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Quarter-End Insights

Our Outlook for Utilities Stocks

Pegging the direction of utilities stocks in 2013 is not for the faint of heart.

  • Utilities are on track to be the worst-performing sector in 2012 with 2% year-to-date total returns through November compared with 15% for the S&P 500.
  • Utilities' average 4.1% dividend yield still looks historically attractive compared with sub-2% U.S. Treasury yields. Recent history suggests this could mean 20% upside is still available.
  • Power prices have stabilized and 2013 will be a key year as forward markets start pricing in 2015 environmental regulations.


Pegging the direction of utilities stocks in 2013 is not for the faint of heart. After trouncing every sector and the S&P 500 with a 19% return in 2011, utilities are on track to post just a 2% return in 2012, well below every other sector and the S&P 500's 15% return. Wither go interest rates, power prices, the worldwide economy, and taxes?

Setting aside the weak U.S. power markets that have constrained earnings and dividend growth for diversified utilities and independent power producers, the utilities sector looks historically attractive with an average 4.1% dividend yield and sub-2% U.S. Treasury yields as of mid-December. The current 250-basis-point spread is well above the 100-basis-point spread that domestic utilities sported going into the 2011 rally. The relationship between this yield spread and valuations the last decade suggests regulated utilities could have another 20-25% upside during the next two years. On the other hand, the market could already be pricing in higher dividend tax rates and higher future interest rates, which would make utilities less attractive despite their higher nominal yields. 

Internationally, European utilities continue feeling the pain from the economic dislocation across the region.  GDF Suez  and  Iberdrola were the latest to revise their outlook for 2013 downward. German utility  E.ON (EOAN) has also said that it is reviewing its previous 2013-15 outlook. Long-term investors willing to endure a bumpy ride could enjoy attractive upside in these cyclical stocks if the European economy rebounds. Even in Latin America--where we saw attractive opportunities just a few months ago--utilities are facing less certain growth outlooks after recent populist government intervention suggests lower returns are on tap.  Copel faces the most risk.

Industry-Level Insights
Power market developments remain the key focal point in 2013 for the largest diversified utilities such as  Exelon ,  FirstEnergy , and  Entergy . Forward power prices have hardly budged the past six months even as other energy prices have climbed. There remains a fundamental disconnect between the shrinking generation supply--coal plants closing, unable to meet pending environmental requirements--and market power prices.

Stagnant power prices and generation margins are crimping the 2014-15 cash flow outlook for some diversified utilities, notably Exelon, and independent power producers such as  NRG Energy and GenOn Energy. We think Exelon might have to cut its 2013 dividend at least 30% based on our mark-to-market cash flow projections. With the stock trading at a 7% yield as of mid-December, we think the market already is incorporating that dividend cut.

We're watching closely key power market auctions during the first quarter in Ohio, Pennsylvania, and New Jersey to see what margins Exelon, FirstEnergy,  Public Service Enterprise Group , and others are able to lock in for power sales as far out as 2016. Exchange-traded forward power contracts tend to be thinly traded, so the deeply liquid and competitive state-run auctions will offer a true assessment of forward power prices. Favorable auction results could push Exelon's dividend cut out a few quarters and bolster cash flows for other diversified utilities.

Regulated utilities also face earnings uncertainty going into 2013. Average allowed returns granted last quarter hit 9.8%, the lowest in at least 20 years. Most recently,  SCANA settled on a 10.25% allowed return in South Carolina--a 45-basis-point cut---and allowed returns on equity in California for  PG&E ,  Edison International , and  Sempra Energy  look set to drop nearly 100 basis points. Still, the spread between allowed returns and U.S. Treasuries remains 200 basis points above the 20-year average. If allowed ROEs continue to fall or interest rates start rising, utilities could have a significant earnings headwind.

Electricity and gas demand also bears watching in 2013. The 2012 winter was abnormally warm, with heating degree days 21% below normal. A reversion to normal could mean a big earnings pickup for natural gas utilities and propane distributors such as  AmeriGas Partners and  Suburban Propane . On the other hand, summer weather was warmer than normal for the second consecutive year, creating a headwind for electric utilities if summer cooling usage returns to normal.

Our Top Utilities Picks
On a market capitalization-weighted basis, the average sector price/fair value estimate ratio is 0.89, down from 0.90 last quarter. But the utilities sector's median 1.03 median price/fair value still shows the valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities. That gap is closing after regulated utilities' weak 2012 returns. We now think regulated utilities on average are just 5% overvalued compared with 16% overvalued going into 2012.

