Our Outlook for Utilities Stocks
Utilities have faced a tough summer, but long-term fundamentals remain positive.
Quarter-End Insights
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If the investment profiles of regulated and merchant utilities have always been distinct, we think the differences between them will only sharpen in the quarters ahead. The fortunes of both groups are likely to improve, in our view, but the former may be shackled by protracted demand weakness and guarded regulators. We think the future for merchant power producers, while also uncertain, holds greater upside potential.
Our cautious stance toward regulated utilities stems from two worries. The first is that revenue growth could remain tepid, and accretive capital projects could be deferred, unless demand for electricity stages a robust recovery. While we are probably past the steepest declines in usage, some industry veterans have painted a somber outlook. Duke Energy (DUK), one of the largest utilities we cover, predicted it could be 2011 before industrial usage resumes growth. FPL Group , another major utility, has made similar warnings. Both Duke and FPL have cut their capital spending projections in response to weak demand.
A second worry relates to regulatory risk. Allowed returns on equity have been falling for two decades. While they seem to have leveled out in recent quarters at around 10.5%, we would be surprised to see them move up materially anytime soon given the historically low level of long-term interest rates. Although regulators need to offer incentives for new investments in order to meet renewable energy targets and prepare for an eventual recovery in demand, they must also consider the interests of their recession-battered political constituents. Fortunately, lower operating expenses and fuel costs have eased some of the pressure for both utilities and their customers. But with filed rate cases at a multi-decade high and higher potential costs coming from environmental legislation, we believe the industry is facing unprecedented regulatory uncertainty.
The medium-term outlook is comparatively bright for merchant power producers, in our opinion. Although the twin forces of weak demand and depressed commodity prices (particularly natural gas) have crippled merchants' margins, we think these phenomena may soon reverse. We think this could lead, in turn, to a doubling in market power prices from current levels. Eventual supply constraints could assert additional upward pressure on power prices. Tight credit, uncertainty around carbon legislation, and the historic drop in demand have limited forward hedging opportunities and dampened capacity expansion. As these factors stabilize, we think the industry may find itself playing catch-up. Average lead times for new plants range from two to 10 years, depending on fuel type. In the meantime, existing plants are poised to benefit from a supply-constrained market.
Among the established baseload merchants we cover, we continue to favor Exelon (EXC), NRG Energy (NRG), Allegheny , and PSEG (PEG). Each of these firms possesses low-cost generation assets that could realize substantial margin expansion as power prices rise. On the regulated side, we continue to steer investors toward those utilities with stable business models and supportive regulatory environments. NSTAR , Southern (SO), and Consolidated Edison (ED) all stand out along these lines.
Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.94, up negligibly from June. We consider utilities neither overvalued nor undervalued (on a price/fair value basis) relative to other sectors in our coverage universe. Ongoing macroeconomic headwinds and regulatory uncertainty, balanced against what we think are attractive yield spreads over U.S. Treasuries for many utilities, lead us to consider the industry fairly valued on the whole.
Given our bullish outlook for power prices in 2011 and beyond, we think independent power producers and diversified utilities, which include companies with large merchant power generation exposure, offer the most attractive valuations. Fully regulated utilities are fairly priced, in our opinion. As such, we see limited opportunity for capital appreciation. We note, however, that several utilities offer attractive current income potential. On a market-weighted basis, we assign a relatively high certainty to our fair value estimates for utilities. Overall, we give the sector a 10.6 fair value uncertainty rating out of 100, with 100 being the most uncertain. This is down from last quarter's 20.5 fair value uncertainty rating after we moved nine regulated utilities to our lowest uncertainty grade following improvements in the credit markets and economy.
