Our Outlook for Utilities Stocks
With interest rates leveling off and power markets stalled, utilities face a tough near-term outlook.
Quarter-End Insights
- Since June, forward power prices in most of the Eastern U.S. regions have retreated 5%-10%, keeping pressure on the near-term earnings outlook for utilities with wholesale power generation.
- The spread between utilities' 4.1% average dividend yield and 10-year U.S. Treasury yields remains near its 20-year high, suggesting that some utilities with 4%-5% yields still have room to run.
- We think valuations for many regulated utilities are stretched, given the risks of regulatory rate cuts, higher interest rates, and dividend tax hikes.
Low interest rates have offered many utilities a fierce tailwind the past three years, but that appears to be fading. And still-falling natural gas and power prices have stymied returns for many of the largest, diversified utilities. Between June and August, utilities were the worst-performing sector, with 2.6% returns compared with 8.0% for the S&P 500. Even regulated utilities, which had outperformed nearly every other sector the past few years as investors sought defensive and high-yielding investments, returned just 3.0% the past three months.
For all utilities, we see several macro risks that could suppress returns during the next one to two years. Even if interest rates stay low and valuations stay high, regulators are catching up and lowering utilities' allowed returns, hurting earnings. The average target return on equity that regulators granted utilities during the second quarter dropped to its lowest level in at least 20 years, 9.9%. Even with this drop, the spread between these allowed returns and the 10-year U.S. Treasury yield remains at all-time highs near 800 basis points. A reversion to the 20-year mean near 600 basis points could mean 10%-20% earnings contraction for many utilities.
Internationally, we think utilities in Europe are well positioned to weather an extended economic downturn and benefit from the upside if the economy improves. We particularly like Electricite de France , GDF Suez , and RWE , which have diversified earnings streams and entrenched positions in the European energy value chain. We also look to the United Kingdom, where firms like National Grid and SSE benefit from one of the few regulatory environments that support earnings growth, cash flow stability, and protection from rising interest rates.
Finally, we see select opportunities among the South American utilities we cover. Near-term headwinds, notably the Brazilian government's plans to reduce electricity rates, have created significant volatility. Continued economic weakness in Brazil could lead to further rate cuts. We still believe CFPL Energia and Endesa Chile are well positioned to benefit from the continent’s long-term infrastructure development needs and continued economic stabilization.
Industry-Level Insights
It wouldn't be another quarter without more merger and acquisition activity among diversified utilities and independent power producers. The latest deal was NRG Energy's bid for GenOn Energy in a $1.7 billion all-stock deal announced in July. In the past two years, every independent power producer and diversified utility except Public Service Enterprise Group has closed a major deal, is working on one, or has declared bankruptcy (Dynegy). If NRG swallows GenOn, it will join Calpine as the only U.S. publicly traded independent power producers with market capitalizations greater than $1 billion.
Diversification is the game of choice right now as diversified utilities and independent power producers try to find ways to cushion the earnings cliff they are experiencing as power prices keep dropping. The forward markets still are giving little value to the severe supply/demand contraction that many regions face during the next 5-10 years as coal plant emissions regulations force plant closures and regulatory uncertainty quashes the new-build generation pipeline.
The Texas market presents the most immediate concern, with reserve margins that could drop well below the grid operator's safe level as early as 2014, according to a recent report. The Midwest and Mid-Atlantic grid operators also recently issued reports that suggest reserve margin compression in those regions. Still, forward power prices reflect virtually none of that tightening supply/demand balance, and utilities like Exelon , NRG Energy, FirstEnergy , PPL , and others have yet to hit a trough earnings base. For investors willing to take a long-term view while collecting the 4%-6% dividend yield many of these names offer, we think there could be considerable upside.
Regulated utilities face an entirely different set of challenges, but we see a similarly bleak near-term outlook for most. The potential for cuts in allowed returns and an uncertain regulatory environment could lead management teams to pull back their investment and earnings growth forecasts. If natural gas and power markets grow more volatile, as we think they will, regulated utilities could face more pressure from rate payers to give up profits or earnings growth to keep bills low. In this environment, we like utilities with the most constructive rate terms, notably Atmos Energy , Consolidated Edison , New Jersey Resources , Wisconsin Energy , and NVE Energy .
Our Top Utilities Picks
On a market-capitalization-weighted basis, the average sector price/fair value estimate ratio is 0.90, up from 0.87 last quarter. But the utilities sector's 1.05 median price/fair value--unchanged from last quarter--still highlights the sharp valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities.
Only three of the 31 U.S. regulated utilities we cover are trading below our fair value estimates as of mid-September. Yet paradoxically, dividend yields and growth prospects for many of those utilities still look attractive. The spread between the 4.1% utility sector average dividend yield and 10-year U.S. Treasuries at 260 basis points is the widest in at least 20 years, and most domestic utilities have no exposure to Europe's financial woes. For safety-minded, yield-seeking investors, we continue to point toward National Grid, American Electric Power , and Alliant .
