Our Outlook for Utilities Stocks
Low gas prices and a warm winter are burning power generators.
Quarter-End Insights
- As natural gas and power prices dropped 30% in late 2011, coal generation fell to 39% of total U.S. generation in December, its lowest share in at least two decades.
- Falling interest rates have been a boon for utilities during the last decade, but regulators are beginning to catch up and cut allowed returns--creating a huge earnings headwind for most utilities.
- The average utility dividend yield at 3.7% remains historically high relative to interest rates, but investment requirements, rising interest rates, and slower usage growth could constrain dividend growth.
Going into 2012, most utilities expected environmental regulations to be the key challenge. But when natural gas and power prices dropped in half starting in September through mid-March, coal power plant owners faced another key setback. Coal generation, which long provided about half of all power consumed in the U.S., now could supply less than 40% in 2012.
Gas generation and renewable generation have sprinted to fill the gap, and we see no near-term slowdown. In the U.S., 17 GW of gas-fired generation is under construction, and we expect capacity utilization for the lowest-cost gas plants could double this year. In addition, winter temperatures that were 16% above normal have created a record supply glut of natural gas, offering power producers a ready supply of low-cost fuel to meet those high-demand summer months. Possible legal delays to proposed power plant environmental regulations have kept power markets depressed as well.
Regulated utilities also face significant headwinds in 2012 with interest rates top of mind. The secular decline in interest rates during the last decade has been a key reason utility stocks have produced total returns more than double the S&P 500 since 2002. But that relative performance has cooled thus far in 2012 as the prospect of inflation and flat--if not higher--interest rates creep onto investors' radars. During the first two months of 2012, the utilities sector's total return was negative while the S&P 500 climbed 9%. As regulators cut allowed returns, energy efficiency takes hold, and utilities face high investment requirements to update infrastructure or meet regulations, earnings and dividend growth could slow.
Industry-Level Insights
Even after the sector's poor 2012 performance thus far, we still consider fully regulated utilities 10% overvalued as of mid-March. Earnings growth already has slowed, and earnings multiples have climbed above what we think is fair for investors to pay for fully regulated utilities. In the group, we urge investors to look for utilities with dividend yields between 4%-5% and investment growth opportunities that are agnostic to customer usage. Some of these projects include environmental retrofits, renewable generation, or efficiency-related infrastructure upgrades.
For utilities with exposure to merchant generation and power markets, uncertainty reigns, but we think the valuations look much more attractive. As a group, the diversified utilities and independent power producers trade at a 20% discount to our fair value estimates. We remain bullish on gas and power prices as supply rationalizes and demand accelerates for both commodities. Low-cost generators such as Exelon (EXC), GenOn Energy , and NRG Energy (NRG) have huge upside potential if power markets rebound.
However, if gas supply remains abundant and power prices low, many coal power generators face tough economics, particularly in light of emissions regulations. Utilities already have announced 30 GW of planned coal plant retirements, and we think that number ultimately can reach 53 GW. Dynegy and Edison International's (EIX) Edison Mission Energy have fallen prey to the convergence of low power prices and tighter emissions regulations. Coal-heavy GenOn Energy, FirstEnergy (FE), and American Electric Power (AEP) also are at risk.
In this environment of low gas and power prices, we favor "clean" power producers such as nuclear giant Exelon and Ormat Technologies (ORA), and diversified utilities that have shifted their earnings mix more toward regulated and retail businesses, such as PPL (PPL) and Public Service Enterprise Group (PEG).
Our Top Utilities Picks
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.90, up from 0.88 last quarter. But the utility sector's 1.01 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.
Several fully regulated utilities are starting to look cheap based on their above-average dividend yields and growth prospects. As of mid-March, six of the 33 regulated utilities we cover trade lower than our fair value estimates, among them Westar (WR), National Grid (NGG), and PG&E (PCG). We also think Latin American utilities Enersis and Endesa Chile as well as European utilities ENEL (ENEL), RWE (RWE), and Electricite de France offer attractive combinations of yield and growth that exceed those of their average U.S. utilities peers.
| Top Utilities Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Yield | |
 | |||||
| Ormat Technologies |  | $27.00 | Narrow | Medium | 0.8% |
| |||||
| Exelon | | $54.00 | Wide | Medium | 5.4% |
| |||||
| GenOn Energy |  | $4.50 | None | High | NA |
| |||||
| National Grid |  | $53.00 | Narrow | Low | 6.0% |
| |||||
| PG&E | | $45.00 | Narrow | Medium | 4.2% |
| |||||
| Data as of 3-22-12. |
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 EBITDA 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)
Even though we believe Exelon's $7 billion acquisition of Constellation in March 2012 was value-dilutive, the addition of Constellation's countercyclical retail business comes at just the right time. As power and gas markets have plunged, Constellation's retail business and regulated utility offer an offset to Exelon's huge generation fleet. Still, Exelon's net position remains long power, mostly in the Midwest, and it will have to overcome some $500 million of giveaways we estimate it made to gain regulatory approval. For those who concur with Exelon management that power prices will stay low for many years, the merger should easily be accretive. But if you believe Exelon can be the utility sector's big winner from environmental regulations, then Constellation will be a drag. Given our bullish outlook, we now see midcycle 2015 earnings approaching $5.70 per share, not the $6.00 we saw on a standalone basis. We still think Exelon offers a compelling value, trading at 13 times its trough earnings we forecast in 2012, and 6.5 times our midcycle 2016 earnings.
GenOn Energy
We think GenOn Energy provides a compelling return opportunity as a largely environmentally controlled independent power producer in constrained regions. 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 in 2011, 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.
National Grid (NGG)
With a 6% dividend yield and top-tier growth prospects, we think National Grid offers one of the most attractive total-return packages in the sector. 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 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 should wrap in late 2012. Management has raised the dividend 8% annually on average the last seven years, including an indicated full-year dividend of GBX 39 per share ($3.02 per ADR share) for 2011-12 fiscal year. If U.K. rate negotiations remain constructive, we think management could start another similar dividend growth streak in 2013 as it pursues some GBP 40 billion of operating and capital investment through 2021.
PG&E (PCG)
The September 2010 San Bruno pipeline explosion continues to obscure PG&E's core best-in-class California regulation and growth prospects. At this point, we assume shareholders' final tab for San Bruno approaches $1 billion; however, we believe the market is pricing in a number north of $2 billion. Adjusting for this difference, PG&E's 13 times P/E on core 2012 earnings still appears cheap relative to its peers. Investors face a challenging 2012-13 with little or no dividend growth, but by 2014 with new rates and the San Bruno tab closed, we expect the company can resume its industry-leading earnings growth. If its investment plans and state regulation remain on track, we think the dividend ultimately could top $2 per share.
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