Value and Income in Utility Stocks
Most utilities stocks are still fairly valued, but the market is not recognizing the value of several firms facing headwinds.
Morningstar’s summer 2018 utilities outlook revealed some opportunities. For the first time in about three years, U.S. utilities were fairly valued by Morningstar measures—after being almost 20% overvalued just late last year. I spoke with strategist Travis Miller about the economic, political, and secular backdrop for the sector. We also discussed our analysts’ top defensive picks and value plays.
The discussion has been edited for length and clarity. Our conversation took place June 5, and valuation data is as of that date.
Laura Lallos: What’s driven the change in utility valuations?
Travis Miller: Utilities are very sensitive to interest rates, both on a fundamental basis and on a market basis. Look at what’s happened to the 10-year Treasury: It’s now up near 3%. So, utilities have suffered, especially relative to the S&P 500. We use a consistent interest-rate assumption on a long-term basis. As prices of utilities have come down relative to the rest of the market, utilities look more attractive than they have in a long time.
Lallos: Do long-term investors need to worry about interest rates?
Miller: If you look back since 2011, utilities have performed almost exactly the same as the S&P 500 in terms of total return. Investors tend to hold utilities for a long time, through many interest-rate cycles. Granted, utilities have significantly outperformed and also lagged the S&P 500 over shorter periods of time, but on the whole, for investors who are looking for stable income and growth, utilities are still a good place to be.
Lallos: What are other headwinds facing the sector?
Miller: The biggest thing is slowing energy usage growth. More-efficient lightbulbs, such as CFLs and now LEDs, take just a fraction of the amount of electricity that incandescent lightbulbs do. Refrigerators, furnaces, air-conditioning units are all becoming much more efficient, and that is hurting the utilities that are still collecting revenue based on usage. But we’re seeing regulatory developments to create ways that utilities can keep their profitability, their profit margins, and their revenue growth even in this period when their core products, electricity and natural gas, are either flat or even declining in some states.
Lallos: What is the effect of natural gas prices?
Miller: Natural gas prices have had a unique impact on utilities. For the past decade, we’ve had a substantial decline in natural gas prices, particularly through the shale revolution in the U.S. On the distribution side, that’s created an incentive for customers to switch over to natural gas heating. For electric utilities, natural gas has become more economic to use to generate electric power than coal and even nuclear, in some cases.
Natural gas has created an opportunity for some states that rely on coal generation for the economy to improve their environmental standards and reduce emissions. Natural gas generation has about half of the carbon emissions of a coal plant. We’re seeing environmental benefits just through pure economics with cheap natural gas.
Lallos: The current administration is increasingly adamant about encouraging or even forcing use of coal. Will that affect demand for natural gas?
Miller: It makes good headlines. Renewable energy and gas generation made good headlines for the previous administration, and now coal and nuclear make good headlines for the current administration. But the fact of the matter is that economics will trump environmental issues in any kind of regulation, whether it’s at the state or federal level.
Right now, natural gas prices are just so low that it’s by far more economic to run natural gas plants than coal. Nuclear is kind of in between. Nuclear has some very good fundamental benefits. Once you put enriched uranium into a nuclear plant, it can run for 18 months or more without any additional fuel. A natural gas plant requires access to gas through a pipeline, and coal plants must have supply available on-site. Nuclear is a unique type of generation— and yet it’s still more costly to run than natural gas generation.
Lallos: What are the prospects for nuclear?
Miller: The current administration is trying to promote nuclear’s reliability benefits. New York, Illinois, and New Jersey have decided to effectively subsidize their nuclear plants. Those are states where the nuclear plants were suffering the most economically.
The key thing here is economics and also the economy within local areas. The nuclear industry is a large employer, particularly of highly skilled workers. So, we’ve seen a lot of local momentum behind saving nuclear plants even though the economics might be bad, and even though there are environmental issues in terms of waste fuel disposal.
Apart from one new nuclear plant under construction in Georgia, new nuclear plants are not in any utilities’ plans right now. The efforts right now are just to save the existing fleet.