Among diversified utilities and independent power producers, we still favor those with low-emission generation assets like Exelon and Ormat Technologies . As power markets tighten, we think GenOn Energy, NRG Energy, and Public Service Enterprise Group can be winners.
| Top Utilities Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Yield | |
 | |||||
| Ormat Technologies |  | $27.00 | Narrow | Medium | 0.9% |
| |||||
| Exelon |  | $54.00 | Wide | Medium | 5.9% |
| |||||
| GenOn Energy | | $4.00 | None | High | NA |
| |||||
| American Electric Power | | $47.00 | Narrow | Low | 4.3% |
| |||||
| Empresa Nacional de Electricidad | | $59.00 | Narrow | High | 4.2% |
| |||||
| Data as of 09-18-12. |
Ormat Technologies
Ormat's baseload geothermal plants offer utilities a more appealing renewable resource than wind and solar generation--which are much less reliable and more expensive--provided you can find the geothermal resource. Ormat's growth from development at more proven geothermal sites will be impressive, but we expect a bumpy ride as growth becomes more dependent on exploration. The company's portfolio provides a consistent profit stream and should grow at a rate unmatched by its peers without dependence on fossil fuels. Reservoir issues at Brawley caused fears about the viability of the land portfolio that we think are overblown, despite the hit to recent profits. New projects will help assuage concerns. Investors looking for an established renewable pure play should find Ormat enticing, especially if the company continues to trade at a discount to peers. Ormat's exposure to emerging markets is significant.
Exelon
Even with Constellation's countercyclical distribution and retail businesses in the fold and cost synergies flowing through, Exelon can't escape its overwhelming leverage to Eastern U.S. power prices. These power prices, highly correlated with sluggish natural gas prices, continue to drag down Exelon's earnings prospects for the next three years. If current markets persist, even Exelon's $2.10 per share dividend could be at risk by 2014. But leverage works both ways, and Exelon is the utilities sector's biggest winner if our outlook for higher power and natural gas prices materializes. Coal plant environmental regulations are tightening and utilities are shutting down plants, all supporting our bullish outlook. With this view, we think Exelon's midcycle earnings power is near $5.50 per share, nearly double our 2014 mark-to-market earnings estimate. Exelon's dividend yield recently topped 6% for the first time since its creation in 2000, so investors are paid handsomely to wait for a power market rebound.
GenOn Energy
We think GenOn Energy offers compelling upside despite its coal-heavy fleet. NRG Energy clearly agrees, taking advantage of trough market conditions to bring GenOn's plants into the fold with an all-stock offer at an implied 11% discount to our fair value estimate. GenOn's power plants occupy strategic locations in supply-constrained areas, giving the firm leverage as power markets tighten and energy prices rise. Equity and power markets are pricing in virtually no power demand or gas price recovery in the U.S. and don't incorporate the dramatic supply/demand changes facing the Eastern seaboard and the Midwest if aggressive environmental rules stick. Supply tightening already has put upward pressure on forward heat rates and capacity prices, both positives for GenOn, though cheap natural gas continues to crush open coal margins. GenOn's hedge profile locks in what we estimate will be trough EBITDA in 2012.
American Electric Power
Ohio regulators introduced significant short-term uncertainty for American Electric Power when they revoked the previously agreed-to electric security plan allowing AEP partial recovery for generation investments as the state transitions to full deregulation by 2015. Company management now expects less than 50% of its fleet will burn coal by 2020, compared with 64% of current generation. Despite its environmental liabilities and likely plant closures, we think AEP remains well positioned to benefit from our bullish outlook on power prices. The company's regulated utilities remain the core growth driver, with projected 9% annual earnings growth during the next five years, based on its aggressive capital investment plans. Given the diversity of operations and earnings growth prospects, we believe AEP's 4.3% dividend yield more than compensates investors for the interim uncertainty.
Empresa Nacional de Electricidad
Weather conditions have negatively affected Endesa Chile's financial results during the past two years. La Nina has brought dry weather conditions to the company's South American operations, resulting in lower-than-average run times for the firm's large hydroelectric generation fleet. Low water levels require the company to purchase higher-cost energy on the spot market to meet contractual requirements. With La Nina predicted to pass in 2012, we forecast normalized weather conditions in 2013 and expect hydroelectric generation to return to pre-La Nina levels by 2014. Our enthusiasm is tempered by the high uncertainty in our valuation from the heightened political risk, foreign exchange volatility, and lack of minority shareholder votes. We therefore require a higher margin of safety than we do for the company's regulated U.S. peers.
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