Regulated utilities could be hit hard by inflation, while diversified firms have long-term value that the market refuses to recognize.
The utility sector continues to be a tale of two divergent groups. The fully regulated utilities continue to climb as investors seek yield and safety in an ultralow interest-rate environment. Electric demand climbed 1% in the second quarter year over year, and industrial demand continues to climb back from its 2009 lows, providing fundamental stability. But if rates turn, inflation kicks in, or the economy falls into another recession, these utilities have a long way to fall.
On the other hand, the diversified utilities and independent power producers in May caught a whiff of the potential impact from environmental regulations coming out of Washington when mid-Atlantic capacity prices jumped in response to forecast coal plant closures. Even though we cut our 2014 midcycle power price assumptions an average of 10% in early June, we still think the low-cost, low-emissions power producers have long-term value that the market refuses to recognize.
Rising interest rates and inflation are the death knell for regulated utilities. With no imminent threat of either one, regulated utilities continue to hold on to their post-recession gains. But cracks are beginning to show. Returns for a group of the 34 largest U.S. regulated utilities were modestly positive during the second quarter but trailed those of the broader markets. The sector's 4.3% average dividend yield is still historically attractive relative to bond yields, but that yield spread against 10-year U.S. Treasuries has tightened 75 basis points since peaking in October 2010.
And with a current average trailing P/E at 16 times for these 34 regulated utilities, valuations are near the two-decade-high average peak of 16.3. During the last four peak-to-trough earnings-multiple cycles, this group of regulated utilities lost an average of 22% compared with an average 4% loss for the S&P 500 during the same periods. The richest right now are New Jersey Resources
Lackluster power prices continue to stymie diversified utilities and independent power producers. Even though we saw a slight pickup in natural gas prices during the second quarter, power prices in most regions did not respond in kind. Forward power prices continue to imply an expansion in supply relative to demand while all fundamental signs point to the opposite: a rebound in industrial demand and retirements of coal plants that can't meet proposed emissions regulations. We believe Exelon's
We continue to believe demand will increase by 1% annually, and 53 gigawatts of coal plant capacity will retire during the next five years. Already utilities have announced more than 20 GW of planned coal plant closures, including American Electric Power's
In June, we cut our 2014 midcycle power price assumptions an average 10% resulting in lower fair value estimates for all of our diversified utilities and independent power producers. The primary driver in our cut was a 13% reduction in our 2014 midcycle natural gas price to $6.50 per thousand cubic feet. Still, our 2014 midcycle power price assumption remains at about 20% higher than current forward prices, driving our bullish outlook for most diversifieds and IPPs.
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On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.94, the same as last quarter. Several large undervalued diversified utilities skew this average lower. The median price/fair value ratio for the sector is 1.02. This reflects our view that the larger, diversified utilities should outperform their smaller, fully regulated peers.