In the Southeast, utilities have tried to build new nuclear plants. Southern Company (SO) in Georgia has struggled with higher than expected costs. SCANA (SCG), a South Carolina utility, also ran into cost overruns. The budget for the plant they were trying to build doubled between when they initially expected to build it in 2008 and last summer, when they terminated the project because the cost just got too high.
Lallos: Why is Scana is one of your top value picks?
Miller: Most utilities stocks are still fairly valued or slightly overvalued right now. But you can look for what we call “hairy utilities,” where the market is not necessarily recognizing the value that is still there because of some negative development. They either have cut dividends or there’s some kind of risk in one of their business segments that the market is overemphasizing. That leads to buying opportunities.
Scana is the poster child for that right now. They abandoned a nuclear plant project that was going to be about half of their entire book value. They’re trying to recover some $4 billion that they’ve invested in the plant, which is not operational.
Typically, when utilities build any kind of infrastructure, they are able to recover the costs from customers through regulatory rates. But there is a “used and useful” standard: As long as the infrastructure is used and useful, then regulators let customers pay the utility for that. A half-built nuclear plant is not used and useful, so there’s debate around whether Scana should be able to recover those costs.
We think they will be allowed to. Otherwise, Scana faces a bankruptcy situation, and it’s in no one’s best interest to let the local utility go bankrupt.
Dominion Energy (D) , our only wide-moat utility, has made a bid to acquire Scana, and essentially wipe clean all the new nuclear issues. This would be one of the biggest customer rate giveaways: about $1,000 for every customer if regulators approve the Dominion acquisition and accept Dominion’s plan to recover nuclear rates.
Lallos: Dominion is one of your top defensive picks.
Miller: Some old-time, large-cap, well-known utilities like Dominion Energy, Southern Company, and Duke Energy (DUK) have been beat down a little bit and are now yielding in the 5% range. These continue to be very steady utilities with good growth prospects. To get a 5% yield in this kind of environment, even after interest rates have gone up so much in the past year, is still really good for income investors right now.
Dominion in particular is a good opportunity. Most of its infrastructure is in Virginia and the mid-Atlantic region, just south of the Marcellus Shale gas region. Because they’re located between gas demand in Virginia and the Carolinas, and Marcellus gas supply, Dominion has been building natural gas pipelines. They’ve also invested billions of dollars in natural gas power generation, and they’re seeing demand growth, both on the natural gas side and on the electricity side. There’s a very vibrant technology area right outside of Washington, D.C., in Loudoun County, which is one their largest service territory regions. It has been reported that 70% of the world’s Internet traffic flows through the county on a daily basis. The tech industry’s electricity consumption is a good growth driver for Dominion.
Lallos: What about renewable energy?
Miller: Renewable energy is still the hottest thing going right now in the power sector. More than 30 states have laws that mandate utilities to invest in renewable energy and, in most cases, achieve some percentage of usage from renewable energy. Beyond that, technologies in solar and wind energy have developed such that they’re now as economic or even more economic than coal and natural gas. This has both environmental benefits and benefits for customers as wind and solar energy prices come down.
One key issue here is grid reliability. It’s very costly to manage a grid when you rely on the wind blowing and the sun shining to produce your electricity. That’s one headwind.
Another headwind is that distributed generation, what people know as rooftop solar, is essentially putting the generation and the demand all in one house. That ends up leading to lower centralized network demand, which is how utilities earn their revenue. We are seeing more industrial sector distributed generation at places such as factories and even server farms owned by firms like Amazon.com (AMZN) and Google (GOOG).
Lallos: How does Morningstar integrate environmental, social, and governance analysis into the overall stock analysis?
Miller: We think there are two key issues for ESG in the utilities sector. One is how utilities are increasing their investment in renewable energy. The other is how utilities are reducing their exposure to coal and nuclear. It may be counterintuitive, but both are opportunities for growth. Environmental regulations that lead to taking coal off the grid, such as carbon emissions caps, can actually be a growth opportunity for utilities. Typically, these coal plants are old and fully depreciated. If a utility can shut down that plant and build a multibillion-dollar gas plant or a multibillion-dollar wind farm or solar farm, that’s a big earnings growth opportunity for a regulated utility.
