Our Outlook for Utilities Stocks
Final environmental regulations give utilities near-term certainty but no comfort.
Quarter-End Insights
- Utilities have now announced coal plant closures totaling 30 GW of the 53 GW we project to comply with two landmark EPA air emissions rulings during the second half of 2011.
- Warmer-than-normal summer weather in 2010 and 2011 and still-tepid demand forecasts are setting up 2012 for tough earnings comps.
- Still-falling natural gas prices are offsetting forward heat rate expansion, keeping power prices flat despite the favorable supply-demand conditions projected in the coming years.
With the Environmental Protection Agency's mid-December publication of the final Air Toxics Rule, utilities in the eastern United States now know all of the environmental mandates they must meet in the next three to four years and can begin the compliance-planning process in earnest. We expect 2012-15 to represent landmark changes in the utilities sector along the lines of the Energy Policy Act of 2005 and deregulation in the 1990s. Even before the final Air Toxics Rule, utilities continued to announce plans to retire and retrofit their coal plants. We've now tallied 30 gigawatts of planned or executed coal plant retirements, representing 10% of the U.S. coal fleet, and we expect more to come.
We think the power markets slowly are beginning to reflect this tightening supply-demand balance up to 2015, offering wider margins for power producers with relatively clean fleets and entrenched positions in coal-heavy regions. These winners include Exelon (EXC), Public Service Enterprise Group (PEG), and NRG Energy (NRG). Despite a 20% drop in average forward gas prices since June, forward power prices in key eastern U.S. regions have fallen just 10%, demonstrating the market's expectation for significantly tighter supply-demand conditions in the coming years. Yet forward heat rates in the coal-heavy mid-Atlantic region remain backward-dated, offering what we think is an opportunity for additional upside in power prices.
Although regulated utilities won't experience the same direct gross margin impact as their merchant peers, they could come under significant regulatory pressure as they petition for higher customer rates to recover increased power costs and new infrastructure investment to comply with the rules. Utilities have about $80 billion of annual investment planned for 2012 and 2013, most of it to address environmental regulations or renewable-energy targets. Key pending mergers involving Progress Energy and Duke Energy (DUK), and Northeast Utilities (NU) and Nstar relate directly to funding requirements for significant investment plans.
Industry-Level Insights
Shareholders of diversified utilities and independent power producers face the most exposure to environmental regulations and power market developments. Exelon's large nuclear fleet in the Midwest and mid-Atlantic regions give it a clear advantage and more upside to environmental regulations than any other U.S. utility. We calculate a 10% move in 2014 power prices results in about $0.50 per share of earnings and $5 per share of value. In November, Exelon raised its 2013 gross margin forecast for the second consecutive quarter to $6.2 billion, 10% higher than its low-end forecast at the beginning of the year.
Developments in Ohio during the fourth quarter could open up a fierce lion's den of competition among megaretailers during the next few years. American Electric Power (AEP) and Duke Energy both moved toward full deregulation by 2015. We expect a flood of high-powered retailers such as AEP, Duke, Constellation Energy , and FirstEnergy (FE) to pursue those customers aggressively. Exelon's pending merger with Constellation gives Constellation even more firepower to attack that Midwest region. All have significant generation fleets in the region that can serve acquired retail load and capture premium margins relative to market rates. Retail businesses also help smooth diversified utilities' cyclical generation profits, which we expect will bottom in 2012 for most.
Among regulated utilities, regulatory risk is increasing. Higher levels of investment require utilities to file more frequent rate-increase requests to protect cash flows. But more frequent rate requests can wear on regulators and consumers. It also raises the prospect for allowed return on equity cuts as interest rates continue to fall. All of this on top of stagnant demand creates more risk for regulated utilities than we've seen this decade. Before the recession, most utilities could count on demand to support returns, but that no longer is the case. At the end of the third quarter, the average awarded ROE had fallen to 10.1%, according to data from industry group the Edison Electric Institute. Several Northeast utilities recently received allowed ROEs near 9%, a level at which we think utilities will have a tough time creating shareholder value. The average allowed ROE never has fallen below 10% in the 21 years the EEI has collected the data.
Our Top Utilities Picks
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.88, up 5% from last quarter. But the utility sector's 1.03 median price/fair value still highlights the sharp valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities. Regulated utilities remain 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 lower than our fair value estimates as of mid-December.
The market continues to flock to regulated utilities, a perceived safe haven from the macroeconomic concerns dominating investor sentiment. A market-cap-weighted index of the 34 largest U.S. regulated utilities is up 18% year to date through November, well above the 1% gain in the S&P 500 and the next-best-performing sector, consumer defensive, at 11%. When including all utilities, the sector is up 15% through 11 months.
Utilities stocks expected to benefit from environmental regulations have outperformed the market and their peers during the second half of the year. Exelon has outperformed the S&P 500 by 4 percentage points this year. The firm remains a top pick with another 35% upside if environmental regulations hold. Among fully regulated utilities, we continue to like Westar Energy (WR) and National Grid (NGG), both with yields near 5% and growth opportunities that top their peers'. We think the most undervalued regulated utility right now is PG&E (PCG), which is down 7% year to date through November on concerns about impacts from the September 2010 San Bruno, Calif., pipeline explosion.
| Top Utilities Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Dividend Yield | |
 | |||||
| Ormat Technologies |  | $28.00 | Narrow | Medium | 0.9% |
| |||||
| Exelon |  | $58.00 | Wide | Medium | 4.9% |
| |||||
| GenOn Energy | | $5.00 | None | High | N/A |
| |||||
| Westar Energy | | $29.00 | Narrow | Low | 4.7% |
| |||||
| National Grid | | $53.00 | Narrow | Low | 5.8% |
| |||||
| |||||
| Data as of 12-13-2011. |
Ormat Technologies (ORA)
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 plants 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, we think investors' negative reaction to operational issues presents an appealing opportunity to invest in a high-quality renewable energy company.
Exelon (EXC)
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 shareholders in its proposed merger. We think a rebound in Midwest industrial power demand, higher gas prices, and 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. Management has raised its low-end 2013 gross margin forecast 10% since January 2011, supporting our $3.37 earnings-per-share estimate. 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 EV/EBITDA.
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 (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. Since 2008, the utility has increased core earnings at a 9% average annual rate, and we think it can sustain that through 2014 pending the outcome of its 2011 rate case. 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 Westar 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 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 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. Management in mid-November raised the interim 2012 fiscal-year dividend 8%, representing a full-year dividend of GBX 39 per share ($3.02 per ADR share), assuming an 8% increase in the final dividend in mid-2012.
If you'd like to track and analyze the stocks mentioned above, click here to create a watchlist. Then simply click "continue," name your watchlist, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.
Other Sector Outlook Articles