Our Outlook for Utilities Stocks
An economic recovery offers both risks and rewards for utilities.
Quarter-End Insights
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- Independent power producers have significant leverage to an improving economy.
- Attractive combinations of earnings growth and dividend yield still exist in the sector.
- Rising bond yields and inflation present longer-term threats to regulated utility returns.
Like all other sectors, the big question hanging over utilities is whether or not we're in a worldwide economic recovery. Regulated distribution utilities are holding off on outlooks for demand beyond more than a year or two. And power markets are pricing in either flat or declining demand for the next three years in most major regions. The only unequivocal positive in the sector right now is the average dividend yield of 4%, which continues to trend above historical averages and represents a favorable spread to long-term U.S. Treasuries.
Electricity demand (and, in many respects, natural gas demand) has shown a near-perfect correlation with U.S. GDP for the last 60 years, and we see no significant reason that relationship would change going forward. Even industrial power use, which decoupled from U.S. economic growth during the last decade, still demonstrates a 0.93 correlation with the industrial production index going back to 1949.
Thus, we are not surprised that power demand fell 0.8% in 2008 and another 4.2% in 2009 as the U.S. suffered through the Great Recession. It also is not surprising that seasonally adjusted power generation has gone up in nine of the first 11 weeks of 2010 as economic conditions have improved and favorable (cool) weather in the Southeast drove more electric heating demand. Still, many utilities issued bearish demand forecasts for 2010 and 2011 during the first quarter. And, if you believe the forward power markets, we are in for a long period of stagnant electricity demand. This is not good for any utility investor.
Industry-Level Insights
For fully regulated distribution utilities, stagnant demand in the face of rising operating costs produces lower returns for investors. Flat or falling demand also requires less infrastructure investment, reducing opportunities for utilities to grow earnings at rates higher than inflation. And continued high unemployment puts pressure on politically minded regulators to hold or cut utility rates by chopping utility returns. We saw this most recently in Florida, where regulators disallowed some $1.1 billion of rate increases that FPL Group's utility had proposed and another $500 million of rate increases that Progress Energy had proposed. We expect decisions later this year on pending rate increase requests at subsidiaries of Public Service Enterprise Group (PEG) and Alliant Energy (LNT) as well as new rate case filings at subsidiaries of PG&E Corporation (PCG), Exelon (EXC), and Southern Company (SO).
We think most regulated utilities in our coverage universe are fairly valued right now. Still-attractive dividend yields offset our outlook for earnings growth to slow from rates many utilities experienced during the past few years. The only fully regulated utilities in our coverage universe that have price/fair value ratios below 1.0 as of March 23 are Westar Energy (WR), National Grid (NGG), Portland Electric (POR), Southern Company, and Consolidated Edison (ED). All feature dividend yields above 5% and strong earnings growth potential from projects such as environmental controls, new generation and transmission lines with favorable cost-recovery mechanisms and allowed returns.
For diversified utilities and independent power producers, lower demand has a twofold negative impact. It reduces supply constraints, allowing more efficient and less costly plants to produce all the power required. It also reduces demand for key fuel inputs such as natural gas and coal. While lower fuel costs can be good for some utilities, they also lower power prices and thus margins for all power producers. The outlook for more efficient supply to meet lower demand is the key driver right now in the power markets. Forward power prices in most U.S. regions are virtually flat through 2013 despite futures curves that imply a 30%-50% increase in coal and natural gas prices in the next three years.
For utilities such as Exelon, Mirant , NRG Energy (NRG), RRI Energy , and Allegheny , in particular, current futures imply substantial margin compression if realized. But we think utility investors are ignoring the follow-on effects on power prices in an economic recovery. A dearth of new fossil-fuel generation capacity, the threat of plant closures for environmental reasons, and rising demand could send reserve margins to perilously low levels in constrained regions such as the mid-Atlantic and Northeast. That is reflected in our bullish outlook for power demand and natural gas prices, translating into higher power prices than the market expects by 2013. Those higher power prices have a leveraged effect on earnings and valuations for certain utilities such as Exelon, Mirant, and NRG Energy, with the best-positioned merchant generation fleet.
