Large Utilities Set to Outperform Smaller Peers
Regulated utilities could be hit hard by inflation, while diversified firms have long-term value that the market refuses to recognize.
The utility sector continues to be a tale of two divergent groups. The fully regulated utilities continue to climb as investors seek yield and safety in an ultralow interest-rate environment. Electric demand climbed 1% in the second quarter year over year, and industrial demand continues to climb back from its 2009 lows, providing fundamental stability. But if rates turn, inflation kicks in, or the economy falls into another recession, these utilities have a long way to fall.
On the other hand, the diversified utilities and independent power producers in May caught a whiff of the potential impact from environmental regulations coming out of Washington when mid-Atlantic capacity prices jumped in response to forecast coal plant closures. Even though we cut our 2014 midcycle power price assumptions an average of 10% in early June, we still think the low-cost, low-emissions power producers have long-term value that the market refuses to recognize.
Rising interest rates and inflation are the death knell for regulated utilities. With no imminent threat of either one, regulated utilities continue to hold on to their post-recession gains. But cracks are beginning to show. Returns for a group of the 34 largest U.S. regulated utilities were modestly positive during the second quarter but trailed those of the broader markets. The sector's 4.3% average dividend yield is still historically attractive relative to bond yields, but that yield spread against 10-year U.S. Treasuries has tightened 75 basis points since peaking in October 2010.
And with a current average trailing P/E at 16 times for these 34 regulated utilities, valuations are near the two-decade-high average peak of 16.3. During the last four peak-to-trough earnings-multiple cycles, this group of regulated utilities lost an average of 22% compared with an average 4% loss for the S&P 500 during the same periods. The richest right now are New Jersey Resources (NJR), Piedmont Natural Gas (PNY), and NSTAR (NST), all rated 2 stars. For most regulated utilities, we still think investors can achieve 9%-10% annual total returns during the next three to five years if inflation, interest rates, and the economy stay at current levels.
Lackluster power prices continue to stymie diversified utilities and independent power producers. Even though we saw a slight pickup in natural gas prices during the second quarter, power prices in most regions did not respond in kind. Forward power prices continue to imply an expansion in supply relative to demand while all fundamental signs point to the opposite: a rebound in industrial demand and retirements of coal plants that can't meet proposed emissions regulations. We believe Exelon's (EXC) $7.9 billion bid for Constellation Energy (CEG) in April was in part a hedge against these persistently weak power markets.
We continue to believe demand will increase by 1% annually, and 53 gigawatts of coal plant capacity will retire during the next five years. Already utilities have announced more than 20 GW of planned coal plant closures, including American Electric Power's (AEP) announcement in June that it plans to close up to 6 GW. Capacity markets seem to concur. In the 2014-15 mid-Atlantic capacity auction conducted in March, prices in the western portion of the region quintupled as 6.9 GW of coal plant capacity failed to clear. We believe capacity prices could continue to rise as markets price in full-year environmental compliance periods, and utilities make final plans after seeing the additional Environmental Protection Agency regulations we expect out by the end of 2011. Rising capacity prices help GenOn Energy (GEN), Exelon, and FirstEnergy (FE) the most.
In June, we cut our 2014 midcycle power price assumptions an average 10% resulting in lower fair value estimates for all of our diversified utilities and independent power producers. The primary driver in our cut was a 13% reduction in our 2014 midcycle natural gas price to $6.50 per thousand cubic feet. Still, our 2014 midcycle power price assumption remains at about 20% higher than current forward prices, driving our bullish outlook for most diversifieds and IPPs.
Our Top Utilities Picks
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.94, the same as last quarter. Several large undervalued diversified utilities skew this average lower. The median price/fair value ratio for the sector is 1.02. This reflects our view that the larger, diversified utilities should outperform their smaller, fully regulated peers.
We continue to see the most value among the diversified utilities and independent power producers that own low-cost, low-emissions generation. These include Exelon, NRG Energy (NRG), GenOn Energy, and Ormat Technologies (ORA). We think the market continues to underestimate the positive earnings impact on these utilities from U.S. EPA regulations we expect during the second half of 2011. In the case of Ormat, investors appear to be extrapolating much slower-growth opportunities from operational difficulties at one geothermal site, concerns we believe are overblown. The company's new-build potential outshines nearly that of all of its merchant peers.
Among regulated utilities, only four of the 33 we cover trade below our fair value estimate as of late June. We like regulated utilities such as Westar (WR) and National Grid (NGG), both with yields near 5% and growth opportunities that top their peers. Each of these utilities have unique characteristics that offer protection from inflation and interest-rate headwinds.
|Top Utilities Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Data as of 6-20-11.|
NRG Energy (NRG)
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 its long-term value. 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. Recently refinanced debt and termination of its STP 3 & 4 nuclear project could free up more than $500 million ($2.10 per share) for shareholders and possibly lead management to initiate a dividend.
GenOn Energy (GEN)
We think GenOn Energy provides a compelling return opportunity as a largely environmentally controlled independent U.S. power producer in a constrained region. The company is well on its way to achieving the $155 million of annual projected synergies worth some $2 per share if they are fully realized. Our fair value estimate assumes the company is able to achieve 70% of its projections. Synergies notwithstanding, GenOn's prospects remain closely tied to power markets in the mid-Atlantic region. Current forward power and capacity markets price in no demand recovery and no change in supply, but we believe coal plant closures and a return of economically sensitive demand growth should drive up power and capacity prices. GenOn's current hedges lock in what we estimate will be trough earnings before interest, taxes, depreciation, and amortization in 2012. Our net asset value calculation suggests the company is worth $8 per share with synergies.
With the largest nuclear power plant fleet in the U.S., Exelon is the best-positioned utility to benefit from an improving economy, rising commodity prices, and environmental regulations that would raise costs for fossil-fuel generation. Given our bullish outlook on long-term power prices, we're disappointed management decided to give away some of that upside to Constellation shareholders in its proposed merger. We think a rebound in Midwest industrial power demand, higher gas prices, and strict environmental regulations can produce an earnings leap in 2014. A 10% move in 2014 power prices from today's levels translates into $500 million of incremental EBITDA. We see no threat to the dividend or interest coverage even as Exelon's earnings bottom in 2012 near $3 per share. However, management's dedication to hedging even through the trough could force investors to wait longer for the earnings upside. With a current enterprise value at 7.0 times our trough 2012 EBITDA, we think the market is ignoring Exelon's leverage to rising long-term power prices. Between 2004 and 2009, the stock never traded below 8 times.
Westar Energy (WR)
Located in the Kansas 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 rate structures ensure strong cash flows and should allow the dividend to increase in line with earnings. Of the $2 billion of growth projects it has planned for the next four years, 90% have preapproved annual-cost-recovery rate structures or are flexible enough to postpone if market conditions are unfavorable. We think these growth opportunities and its current 5% dividend yield present a compelling total-return package.
National Grid (NGG)
This U.K.-based regulated utility should benefit substantially from a shift away from fossil fuels and toward renewables in the U.K. and the 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. Negotiations begin this year for the firm's 2013-21 U.K. rate cycle. With a 6% dividend yield and a good chance that management will extend its seven-year streak of annual dividend increases greater than 8%, we think National Grid offers one of the most attractive total-return packages among regulated utilities. We expect the annual fiscal 2012 dividend to climb above GBX 39 per share ($3.11 per ADR share).
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Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.