Utilities: Is a Sector-Shaking Pile-up Coming?

• The utilities sector kept its foot on the gas during the second quarter, speeding past the peak that the Morningstar U.S. Utilities Index hit in February. Morningstar's worldwide utilities sector coverage traded at a 1.07 market-cap-weighted price/fair value as of the end of May, but the median price/fair value for U.S. utilities is 1.14, near an all-time peak.
• The 200-basis-point spread between U.S. utilities' 3.6% average dividend yield and 1.6% 10-year U.S. Treasuries suggests utilities have a long way to run, based on historical averages. Even with historically high valuations, utilities' yield properties remain attractive.
• European energy market policy is splintering. The biggest markets--Germany, U.K., and France--are pursuing three different ways of addressing carbon emissions reduction that an EU-wide carbon credit trading scheme has not achieved. Brexit offers a buying opportunity.

U.S. utilities are up 18% year-to-date through mid-June, far exceeding the returns for any other sector. Another jump in early June leaves the sector up 26% since last June, among the best trailing 12-month returns for the sector in at least the past 25 years. And with the U.S. Federal Reserve seemingly content to maintain a near-zero interest rate policy, the rally might continue. Utilities' dividend yields are exceedingly attractive relative to long-term bond yields.

We think deal activity in the sector is both a product of and a cause of the high valuations in a low-interest-rate world. In the sector's latest deal,

Mid-cap utilities in constructive and fundamentally attractive markets are prime targets. We wouldn't be surprised to see firms like

So when will the music stop? A sudden and unexpected rise in interest rates could bring a sharp near-term correction. However, history shows that utilities produce fairly steady total returns over three- to five-year periods regardless of how interest rates move. A long-term concern always is capricious regulation. We think electricity demand will slow to just half of the U.S. real GDP rate during the next decade. As utilities invest in renewable energy, distributed generation and new technology, they will have to rely more heavily on regulators to increase customer rates. That is never popular.

European utilities continue to struggle managing nationalist policies primarily focused on reducing carbon emissions and figuring out a place for nuclear. We think the market is overly punishing

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Top Picks

Electricite de France

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Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: EUR 17

Fair Value Uncertainty: High

Consider Buying: EUR 10.20

With EDF trading near EUR 10 per share, we think the downside is priced in and a likely rally is ahead if EDF announces it will abandon the Hinkley Point C new nuclear project. The project has become a head-scratching nightmare of delays, design issues, wildly out-of-market economics, and a scramble for funding, including a dividend cut this year and, we think, a likely dividend cut next year. Brexit adds more uncertainty. We now believe the project will be a EUR 1-2 per share value drag if it goes forward, and we think the market is pricing in even more downside. EDF is more attractive without Hinkley, and a new carbon mechanism in France will help unlock that value.

RWE

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Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: EUR 18.00

Fair Value Uncertainty: High

Consider Buying: EUR 9.00

Germany's RWE is one of the largest electricity and gas suppliers and power generators in Europe but has plans to split the business in 2016. RWE will hold the suffering conventional generation and commodities businesses while spinning off its stable, growing renewable energy, retail supply, and distribution grid businesses. We expect weak energy markets to persist at least through 2017. Our sum-of-the-parts analysis values legacy RWE at EUR 3 per share and the spin-off at EUR 15 per share. On a consolidated basis, we expect trough EUR 5.1 billion EBITDA in 2017, primarily due to the drop in conventional generation earnings from renewable energy growth, high gas prices, and capacity overbuild. Management has cut back investment in renewable energy, but we still expect that segment to grow modestly, especially if RWE International can raise cheap equity capital following the spin-off. We continue to watch how RWE and the German government resolve concerns about funding some EUR 10 billion of present-value nuclear decommissioning liabilities.

Calpine

CPN

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $20.00

Fair Value Uncertainty: High

Consider Buying: $12.00

Calpine is uniquely positioned among independent power producers as the industry's predominant natural gas generator, with the most efficient fleet in the U.S. This allows Calpine to benefit from tightening supply-demand conditions in the power markets and low gas prices across Texas, California, and the Mid-Atlantic. All of Calpine's operating regions are struggling to provide market incentives for newbuild expansion and pending emissions regulations that will take significant coal plant capacity offline throughout the U.S. We expect this to create supply constraints across Calpine's core operating regions, allowing it to capture significant margin expansion independent of natural gas prices. We forecast $840 million free cash flow before growth in 2016, an effective 16% yield.

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