Our Outlook for Utilities Stocks
Fast-approaching environmental regulation could reshape the utilities sector.
Quarter-End Insights
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- Environmental regulation talk will accelerate this quarter as more rules are finalized and utilities plan their compliance strategy.
- Regulated utilities continue to outperform the market and still look rich given slowing growth and potential interest-rate headwinds.
- Regulators' rulings in five pending merger and acquisition deals representing $33 billion of combined equity value will provide a good judge of the regulatory environment.
Change comes slowly in the utility industry, but it's about to ramp up. Not since deregulation in the late 1990s has the sector undergone the upheaval we expect during the next year. Barring last-minute legal or political meddling, the U.S. Environmental Protection Agency's environmental regulations are set to reshape the sector. Utilities are hustling to position themselves for tightening regulations in 2012, 2014, and likely 2015 covering coal plant emissions, coal waste disposal, and water use.
In response, utilities already have announced plans to close 26 gigawatts of coal plants, 8% of all coal plant capacity in the U.S. We think that number could double by 2015. More importantly, the closures are concentrated in the eastern half of the U.S., dramatically altering the source and price of power in states that derive a large share of their power from coal plants like West Virginia (97%), Kentucky (93%), Indiana (90%), and Ohio (82%). Already utilities have mounted legal appeals, but political momentum in Washington is strong, and we expect the rules will hold mostly intact.
Customers' sensitivity to higher rates while the economy struggles to rebound complicates the matter. We expect a boost in energy efficiency, more clean-burning gas-fired generation, and tough decisions from regulators regarding infrastructure investment. In some cases, a heat wave or cold snap like we've seen in Texas and the Southeast recently could lead to blackouts unless utilities and regulators address these key issues.
Despite these uncertainties, investors continue to flock to utilities. The Morningstar utilities index reached a three-year high during the second quarter and has outperformed the S&P 500 by 6.5 percentage points since January 2010. And the sector's 4.3% average dividend yield still looks attractive with its spread against 10-year U.S. Treasuries reaching a 20-year high in early September at 243 basis points. Now more than ever, we think investors must choose their utilities carefully to capture the winners and avoid the losers as the sector changes rapidly.
Industry-Level Insights
Diversified utilities and independent power producers have the most to lose or gain from environmental regulation and legislation. We know the clear winners, but the market has yet to digest the more nuanced impact on others. Exelon holds the biggest option upside with the nation's largest emission-free fleet located in regions with the highest concentration of dirty coal plants. Stubbornly low Midwest power prices finally began to move up in March with 2012 implied market heat rates in the region expanding 22% during the last six months and power prices far outperforming oil, natural gas, and coal during the same period.
As a result, Exelon raised its 2013 gross margin forecast in July, and we expect another jump when it announces third-quarter results in late October. When Midwest power prices fully incorporate the environmental compliance costs that coal generators will face starting in 2012, Exelon could add another $200 million ($0.30 per share) of earnings in 2012 and $900 million ($0.90 per share) in 2013. To a lesser extent, Public Service Enterprise Group is another winner. And despite coal-dominated fleets, independent power producers GenOn Energy and NRG Energy could realize net benefits given their strong local competitive advantages.
Regulated utilities faced a difficult start to the third quarter with Hurricane Irene and the East Coast earthquake causing what we estimate will be $1 billion of repair costs for utilities. Stagnant electricity demand remains a challenge. Seasonally-adjusted U.S. electricity demand edged higher in January and June with extreme weather in the South, but core demand has been essentially flat for three years.
With utilities facing more than $80 billion of planned capital investment during each of the next three years and regulators' reluctance to raise rates on cash-strapped customers, earned returns continue to trend down. The only respite is the even faster drop in interest rates and spreads. Industrial demand remains the lone bright spot, up nearly 7% from its late-2009 lows and up 3% on average this year, but these typically are the lowest-margin customers. Warmer-than-normal summer weather should be a mild positive for third-quarter earnings but 2010's scorcher remains a tough comparison.
Our Top Utilities Picks
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.84, an 11% drop from last quarter as the market downturn made many utilities stocks more attractive. Still, the median price/fair value ratio for the sector is 1.06, up 4% from last quarter as the smaller-cap regulated utilities significantly outperformed. Regulated utilities are 5% overvalued on a market-cap-weighted basis while diversified utilities (with power-generation exposure) are 20% undervalued. Only five of the 33 regulated utilities we cover trade below our fair value estimates as of late September.
Utilities stocks expected to benefit from environmental regulations have begun to move favorably as the industry and investors digest the potential impacts. But we still see plenty of upside. Exelon has outperformed the S&P 500 by 11 percentage points this year as environmental regulation has gained momentum. The firm remains a top pick with another 30% upside if environmental regulations hold. We also consider top picks GenOn Energy and NRG Energy winners from environmental regulations.
Among fully regulated utilities, we like Westar Energy and National Grid , both with yields around 5% and growth opportunities that top their peers. Each of these utilities has unique characteristics that offer protection from inflation and higher interest rates.
| Top Utility Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Dividend | |
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| Ormat Technologies |  | $28.00 | Narrow | Medium | 1.0% |
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| Exelon |  | $58.00 | Wide | Medium | 4.9% |
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| GenOn Energy | | $5.00 | None | High | NA |
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| Westar Energy | | $29.00 | Narrow | Low | 4.9% |
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| National Grid |  | $53.00 | Narrow | Low | 5.6% |
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| Data as of 9-21-11. |
Ormat Technologies
Ormat's baseload geothermal plants offer utilities a more appealing renewable resource than wind and solar generation, which are less reliable and more expensive. Our bullish thesis for Ormat remains intact despite headwinds and project delays. Ormat's relatively low-cost, clean power pants and technological edge make it the only independent power producer with a moat. We think Ormat's growth from developing existing projects could lift earnings faster than its peers with virtually no commodity exposure. We project that renewable energy demand will drive 26% annualized earnings before interest, taxes, depreciation, and amortization growth through 2015. With an enterprise value that is just 7 times our 2012 EBITDA estimate and 6 times our 2013 EBITDA estimate, we think investors' negative reaction to operational issues presents an appealing opportunity to invest in a high-quality renewable energy company.
Exelon
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 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 Energy Group 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 about $0.50 per share of earnings. 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 8 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 lower than 8 times.
GenOn Energy
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 synergy projections. Synergies notwithstanding, GenOn's prospects remain closely tied to power markets in the mid-Atlantic region. Current forward power and capacity prices are beginning to move up in response to environmental regulations announced this year, but significant upside remains, particularly if gas prices begin to move up on expectations for more cleaner-burning generation. GenOn's current hedges lock in what we estimate will be trough earnings in 2012. Our net asset value calculation suggests the company could be worth $8 per share with synergies.
Westar Energy
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. Since 2008, the utility has increased core earnings at a 9% average annual rate, and we think it can sustain that through 2014. 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 Westar's current 5% dividend yield present a compelling total-return package.
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 the Northeast U.S. Building high-return transmission grids on both sides of the Atlantic Ocean should drive strong earnings growth, while favorable regulated rate structures protect those earnings from inflation through automatic adjustments. Negotiations to determine the firm's 2013-21 U.K. rates have begun. 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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