Are Utilities' Dividends Worth the Worry?

Dividend yields for utilities look as attractive as ever. But trying to figure out what might happen to the sector if inflation returns, interest rates rise, commodity prices spike, or environmental legislation passes can leave investors pleading to higher powers. To help break these issues into digestible pieces, we talked with Travis Miller, the senior analyst in charge of Morningstar's Equity Research utilities team.

Haywood Kelly: You're bullish on power prices. Could you walk us through your reasoning?

Travis Miller: Like all commodities, power prices depend on two factors, the marginal cost to produce power and the market's supply-demand balance. On the cost side, marginal costs of power are closely tied to natural gas. During the past decade, utilities built many natural gas-fired power plants to meet rising electricity demand. Now, in most markets, the cost to buy natural gas is the primary compo­nent of marginal cost and is the key determi­nant of power prices. We do not see that changing. We also think natural-gas prices could rise some 50% by 2012 as rising demand in an improving economy helps work off the current oversupply of natural gas in North America, boosting power prices commensu­rately. Caps on carbon emissions could lift prices further by raising marginal costs for natural gas- and coal-fired power plants.

On the power-demand side, weather and the economy are the key factors. Back-to-back years of cool summer weather in 2008 and 2009 as well as the economic downturn have damped electricity use. As the economy rebounds, weather conditions normalize, and consumers adopt new products such as electric cars, demand should rise, once again stressing a mostly fixed supply base of power plants. Blackouts in California and the Northeast during the last decade and annual power price spikes in Texas demonstrate the perils of stretching the supply/demand balance too thin.

HK: Which companies would stand to gain the most from this pricing scenario?

TM: We think two types of companies benefit from higher power prices. The clear winners are utilities with nuclear plants or renewable power generation in deregulated markets. The biggest U.S. nuclear owners include Exelon EXC, Entergy ETR, and Constellation CEG. Nuclear power has the lowest operating costs of any fuel-based power generation source. Moreover, nuclear costs are relatively fixed and are not tied to natural-gas prices. So as natural gas prices and higher electricity demand drive power prices higher, nuclear companies' operating leverage drives profits much higher. Large renewable power generation owners such as FPL Group FPL realize similar benefits. The second group of winners includes utilities that own highly efficient power plants in high-demand areas such as New York City; Washington, D.C.; Eastern Texas; and areas of the Northeast. Although these utilities do not have as much operating leverage because their costs often are tied to fossil fuel prices, they should nonetheless benefit from tight supply conditions in their regions. Utilities we think fall into this category are Public Service Enterprise Group PEG, Mirant MIR, and NRG Energy NRG.PAGEBREAK

HK: We've gone through a horrendous period of industrial demand for electricity. How important are near-term demand forecasts to your fair value estimates?

TM: As we discussed, demand forecasts are critical to our outlook for power prices. Demand forecasts also are critical for distribution utilities in regulated markets because demand drives investment needs and, ultimately, earnings growth. Through August, total U.S. power demand was down more than 4% year over year. If this holds for the full year, it would be just the fourth time in 60 years that annual usage has fallen, and it would eclipse the current record 2.8% decline in 1982. Among industrial customers, electricity use has fallen and then plateaued since the late 1990s. We think it will end 2009 down another 12%, for a 16% total decline since the economy entered the recession in 2007. That should correct a bit as the economy recovers, but we do not expect it to return even to 2007 levels. The largest rebound we expect to see is in weather-sensitive residential demand. Here, a reversal of cool summers in 2008 and 2009 could lead to a 3% jump in residential demand as well as a return to 1% to 2% annual demand growth. If consumers continue adopting electricity-hungry products, including electric cars, demand could rise even faster.

HK: Looking further out, where do you see the industry 10 years from now? Whose moats are likely to get stronger or weaker?

