Utilities: Back to Fair Value With Some Emerging Opportunities

• On a global basis, utilities now trade mostly in line with our fair value estimates at a 1.0 price/fair value ratio. Most utilities across our 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, U.S. utilities' dividend yield premium relative to interest rates has evaporated as interest rates have continued to climb. The spread between utilities' 3.5% dividend yield and 3% 10-year U.S. Treasury yield is the smallest since 2009 and near the 25-year average spread. Utilities had enjoyed a 200-basis-point yield premium as recently as late 2016, which helped cushion the sector from the sharp rise in interest rates. But with little yield premium left, we expect utilities will become more sensitive to interest rate changes.
• On the active M&A front, Great Plains Energy and Westar Energy closed their merger, creating  Evergy (EVRG). We still expect AltaGas to close its acquisition of  WGL Holdings (WGL) and we wouldn't be surprised if industry consolidation continues.  CenterPoint's (CNP) acquisition bid for Vectren could be a model for future deals.  Dominion Energy (D) and  Scana (SCG) likely will find out by year-end if South Carolina regulators will bless their merger proposal.

Utilities have had a rough road the past six months, down 9% since they peaked in November while the S&P 500 is up 9% since then, both including dividends. No other sector has performed so poorly during that time period. We don't see that trend reversing any time soon. A strong economy and a steady climb in interest rates rightfully could send investors away from utilities.

The sector downturn has made valuations much more reasonable, but we still don't think investors should get overly excited about the sector as a whole. On a median basis, utilities now trade in line with our fair value estimates, both globally and in the U.S. This is the cheapest the sector has been since 2015. In the U.S., this is a sharp reversal since mid-November when utilities reached a peak 1.18 price/fair value ratio.

The sector pullback does create some select opportunities for income and value investors, as we highlight below. We think income investors should pick wisely among those utilities with yields above 4% and decent growth prospects. Value investors have opportunities among a few utilities that risk-averse income investors have abandoned. Two of those, Scana and  PG&E (PCG), likely won't pay dividends the rest of the year but offer 25% or more upside if they clear their respective hurdles with minimal harm. We think the market is pricing in a worst-case outcome for both.

Sector fundamentals remain strong. For the most part, U.S. utilities have strong balance sheets and reasonable payout ratios that should support dividend growth for at least the next few years. We see plenty of growth opportunities in the sector. Low gas prices are supporting infrastructure investment to give more customers access to low-cost energy. Low gas prices also are driving a continued shift away from coal power generation to gas generation despite the Trump administration's efforts to save coal. We think policy efforts are doomed as long as gas prices stay low.

Renewable energy is another source of global near-term and long-term growth for utilities. In the U.S. wind generation costs have come down such that wind can compete with natural gas as the generation fuel of choice to meet public policy objectives and serve electricity demand growth. Solar is on the same falling cost trajectory. Utilities like  Xcel Energy (XEL),  NextEra Energy (NEE),  CMS Energy (CMS), and others have made renewable energy investment their primary source of growth during the next five years. Infrastructure to support electric vehicles offers more growth potential.

Top Picks

The utilities sector continues to trade near its market-cap weighted fair value globally. Valuation multiples such as P/E and P/B remain slightly above 10-year averages but are down markedly in the past nine months. This is as cheap as the sector has been in several years, creating some select buying opportunities for income and value investors. 

 Scana (SCG
)Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $57
Fair Value Uncertainty: Medium
5-Star Price: $39.90

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 has warmed to our thinking as the merger spread closed from 30% to 18% since March even as Scana suspended its dividend. 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.

 PPL (PPL
)Star Rating: 5 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 $15.4 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. U.K. politicians are pressuring regulators to reduce the region’s high power prices. Much of the political focus has been around the electric suppliers to which PPL has no exposure. Ultimately, we think the U.K. regulatory environment remains constructive, albeit with lower allowed returns.

 Dominion Energy (D
)Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $84
Fair Value Uncertainty: Low
5-Star Price: $67.20

Dominion Energy's investments in energy infrastructure projects in the Eastern United States should result in wide-moat businesses generating approximately 50% of operating earnings by 2021, up from about 30% in 2016. The remaining earnings are primarily from narrow-moat regulated gas and electric utilities in states with long histories of constructive regulatory frameworks, industry-leading sales growth, and high-return investment opportunities. In addition, the 2016 Questar acquisition added a 2,700-mile pipeline network in Utah, Wyoming, and Colorado that we believe will offer wide-moat investment opportunities into the next decade. These opportunities and the earnings power of its core businesses should allow Dominion to increase its dividend 10% in 2019 and in line with earnings through the next decade. Dominion's wide moat, secure and growing dividend, and long-term earnings growth outlook have the potential to deliver double-digit total annual returns for conservative investors for the foreseeable future.

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