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Morningstar
Quarter-End Insights

Utilities: Starting to Look Attractive After a Woeful 2015 Start

Utilities' 4% dividend yields still look attractive even with the chance for rising interest rates.

Travis Miller
  • U.S. utilities are down 9% year to date and have underperformed the S&P 500 by 12 percentage points through early June, marking the sector's worst stretch since the 2008-09 market crash.
  • After Morningstar's utilities valuations hit an all-time high at the end of January, the sector now trades near fair value. Utilities even trade at a slight discount to Morningstar's overall market valuation.
  • Outside of the eurozone, utilities' fundamentals remain strong, with moderate payout ratios, solid balance sheets, and a bevy of high-quality growth opportunities.
  • Utilities' 3.6% average dividend yield as of mid-June is still historically attractive relative to 10-year U.S. Treasury yields, even after the recent bond sell-off. The spread between interest rates and utilities' dividend yield has closed to 110 basis points.

After nearly 18 months of waiting, it's finally time to take a look at utilities again. The sector's swoon since January has created a long-awaited opportunity for income investors. Several high-quality utilities with long histories of growing dividends, strong balance sheets, and attractive growth prospects now trade well within buying range based on our fair value estimates.

The last time the utilities sector was this cheap was in late 2013, when it briefly traded below fair value. Before that, utilities last traded below fair value in mid-2010. It has been a fast and ugly fall for utilities this year since valuations peaked in January. The sector's 12-percentage-point drop from its late January peak through early June is the sector's worst stretch since the market crash in 2008-09.

Few utilities are screaming cheap, but investors seeking 8%-10% total returns with long holding periods now have some high-quality options. Stalwarts such as Southern Company , Duke Energy , American Electric Power , and PPL trade below fair value and yield 4% or better. About 20% of Morningstar's utilities sector coverage trades at 4 or 5 stars.

U.S. utilities' fundamentals remain strong. We're forecasting median 5% dividend growth for the group during the next three years, with some utilities such as Edison International , ITC Holdings , NextEra Energy , and Dominion Resources well above that. Infrastructure replacement and efforts to maximize the value of low-cost natural gas supplies support this growth. A sharp uptick in interest rates could stall some of that growth as financing becomes dearer, but many of these projects have regulatory support and secure financing.

Going into the summer, we're keeping a close eye on eastern U.S. power markets, where top picks NRG Energy , Calpine , and Exelon operate. The long-developing wave of coal plant shutdowns has accelerated this year as persistently low gas prices and noncarbon emissions regulations bite. On June 10, regulators approved the Mid-Atlantic grid operator's Capacity Performance scheme to encourage power generation reliability. NRG Energy, Calpine, and Exelon all should benefit from market premiums that encourage reliability and emissions-friendly generation such as gas, nuclear, and renewable energy.

European utilities continue trying to find ways to manage through persistently weak power markets and tough government oversight. Most recently, European politicians have made noise about shutting coal power plants to speed their environmental agendas. This puts German utilities E On (EOAN) and RWE (RWE) back in the spotlight. German politicians already retired their nuclear plants, and their gas plants are losing money. Shuttering coal plants would gut their generation businesses. The market appears to be pricing in doomsday, but we think sanity could prevail. For risk-averse European investors, we continue to think that Electricité de France (EDF) offers the best combination of valuation, yield, and dividend stability, with modest growth during the next three to five years.

Top Utilities Sector Picks

Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
RWE EUR 37 Narrow High EUR 22.20
ITC Holdings $42 Wide Low $33.60
Calpine $26 None High $15.60
Data as of June 22, 2015

RWE (RWE)
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 United Kingdom and the Netherlands, and renewable energy assets in Europe and North Africa. About half of its profits are earned in Germany. RWE's low-cost power generation assets are difficult to replicate and earn high returns when costs rise for alternative power generation sources; however, the surge of renewable generation and nuclear phaseout in Germany have crushed profitability for its fossil-fuel generation. That said, we think RWE can sustain its EUR 1 per share dividend for the foreseeable future while retaining upside to an improving European economy.

ITC Holdings
ITC Holdings' wide moat and the financial incentives federal regulators offer to improve the U.S. electric transmission grid have produced healthy returns on capital and strong earnings growth for ITC since its IPO in 2005. We expect ITC's capital investments to support close to 9% average annual earnings growth and 13% annual dividend growth during the next five years even as regulated rates of return come down. Regulators' new methodology for calculation of allowed returns following a decision in New England is a headwind, but we think any downside is more than priced into the stock as of mid-June. Public policy promoting renewable energy should support ITC's growth investments and earned returns well above its peers.

Calpine
Calpine is an independent power producer with 25.4 gigawatts of generation capacity throughout the United States and Canada, assuming it closes its sale of six power plants in the Southeast. The company operates in three regions: West (7.5 GW), Texas (9.4 GW), and East (9.6 GW). Its fleet is 97% natural gas generation. The rest of its portfolio comprises 725 MW of California Geyser geothermal plants and 4 MW of solar generation. Calpine's natural gas fleet is one of the most efficient and lowest-cost in the United States. We think this cost advantage positions Calpine well regardless of how natural gas prices move. Although the company would face reduced output if natural gas prices rose, its efficient fleet would still capture significant margin from higher power prices. In addition, Calpine's fleet is well-positioned in regions where electricity supply/demand conditions are tightening.

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Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.