PPL has attractive regulated growth opportunities that could produce 6% annual rate base growth through 2022, supported by PPL's 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 2022. 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 around the electric suppliers to which PPL has no exposure, although returns are likely to decline for all utilities under the next regulatory review.

 FirstEnergy (FE
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $40
Fair Value Uncertainty: Low
5-Star Price: $32

FirstEnergy's discount to our fair value estimate is primarily due to concerns that FirstEnergy Solutions, or FES, 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% from 2018-21, driven by the transmission segment growing more than 7% annually.

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Utilities: Under Pressure in Early 2018
Utilities sell-off presents opportunities for long-term investors.

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