| Utilities Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
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| Electric Utilities | 3.10 | 0.97 | 0.94 | 3.2 | 11.0 |
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| Gas Utilities | 3.18 | 0.94 | 0.91 | 3.3 | 10.0 |
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| Water Utilities | 3.00 | 1.07 | 1.06 | 0.0 | 10.8 |
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| Diversified Utilities | 3.44 | 0.85 | 0.85 | 0.0 | 9.9 |
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| Data as of 09-14-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of each industry's underlying stocks. |
Our estimate of price-to-fair value for the utility sector was unchanged in the quarter. In general we think the market is accurately discounting utilities' earning potential. Although mispricing appears largely absent in today's market, we see one diversified utility, Exelon, as underpriced. In our view the market is underestimating the bullish fundamentals for natural gas that could lead to significant margin expansion for Exelon. On the regulated side, the pickings are slimmer still. Although near-term demand trends and regulatory outcomes are uncertain, we think the long-term profit potential for regulated utilities is well-understood and fairly reflected in today's prices.
One area of utility investment that we continue to monitor with interest is power transmission. Federal government incentives for these projects offer attractive value-creation potential. These projects hinge less on demand and more on the need to ensure the long-term structural integrity of the power grid. Several of the utilities we regard highly--such as Westar (WR), Northeast Utilities (NU), American Electric Power (AEP), Allegheny Energy, and NSTAR--are pursuing large transmission projects that should boost earnings regardless of demand trends.
Our Top Utilities Picks
Although we believe the long-term fundamentals for the utilities industry are solid, we have assigned a 5-star rating to only one of the firms we cover, and a 4-star rating to six. As the economy recovers, however, we could see more-attractive opportunities emerge among some of our top independent power producers and regulated utilities. As such, we recommend keeping these stocks on your radar screen.
| Top Basic Materials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Dividend Yield (%) | |
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| Exelon Corporation |  | $76.00 | Wide | Medium | 4.1 |
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| NRG Energy |  | $37.00 | None | High | 0.0 |
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| NSTAR | | $35.00 | Narrow | Low | 4.6 |
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| Consolidated Edison Company | | $44.00 | Narrow | Medium | 5.7 |
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| Southern Company | | $34.00 | Narrow | Low | 5.5 |
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| Data as of 09-23-09. |
Exelon (EXC)
Because of its low-cost nuclear power plants, Exelon is the only utility we cover that has earned a wide-moat rating. Despite today's weak power prices, we believe Exelon's long-term fundamentals remain intact. Management has demonstrated a long-standing commitment to creating shareholder value through stock repurchases and dividend hikes. Exelon hedged substantially all of its power production and fuel costs for 2009 and 2010 prior to the recent collapse in margins, which should lend stability to the firm's earnings in today's turbulent market.
NRG Energy (NRG)
With one of the best near-term hedge profiles among independent power producers, NRG should have strong earnings momentum going into what we think will be a more favorable commodity cycle in 2011 and beyond. Its power plants in Texas, California, and the Northeast are located in supply-constrained markets that should benefit from an economic rebound and continue producing strong margins even with the threat of carbon-emissions restrictions looming.
NSTAR
We think Boston-based NSTAR, a fully regulated transmission and distribution utility, will continue to outshine its peers. NSTAR's strength is its predictable, rising cash flow. Strong cash flows, in turn, have translated into an impressive record of dividend increases. We expect the firm will continue its dividend growth at a healthy 5% pace for at least the next five years. For risk-averse, income-seeking investors, we think NSTAR is among the most attractive firms available.
Consolidated Edison (ED)
As a regulated "wires and pipes" utility, Con Ed generates dependable earnings and dividends. Aging assets and demand growth in New York City are driving a massive capital investment program at the firm. Over the next three years, Con Ed plans to invest some $7 billion--well above historical levels. Given Con Ed's supportive regulatory environment, we are confident the company will earn an attractive risk-adjusted return well into the future.
Southern Company (SO)
Southern has built envious regulatory relationships by providing comparatively cheap, reliable power to its customers. As a result, the firm enjoys industry-leading allowed returns on equity. Southern's strong earnings growth prospects, rock-solid financial condition, and appealing dividend yield justify its place as a core holding in most income investors' portfolios.
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