Utilities Power Past Fair Value

• Utilities' market-beating run this year leaves the sector 7% overvalued as of mid-June. In particular, the higher-yielding, most defensive utilities have benefited from another pullback in interest rates.
• In early June, the U.S. Environmental Protection Agency released the highly anticipated proposal for U.S. limits on carbon dioxide emissions from power plants. The proposal would reduce carbon emissions 30% from 2005 levels by 2030, but each state has its own targets, so not all utilities face the same risks. 
• The Eastern U.S. and Texas should see significantly more volatile power prices this summer as more expensive natural gas plants continue to replace aging coal plants. Increased volatility and higher prices should strengthen the moats of low-cost, incumbent power producers.
• The utilities sector average dividend yield remains near 4%, nearly double the market's average yield and 130 basis points above the 10-year U.S. Treasury yield.

 

Utilities are making up ground this year after trailing the market significantly last year. The Morningstar Utilities Index is up 13% year-to-date, including dividends, more than double the total return of the S&P 500 through mid-June. Part of this likely is due to the renewed bond rally with 10-year U.S. Treasury yields falling to 2.6% from 3.0% in January. It is also partially due to a rebound in power and natural gas prices that raised earnings for power producers.

Some of the most defensive companies in the utilities sector have performed the best this year, including many of the regulated natural gas utilities. We think those stocks are significantly overvalued now and could face a sharp drop if interest rates start to creep up. However, most utilities are in strong financial positions with robust growth investments, allowing them to continue raising dividends. The same gas utilities that have rallied should be able to grow their dividends 3%-5% annually with investment that will strengthen the existing infrastructure and serve new demand seeking to capitalize on historically low gas prices.

The key risk in the sector right now is environmental regulation. The U.S. Environmental Protection Agency won two key court cases during the second quarter supporting their regulations limiting certain non-carbon coal plant emissions. The caps on mercury emissions, in particular, are leading utilities to shut down old, inefficient coal plants. In addition, the EPA released its proposed carbon emission limits on June 2. The proposal is a complex set of regulations for each state that will go into effect in 2030. Although the proposal represents all upside for nuclear and renewable energy, the distant and flexible compliance guidelines limit any near-term benefits.

Power and gas markets in the U.S. awoke with a startle from their three-year slumber following the January-February Polar Vortex. Between January and May, forward power prices and natural gas prices in the Mid-Atlantic region climbed 18%. This represents a significant earnings boost for all utilities with wholesale generation fleets in the Eastern U.S., especially nuclear plant owners. In the Northeast, some power plants couldn't get the gas they needed to run their plants because there wasn't enough pipeline capacity to ship the amount of gas they needed. Ongoing concerns about pipeline capacity are driving billions of dollars of investment in the Eastern U.S. gas pipeline network.

Top Utilities Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Yield
RWE AG		EUR 41.00	Narrow	Medium	3.4%
FirstEnergy		$41.00	Narrow	High	4.2%
Centrica		GBX 370	Narrow	Medium	5.3%
Data as of 6-13-2014

RWE (RWE)
RWE is one of Europe's five largest utilities, with vertically integrated generation, transmission, and distribution operations serving 16 million electric customers and 7 million gas customers. It also owns and operates power generation and supply in the U.K. and the Netherlands, and renewable energy assets in Europe and North Africa. About half of its profits are earned in Germany. These assets leave it heavily exposed to European power markets, which have languished from the continent-wide recession, an influx of government-supported renewable energy and nuclear plant retirements in Germany. We don't see much near-term earnings or dividend upside, but RWE remains the most levered utility to a European economic rebound, so this could be a good pick for investors willing to wait for a turnaround.

 FirstEnergy
FirstEnergy is one of the largest investor-owned utilities in the U.S. with 10 distribution utilities serving 6 million customers in six Mid-Atlantic states. Two thirds of its customers are in Ohio and Pennsylvania. FirstEnergy also owns and operates one of the nation's largest transmission systems with more than 24,000 miles of lines. FirstEnergy's Competitive Energy Services segment owns a power plant fleet of 13 GW of nuclear, coal, gas, hydro, and wind and is the second-largest retail electricity supplier in the U.S. FirstEnergy has revised its strategy to focus on its regulated distribution and transmission businesses following several years of depressed power prices that have challenged the company's deregulated operations. Its plan to raise equity for a $2.8 billion transmission investment plan and its decision to cut its dividend 35% in January have pressured the stock, but we think the company now is on firm footing.

 Centrica
Centrica PLC is a vertically integrated utility based in the U.K. with operations that produce and supply natural gas and electricity. Its British Gas business unit is the largest residential supplier of natural gas, electricity, and HVAC services in Britain. Centrica owns the Rough natural gas storage facility, representing 70% of the U.K.'s total storage capacity. Its North American Direct Energy unit, although growing rapidly, is smaller than British Gas, but has a similar business model. Energy prices across its spectrum of businesses have fallen during the last year, pressuring margins. We think long-term fundamentals support higher power, natural gas and retail energy prices that Centrica can capture to lift margins.

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