Dominion Energy was once one of the larger coal plant owners. Duke Energy is another great example. They’re transforming their fleet and going from mostly coal to mostly gas and renewables. Among U.S. utilities, Duke is one of the largest investors in renewable energy.
Lallos: What about the impact of government subsidies on renewable energy?
Miller: Subsidies are going to run out in the next few years for wind and solar, so it won’t be as attractive to invest in wind and solar. But wind and solar technology has come so far that utilities don’t need the tax credits anymore to make it economic to build large solar or wind farms.
Xcel Energy (XEL) is a good example. Most of its service territory is in the Upper Midwest, a great wind region, and Colorado, where you have a lot of political and public support for renewable energy.
Xcel can build wind and solar farms cheaper than building any type of fossil fuel generation. They’ve got such a good wind resource in the Upper Midwest that they don’t have the grid reliability issues that we see in other places. They call their investment plan “steel for fuel,” where they’re willing to put steel in the ground— put wind farms up, put solar farms up. That lowers the fuel costs that customers pay in the end.
Subsidies in the U.S. and Europe have helped renewable energy reach the point where it can be economic worldwide. Europe is even several years ahead of the U.S. in terms of transforming their grid from legacy generation sources to renewables.
Lallos: One of your top defensive picks is a U.K. company, PPL (PPL). How does it compare with Dominion and Duke, given the different regulatory environment?
Miller: About half of PPL’s business comes from the Pennsylvania area and about half comes from the U.K. Pennsylvania’s a great place for a utility right now with the transition from coal generation to gas generation.
There are two concerns in the U.K. One is that politicians on a local level are very concerned about power prices and customer bills. However, there’s a distinction here between suppliers and distribution utilities. Energy suppliers are feeling the most political heat, and PPL is on the distribution side, so we think it is better insulated from the politics. Still, investors are concerned that politicians will push back against customer rates. The other issue is currency: If the pound appreciates, that’s going to hurt PPL’s dollar-denominated earnings.
But if you look at our analysts’ projections for U.S. earnings plus U.K. earnings, we don’t see any way to get to the current valuation. The market’s assuming an entire collapse in the U.K. business earnings. We don’t see that on a currency basis. People are scared that politicians will push back on the distribution rates, but the key here is that distribution rates are fixed. Supply rates in the U.K. are marketbased, and the politicians are most concerned about that. We think investors have mixed the two in a bit of a misunderstanding about PPL’s risk.
As an aside, Berkshire Hathaway (BRK.A) (BRK.B) Energy has one of the largest U.K. distribution utilities, very similar to PPL’s. We don’t hear any gnashing of teeth about Berkshire Hathaway Energy’s U.K. distribution utility. PPL is a good way to get a kind of mirror of Berkshire Hathaway Energy right now.
As you noted earlier, value is not easy to find in the sector, which makes some of the hairier names interesting. Any other hairy picks?
Miller: FirstEnergy (FE) is a primarily Ohio-based utility that we see as a very strong regulated utility. They’ve just gone through a bankruptcy situation in their nonregulated business, and the market is still perceiving it as a struggling diversified utility.
Almost their entire business on the nonregulated side was coal and nuclear generation. Its territory is right outside the Marcellus Shale, so they were ground zero for the collapse in natural gas prices and the collapse in economics for coal and nuclear plants that created a distress situation. They’ve resolved that and right now you have a fully regulated utility trading at a discount. There’s also still a hangover from a dividend cut FirstEnergy made several years ago.
Our analyst in Europe thinks that Engie ENGI:FR is one of the most undervalued names and highest-quality businesses. They have operations across the world, notably in Latin America where they will get almost one third of their earnings.
In Europe, they have been slower than peers to invest in renewable energy, but we think Engie’s hydro and nuclear fleet is solid. Engie has refocused on regulated distribution operations in France and other places in Europe that should stabilize earnings and support a healthy dividend. This is a great pick for anybody who’s interested in Latin American and European energy use without as much commodity exposure as the integrated oil companies.
Laura Lallos has a position in the following securities mentioned above: AMZN, BRK.B, D, FE, GOOGL, SO. Find out about Morningstar’s editorial policies.