Our Outlook for Utilities Stocks
Utilities are keeping an eye on Washington in 2011.
Quarter-End Insights
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- Environmental policy we expect to be finalized in 2011 could dramatically alter the outlook for U.S. power producers.
- Fully regulated electric and gas utilities appear 10%-15% overvalued but still offer historically attractive dividend yields relative to Treasuries.
- Consolidation continues, but we think the low-hanging fruit is mostly picked.
As we suggested earlier this year, the utility sector rally has indeed slowed, and we now believe the sector is mostly fairly valued. Fourth-quarter sector returns were just half that of the S&P 500 through mid-December. Rising bond yields have reduced the relative attractiveness of the sector's 4.3% average dividend yield to levels last seen in April. Power demand is only crawling back and remains well below prerecession levels. Additionally, Congress is offering only a two-year respite from another round of dividend-tax concerns that would hit utilities the hardest.
We continue to see the most value among utilities with exposure to market-based power generation such as Exelon , GenOn Energy , and NRG Energy . Near-term margins continue to fall for many power producers with the coal forward curve up 10% since this summer and the natural gas forward curve down 15%. But our top picks have fleets that are well positioned to benefit from a long-term rebound in margins and a tightening of supply-demand conditions in electricity markets as power use grows and power plants close because of age or environmental concerns.
The key development we think utility investors should watch in the coming months is federal environmental policy. With a half-dozen proposals that would tighten regulations on everything from carbon emissions to power plant water use, the industry could face a generational shift in policy. For environmentally friendly power producers such as Exelon, Public Service Enterprise Group , and NextEra Energy , new regulations that would result in coal plant retirements could have a substantial positive impact. Alternatively, other proposed regulations such as water-cooling requirements could erode the low-cost advantage our top picks enjoy.
Industry-Level Insights
Regulated utilities stole the deal-making stage from their merchant peers in the fourth quarter, continuing an impressive year of industry consolidation. Northeast Utilities and Nstar made the biggest splash with their $9 billion merger followed closely by AGL Resources' $3.2 billion bid for Nicor . PPL closed its $7.6 billion deal to buy E.ON's Kentucky utilities after raising $2.9 billion of debt at credit spreads that averaged less than 100 basis points.
We think these deals highlight two key trends. First is the need for capital to support still-aggressive investment plans. Northeast Utilities found Nstar's strong cash flow an attractive way to finance its multi-billion-dollar slate of projects during the next few years. And with interest rates still at historic lows, utilities have rushed to the credit markets to fund capital budgets or acquisitions as PPL and AGL did. Utilities such as Westar Energy , Portland General , and SCANA face similar financing needs and could be active in the markets during the next year. Sharp increases in interest rates could slow growth and weigh on stock prices of these firms.
Second, we think the deals support our view that regulated utilities' valuations are overheated. AGL committed to pay 17.5 times our estimate for Nicor's 2011 earnings, some 30% more than what we think is reasonable for a slow-growth regulated gas utility like Nicor. Current market valuations appear similarly rich for other regulated utilities such as Piedmont Natural Gas , New Jersey Resources , and Wisconsin Energy .
Merchant power producers and diversified utilities face much different challenges in 2011. We estimate that even moderate U.S. Environmental Protection Agency regulations targeting mercury and ozone-related emissions for coal power plants could lead to 53 gigawatts of plant closures during the next five years. This will be concentrated in the eastern U.S. and represent 6% of total U.S. power generation. Already utilities have announced 11 gigawatts of coal plant closures or impairments.
Industry estimates suggest plant closings would lift margins 20%-30% for surviving generators. We don't think any of this is priced into forward power prices or current stock prices of our top picks. We expect initial ozone-related standards will be finalized by June with implementation in 2012 followed by stricter standards in 2014. Mercury-emissions standards must be finalized by November with likely implementation by 2015.
Our Top Utilities Picks
Our three 5-star utilities as of mid-December (GenOn Energy, Exelon, and NRG Energy) posses substantial leverage to a cyclical upturn in power markets and would be net benefactors from tighter environmental regulations. All three face challenging near-term earnings pressure but have long-term growth potential that we think the market is ignoring.
The only fully regulated utilities in our coverage universe that we think are undervalued as of Dec. 16 are Westar Energy, National Grid , and Portland General. These firms have dividend yields near 5% and above-average earnings-growth potential from projects such as environmental controls, renewable generation, and transmission lines that are less economically sensitive than traditional demand-driven growth projects in generation and distribution.