TM: Utilities that can keep costs low and operate efficiently are going to be the key winners whichever direction the industry takes. The biggest possible change facing the industry is carbon legislation. If carbon restrictions become law, many coal-fired power plants could be forced to shut down. The United States will rely on natural gas for even more of its power generation, and consumers' utility bills undoubtedly will rise. Large power producers such as Exelon and Entergy that are industry leaders in low-cost, low-carbon, highly efficient operations should thus strengthen their moats. Utilities that rely heavily on coal-fired power plants and face difficulty passing higher costs to customers could struggle. These could include utilities such as Ameren AEE, Great Plains Energy GXP, and Allegheny AYE.

HK: You spend a lot of time thinking about the regulatory environment. How do you go about quantifying that?

TM: We quantify a utility's regulatory environ­ment by looking at historical and projected returns on equity. In the United States, most state regulators set customer rates based on a target return on equity. But if the utility lets costs balloon or overinvests in inefficient infrastructure, its actual earned returns might fall short of that regulatory target. This shortfall hits investors' pocketbooks through slower dividend growth or even dividend cuts in some cases.

HK: Which companies operate in the best and worst regulatory environments?

TM: Right now, the most constructive regula­tory environments are in the Southeast and California. One of our perennial favorites is Southern Co. SO because of its strong regulatory relationships in Georgia and Alabama and its long history of earning high returns on equity. Its 60-year string of stable or growing dividend payments is testament to its regulatory strength. In California, utilities such as PG&E Corp. PCG, Edison International EIX, and Sempra SRE do not have the history of strong returns like Southern, but regulation has changed drastically in the state in recent years. These utilities now benefit from allowed returns on equity above 11% and timely adjustments that keep rates in line with costs. We expect this type of regulatory environment and the state's infrastructure needs to support above-average earnings growth and consistent returns on equity. On the flip side, utilities such as Ameren, NiSource NI, and Pinnacle West Capital PNW continually struggle with unfavorable regulation, resulting in low earned returns and meager dividend growth.

HK: You've been recommending Exelon-so much so that Paul Larson recently added it to Morningstar StockInvestor's Tortoise Portfolio. Let's talk more about this story. What are the key drivers to your fair value estimate?

TM: The big story for Exelon is the earnings growth it can achieve as power prices rise in the Midwest and Mid-Atlantic markets. As the largest nuclear power plant owner in the U.S., Exelon has the most leverage of any utility to rising power prices. We think it can achieve 13% annual earnings growth through 2015 as power prices rise, regulatory price caps expire, and carbon caps take effect. Longer term, Exelon's scale could allow it to boost growth by adding incremental nuclear plant capacity at a much lower cost than competitors. It also has been the most efficient nuclear operator in the United States for several years running, lowering costs for power generation and boosting returns for investors.

HK: Are there any other names you'd recommend, particularly for investors looking for income?

TM: We think dividend yields across the sector are very attractive right now but caution investors to choose wisely in the space. We recommend looking for utilities such as Southern, NSTAR NST, Scana Corp. SCG, and Duke Energy DUK in strong, stable, and progressive regulatory environments. These companies historically have maintained efficient operations and passed along higher costs to consumers with relative ease.

HK: Finally, you're picking up coverage of several large European utilities. How would you characterize the economic moats of those firms-are they decent businesses?

TM: Most European utilities are among the largest energy companies in the world and are national champions-E.ON in Germany, EDF in France, Iberdrola in Spain, and ENEL in Italy. Given their scale and near-monopoly statuses in certain markets, these utilities have strong advantages. However, European regulation has at times proved heavy-handed and unfriendly for equity investors. Political sensitivity to high energy prices and workers' rights have kept utility rates constrained and costs inflated. These utilities all remain exposed to commodity price fluctuations that seem to depend more on international relations than fundamentals. Thus, we think long-term investors should remain cautious. We do see one bright spot in U.K. grid owner National Grid NGG. With the U.K.'s progressive regulation and desperate need for new energy infrastructure, National Grid should realize high-return earnings growth for many years.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.