Utilities: Repeating a Stellar 2014 Performance Will Be Tough

• Utilities lived up to their reputation as bond substitutes in 2014. The Morningstar Utilities Index total return was 23% through mid-December, in part helped by interest rates that fell 30% during the calendar year.
• Relative to fixed-income substitutes, utilities remain an attractive yield investment. As of mid-December, utilities' average dividend yield was 3.7% compared with a 2.1% yield for the 10-year U.S. Treasury. This remains a historically high yield premium even though utilities' average dividend yield is below their 4.5% long-term average yield.
• Frustration in Europe on all sides of the energy debate is leading to policy rethinks continentwide. The U.K. took the most aggressive step by instituting a capacity market starting in 2018. Successful implementation could spawn followers, providing a competitive lifeline to most of the beleaguered European utilities.

If not for health-care stocks' M&A-fueled run in the second half, utilities would have been the darling sector of the year. Utilities are poised to post 2014 total returns double the S&P 500 and far better than every other sector except health care and real estate.

This performance supports the longstanding relationship between interest rates and utilities' performance relative to the rest of the market. The 10-year U.S. Treasury yield reached a cyclical peak in January at 3.0%, then fell throughout the year to 2.1% by mid-December. During that period, utilities' total return was 23% compared with the S&P 500's 10.5% total return.

However, history also shows utilities' outperformance could fade in 2015. During the past three decades, utilities have averaged 10.9% total annualized returns in two-year periods of rapidly falling rates. The S&P 500 has averaged 7.7%. To converge on those historical returns, utilities will have to end 2015 mostly flat and slightly underperform the S&P 500.

Utilities' yield paradox remains a key theme going into 2015. The sector's 3.7% average dividend yield is historically attractive relative to the 2.1% 10-year U.S. Treasury yield. Yet utilities' average dividend yield is well below the sector's 4.5% average yield during the past three decades. This is just one of several traditional metrics that suggest utilities are overvalued. The sector median 1.12 price/fair value estimate and 18 price/earnings ratio are at decade highs. Still, fundamentals remain strong, and we don't see any dividends at risk, so long-term investors still might find the sector's income traits attractive.

In Europe, all of the sector's action is in the power markets. Unintended consequences of the continent's aggressive environmental push have sunk wholesale power prices and squeezed margins for legacy power producers yet raised subsidy-laden customer bills and hardly curbed carbon emissions. Intermittent wind and solar generation is requiring grid upgrades to avoid reliability problems. We expect 2015 will be a critical year as politicians decide how far to push environmental regulations and how far power producers can last without breaking.

The United Kingdom is the first to try a capacity market to address reliability concerns as its carbon-reduction program forces plant closures in the coming years. If European utilities and regulators deem the December 2014 auction for 2018 payments successful, we think additional countries could take a similar approach. This is great news for beleaguered utilities such as

(

) and

) also should be a big winner from capacity markets and from support for new nuclear development in the U.K.

In the Eastern United States, power and gas prices are back to multiyear lows after a runup in the first half of the year following the January polar vortex that crimped power and gas markets. However, natural gas prices have fallen more than power prices, giving a big boost to margins for power producers with gas-fired generation such as

The outlook for 2015 looks pretty much the same as it was going into 2014 before the polar vortex. Forward power and gas curves are mostly flat, and Eastern U.S. shale gas continues to push off any upside for power producers such as Exelon. But the polar vortex has spawned interest in long-haul gas pipeline investments and payments for power plants with the capabilities to run during extreme weather events. Regulatory decisions related to pipeline projects and market structures will be key to watch in 2015.

RWE

(

) (Germany)

RWE is one of Europe's five largest utilities, with vertically integrated generation, transmission, and distribution operations serving 16 million electric customers and 8 million gas customers. It also owns and operates power generation and supply in the U.K. and the Netherlands, and renewable energy assets in Europe and North Africa. About half of its profits are earned in Germany. The collapse in wholesale power prices throughout Europe and the march toward nuclear plant shutdowns in Germany have decimated profits. But the company has the most leverage of any utility if energy markets stabilize, demand rebounds, and reliable generators such as RWE start receiving capacity payments. Its large U.K. fleet should benefit from capacity payments starting in 2018.

Centrica

(

) (U.K.)

Centrica is a vertically integrated utility based in the U.K. with operations that produce and supply natural gas and electricity. British Gas is the largest residential supplier of natural gas, electricity, and HVAC services in Britain. Centrica owns the Rough natural gas storage facility, representing 70% of the U.K.'s total storage capacity. Its North American Direct Energy retail unit is smaller than British Gas but growing rapidly. We believe problems in 2014 are short term and cyclical, not structural. We expect retail energy margins at British Gas and Direct Energy to recover, driving higher earnings. In addition, we suspect the U.K. general election in May 2015 will reduce some of the rhetoric from politicians calling for energy price freezes and the breakup or privatization of large energy companies such as Centrica.

Exelon

EXC

Exelon's regulated distribution utilities deliver power and gas to 7.8 million customers in Illinois, Pennsylvania, and Maryland. It recently made an acquisition offer for Pepco Holdings, which will add a utility in New Jersey. Exelon also owns 11 nuclear plants and 35 gigawatts of generation capacity throughout North America, producing 22% of U.S. nuclear power and 4% of all U.S. electricity. Exelon also is the largest power retailer in the U.S., serving about 150 terawatt hours of load. Exelon's nuclear fleet is both the source of its wide moat rating and its source of upside if power prices rebound in the Eastern U.S., as we think they will on a normalized basis. In the meantime, Exelon should benefit if Eastern U.S. grid operators begin rewarding firm power generation sources, such as Exelon's nuclear fleet, that can provide power during extreme weather events.

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