Among diversified utilities, we think Public Service Enterprise Group is best positioned to offer investors dividend growth and long-term upside from a recovery in power markets despite its less attractive relative valuation as of mid-December. Its New Jersey regulated utility is poised for 15% earnings growth the next three years, offering all the cash it needs to continue funding 3% dividend growth despite flat earnings at its wholesale generation segment. Cheaper diversified utilities such as Exelon,  PPL , and Entergy we think offer more upside but also more risk.

We split the regulated utilities into two groups. One group comprises companies like  American Electric Power , which is going through a strategic makeover as Ohio deregulates, and PG&E, which faces regulatory uncertainty still tied to the 2010 San Bruno pipeline explosion and its upcoming 2014-16 general rate case filing. These uncertainties offer investors opportunities to pick up quality companies at what we think is a discount to their peers and fair values. The other group comprises high-quality utilities with stable, transparent cash flow and dividend growth. Some of these like  Southern Company  ,  Westar Energy , and  Alliant Energy have less attractive upside but still offer historically attractive yields topping 4%.

Top Utilities Sector Picks
Star Rating Fair Value
Fair Value
Ormat Technologies $27.00 Narrow Medium 0.8%
Exelon $42.00 Wide Medium 7.0%
NRG Energy $28.00 None High 1.6%
American Electric Power $46.00 Narrow Low 4.3%
Westar Energy $30.00 Narrow Low 4.7%
Data as of 12-13-12.

 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--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 has become 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, supporting consistent cash returns on invested capital. Reservoir issues at Brawley caused fears about the land portfolio that we think are overblown, despite the hit to recent profits. New projects will help ease concerns. Investors looking for an established, pure-play renewable energy developer should find Ormat's 13% annual growth in EBITDA through 2014 enticing. Ormat also has significant exposure to emerging markets, supporting cash flow growth.

Even with Constellation's countercyclical distribution and retail businesses in the fold and cost synergies flowing through, Exelon still 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, we expect management will opt to cut its $2.10 per share dividend 30%-50% as early as the first quarter of 2013. 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 $4.25 per share, nearly double our 2014 mark-to-market earnings estimate.

 NRG Energy
NRG Energy's $1.7 billion merger with GenOn Energy this year is another example of what we think is management's keen eye for value-creation opportunities. This downcycle has been tough on NRG's wholesale generation fleet, and that's likely to continue until power markets rebound. But NRG's aggressive move into countercyclical retail and stable-return renewable energy businesses is cushioning earnings and shareholder returns. Even as wholesale generation earnings plummet, we expect flat EBITDA the next two years. By 2014, we expect the renewables business alone will support its newly initiated $0.36 per share dividend. NRG also is in a race to prove it can establish a low-cost economic moat by serving its retail supply needs with its wholesale generation fleet, notably in Texas. If it can expand this wholesale-retail strategy with GenOn's generation fleet, management once again will prove its prescience.

 American Electric Power
With diverse operations and strong earnings growth prospects, we believe American Electric Power's 4.5% dividend yield is attractive. In August 2012, Ohio regulators provided regulatory clarity by approving most of AEP's revised electric security plan, allowing AEP partial recovery for generation investments until deregulation in 2015. The deal postpones AEP's plans to close some of its coal plants, but poor economics and environmental liabilities still likely will result in a significant reduction in its coal generation capacity. Despite these plant retirements, we think AEP remains well positioned to benefit from a future recovery in Midwest power prices. We see 6% consolidated earnings growth the next four years, with our projected 9% earnings growth based on aggressive capital investment plans at the company's regulated utilities offsetting the near-term weakness at its Ohio generation fleet.

 Westar Energy
By the end of 2014, Westar is on track to nearly double its asset base since 2006 with investment in generation, transmission, and environmental controls. With cash flow tight, investors have had to settle for pedestrian 3% annual dividend growth. But as Westar's investment pace slows and rate increases flow in, dividend growth should accelerate. In addition, as Westar's investment mix shifts to higher-return transmission projects, earned returns and cash flow should grow. Still, Westar must finish its environmental controls projects and navigate a likely 2015 rate case without another cut in allowed returns like Kansas regulators issued in 2012. Assuming fair rate recovery, we think earnings per share can approach $2.50 by 2016, a 6% annual growth rate from 2011. With a 60%-75% payout target range and a 4.7% yield as of mid-December, we think attractive returns are in store.

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