Utilities: Running in Place, but Hurdles Ahead

• On a global basis, utilities now trade mostly in line with our fair value estimates at a 1.0 price/fair value ratio, the same as last quarter. In the U.S., utilities are slightly overvalued as a group, but most of the high-quality firms trade at 15%-20% premiums to fair value.
• Most utilities across our coverage continue investing heavily in infrastructure, ranging from renewable energy to local energy distribution. As long as energy prices remain stable, we expect 5%-7% annual earnings and dividend growth across the sector during the next few years.
• U.S. utilities' 3.45% sector dividend yield is just 40 basis points higher than the 10-year U.S. Treasury yield after the recent falloff in bond prices. This is among the smallest premiums since bond yields fell below the utilities dividend yield in 2008. We think the valuation tailwind that utilities have enjoyed from this yield premium could be easing.
• M&A has slowed in 2018 after its blistering pace in 2015-17. The worldwide pool of midsize utilities that would be good targets is shrinking. Most utilities have enough internal investment opportunities to sustain earnings growth without M&A. Reshuffling continues among some large European utilities, most notably recent speculation that giant  Electricite de France (EDF) could split up.
• Hurricane Florence, California wildfires, and the Boston-area gas pipeline explosion in the U.S. illustrate the unplanned operational risks that can hurt utilities investors' returns.

Utilities appear to have hit a valuation plateau, but we still think downside risks outweigh upside catalysts. After reaching peak valuations in November 2017, U.S. utilities have underperformed the S&P 500 by 17 percentage points. Since the sector reached our fair value midyear, performance stalled. But regulated U.S. utilities still trade at 19 price/earnings, 13% higher than their 10-year average.

We think utilities could be stuck in a Goldilocks pattern--not too hot and not too cold. Equally strong tailwinds and headwinds could keep the sector at a standstill for the foreseeable future. On the positive side, utilities' fundamentals remain strong, dividend yields remain attractive relative to fixed-income alternatives, and near-term earnings growth is virtually locked in. But we think regulatory and financial risks threaten to derail any upside momentum in the coming years.

Utilities are facing more regulatory scrutiny as they try to raise customer rates to pay for the heavy investment cycle underway. U.K. utilities have been on edge this year anticipating a cut in regulatory allowed returns to keep customer bills in check. In the U.S., utilities are still growing earnings and keeping customer bills flat due to low energy prices and U.S. tax reform. But regulators are cutting allowed returns, which will slow earnings growth.

Financial risks are building as rising interest rates and plateauing stock prices make investment less attractive. Most utilities have enough financial power from years of ultralow financing costs that they can continue growing 5%-7% for the next few years. But as regulatory returns come down and financing costs rise, net new investment will slow. Utilities will be forced to rely more heavily on public policy support to sustain their current growth rates.

Value investors might like the attractive risk/reward trade-offs that we think utilities like  Scana (SCG),  PPL (PPL), and  PG&E (PCG) offer. But we think income investors should hold off until valuations come in for high-quality picks like  Xcel Energy (XEL),  Alliant Energy (LNT),  New Jersey Resources (NJR), and  CMS Energy (CMS). We still think utilities investors should demand at least a 3% yield before considering a buying opportunity.

Top Picks

 Scana (SCG)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $56
Fair Value Uncertainty: Medium
5-Star Price: $39.20

In January,  Dominion Energy (D) 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, but we estimate the market is giving the deal just a 5% likelihood of closing. Scana trades at a 26% discount to the implied acquisition value as of late September. 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: 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 $15.4 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: 4 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 next five years.