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.91, down from 0.96 last quarter as the sector rally stalled in the fourth quarter. Several large undervalued diversified utilities, such as Exelon, FirstEnergy , and Entergy , skew this average lower. The median price/fair value ratio for the sector is 0.94 down from 1.06 last quarter. This reflects our view that the smaller, fully regulated utilities could underperform their larger, diversified peers.
The utilities we highlight below feature high-quality assets, strong management teams, and good earnings-growth prospects. The 5-star names look attractive at today's market prices, while the 3-star picks reflect names we think investors should keep high on their watchlists.
| Top Utilities Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Dividend | |
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| GenOn Energy |  | $7.00 | None | High | NA |
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| NRG Energy | | $39.00 | None | High | NA |
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| Exelon | | $67.00 | Wide | Medium | 5.1% |
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| Westar Energy |  | $28.00 | Narrow | Medium | 5.0% |
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| National Grid | | $51.00 | Narrow | Medium | 6.1% |
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| Data as of 12-16-10. |
GenOn Energy
We think GenOn Energy provides the most compelling return opportunity among independent U.S. power producers. But a key value driver behind the merger is the $150 million of projected synergies, which we estimate could be worth $1.04 billion ($1.36 per share) if they are fully realized. Our model assumes the company is able to achieve 70% of its projections. These synergies notwithstanding, GenOn's prospects remain closely tied to power markets in the mid-Atlantic region and California and volatile fuel prices. Current forward power markets price in no demand recovery and no change in supply, but we believe plant closures and a return of economically sensitive demand growth should drive up market heat rates independent of commodity pricing. GenOn's current hedge profile locks in what we estimate to be trough earnings before interest, taxes, depreciation, and amortization in 2012, unless power markets deteriorate materially.
NRG Energy
We think NRG is an excellent pick for investors looking for an independent power producer with a high-quality management team and asset profile that will benefit from an improving U.S. economy and rising power demand. Its low-cost legacy power plants in Texas, California, and the Northeast still represent the bulk of the long-term value we see. But after nearly $3 billion of acquisitions during the past year, management has diversified its earnings profile with more natural gas generation, renewable energy, and countercyclical retail businesses. We think these moves preserve the firm's optionlike upside in more favorable commodity cycles while reducing its exposure to tighter environmental regulations. We expect the firm will finish 2010 with about $1 billion of cash after closing its announced deals.
Exelon
Operating leverage to rising Midwest U.S. power prices is the key value driver for our only wide-moat utility. With its low-cost nuclear fleet, Exelon benefits more than any other utility from a post-recession demand rebound, tighter environmental regulations, rising natural gas and coal prices, and higher power prices from tighter supply in constrained regions. With an enterprise value that is just 6 times our trough 2013 EBITDA estimate, we think the market is ignoring this upside. We are most focused on the company's ability to hedge in favorable economics for 2013-14. A rebound in Midwest industrial power demand and higher gas prices would help. A 10% move in 2013 power prices from today's levels can translate into $800 million of incremental EBITDA. If politicians revive carbon-cap legislation, we estimate it could add $900 million of incremental EBITDA and $6 per share of value. The company's $2.7 billion of cash as of Sept. 30 and management's long track record of value-creating stock buybacks and dividend hikes give us additional comfort.
Westar Energy
Earnings growth at this fully regulated Kansas utility climbed back on track in 2010 with favorable summer weather, improving industrial demand and continued rate increases for its key investments in transmission lines and environmental controls. Located in the U.S. wind alley, Westar has an enviable pipeline of high-return transmission projects that will connect rural wind farms to population centers to meet renewable-energy standards. We expect annual earnings growth to average 7.5% through 2013 based on already-approved projects. The company's favorable regulated-rate structures ensure strong cash flows and should allow the dividend to increase in line with earnings. Of its three-year $1.5 billion investment plan, $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 are unfavorable. A current 5% dividend yield is well above the industry average.
National Grid
This U.K.-based regulated utility should benefit substantially from a shift away from fossil fuels and toward renewables in the U.K. and U.S. Northeast. Building high-return transmission grids on both sides of the Atlantic 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 offers one of the most attractive total-return packages among regulated utilities. We expect the annual fiscal 2011 dividend to climb to GBX 36.37 per share ($2.87 per ADR share), a 6.5% yield as of mid-December.
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