Our Top Utilities Picks
Although we have only one 5-star utility in our coverage universe right now (Exelon), we think several more high-quality utilities are worth watching closely. On a market-capitalization-weighted basis, the average sector price-to-fair value is 0.93, however several large diversified utilities skew this average lower. The median price-to-fair value for the sector is 1.05 at the end of the first quarter, down 3% from the sector median at the end of 2009. This reflects our view that the fully regulated utilities could underperform the diversified utilities and IPPs in the next few years.
The utilities and IPPs we have rated 4 stars feature high-quality assets, strong management teams, and good earnings growth prospects. But we think investors should demand wider margins of safety for these firms given the substantial leverage to uncertain future power market conditions. Here are our top utility picks:
| Top Utility Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Dividend Yield | |
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| Exelon |  | $73.00 | Wide | Medium | 4.7% |
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| NRG Energy |  | $37.00 | None | High | NA |
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| Westar Energy | | $27.00 | Narrow | Medium | 5.6% |
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| National Grid (ADR) | | $57.00 | Narrow | Medium | 6.1% |
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| Southern Company |  | $36.00 | Narrow | Low | 5.3% |
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| Data as of 3-25-10. |
Exelon (EXC)
Operating leverage at its large nuclear fleet is the name of the game at this wide-moat utility, the only one in our coverage universe. Despite today's weak power prices, we believe Exelon's long-term fundamentals remain intact, and its 8 times EV/EBITDA market valuation ignores this upside. We are most focused on the company's ability to hedge in favorable economics for 2012. A rebound in Midwest industrial power demand, higher gas prices, and normal summer weather would help. A 10% move in 2012 power prices from today's levels can translate into $800 million of incremental EBITDA. Carbon caps could add another $900 million of incremental EBITDA and account for $6 per share in our fair value estimate. Management's demonstrated long-standing commitment to creating shareholder value through stock repurchases and dividend hikes gives us additional comfort.
NRG Energy (NRG)
We think NRG is an excellent pick for investors looking for a high-quality management team and good asset profile to benefit from an improving U.S. economy and rising power demand. 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 the most from an economic rebound. Even though it has a large fleet of coal-fired power plants, we think it should be able to continue producing strong margins even with the threat of carbon-emissions restrictions looming.
Westar Energy (WR)
After suffering its coolest summer in 40 years in 2009, we think this fully regulated Kansas utility has some impressive earnings growth stored up for 2010 and 2011. We think earnings should rebound some 35% in 2010 if summer weather returns to normal and industrial demand starts to pick up again. Beyond 2010, earnings growth from regulated investments in clean coal and renewables-related transmission should flow directly to shareholders through the company's favorable regulated rate structures. Of its three-year $1.5 billion investment plan through 2012, $1.1 billion will be spent on projects that have preapproved annual cost recovery rate structures or are flexible enough to postpone if market conditions remain unfavorable. A current 5.5% dividend yield is well above the industry average.
National Grid (NGG)
This U.K.-based regulated utility specializes in owning, operating, and building transmission on both sides of the Atlantic. With that expertise and its large service territory footprint, National Grid should benefit more than most other utilities as regulators and politicians force utilities to shift away from fossil fuels and toward renewables in the U.K. and U.S. Northeast. Building high-return transmission grids in both countries should drive strong earnings growth while favorable regulated rate structures protect those earnings from inflation through automatic adjustments. With a dividend yield near 6% and management's 8% dividend growth target through 2012, we think National Grid is one of the most attractive regulated utility investments still available. We expect the annual fiscal 2010 dividend to climb to GBX 38 per share ($2.95 per ADR share) with the June 2010 final payment.
Southern Company (SO)
Southern's total return proposition is among the more appealing in our coverage universe, especially for patient investors. The current 5% dividend yield is higher even than current yields on its own parent company debt, and we think the equity offers above-average growth prospects for many years. Although economic growth in its service territories remains uncertain, the primary driver of our 5% earnings growth forecast through 2012 is an enviable investment program revolving around a new nuclear plant, environmental upgrades to its fossil fuel power plants, and transmission and distribution investments. Much of this investment is preapproved and should close to rates annually based on constructive regulatory mechanisms with industry-leading returns on equity. This minimizes lag, protects returns, and justifies our premium 14 times 2011 earnings multiples at our fair value estimate. Southern's Georgia rate request in 2010 will be a key.
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