Utilities: How Long Can the Yield Paradox Survive?

• Despite a brief sector swoon as interest rates rose during the third quarter, the Morningstar U.S. Utilities Index remains near record highs. Morningstar's worldwide utilities sector coverage traded at a 1.05 market-cap-weighted price/fair value as of the end of August, but the median price/fair value for the U.S. utilities we cover is 1.11. We still have no 4- or 5-star fully regulated utilities in our worldwide coverage.
• The 190-basis-point spread between U.S. utilities' 3.6% average dividend yield and 1.7% 10-year U.S. Treasury yield suggests utilities could have a long way to run, based on historical averages. Even with historically high valuations, U.S. utilities' dividend yields and growth potential remain attractive for long-term income investors.
• The key risk to our earnings growth outlook is a cut in regulated utilities' allowed customer rates. We estimate every 1 percentage point cut in rate-setting allowed returns on equity cuts our aggregate earnings growth outlook to 3% from 5%.
• European utilities continue to search for ways to manage through regulatory, political, and economic challenges. If the market rewards newly slimmed-down E.ON and RWE's Innogy spin-off with the premium valuations of their regulated peers, shareholders could benefit.

As central banks around the world continue to experiment with ultra-loose monetary policy, utilities continue to hold their place as the best-performing sector in 2016, up 18% through mid-September. Rumors of a rate rise in the U.S. in late summer gave the sector a brief pause, as we expected. Interest rates rose 30 basis points, utilities fell 6%, and the S&P 500 is up 2% since mid-summer. Still, investors seem hesitant to give up on utilities.

The key support remains what we've been calling the yield paradox. U.S. utilities' dividends, credit metrics, and growth outlook are by and large incredibly strong. For long-term, income-focused investors, utilities' cash returns have rarely been so attractive. U.S. utilities' 3.6% dividend yield is still nearly two percentage points higher than 10-year U.S. Treasury yields. And we think U.S. utilities in aggregate will grow their dividends 5% annually on average during the next five years. This combination of dividend yield plus growth portends excellent cash returns for income investors relative to fixed-income options.

But we continue to see storm clouds lingering. Valuations remain stretched on a historical basis, and risk to our earnings growth outlook is building. Future cash returns and dividend yields might look good, but weak stock performance could wash away those returns. U.S. utilities' 19 P/E as of mid-September is near the level reached in January 2015 before the sector went on a six-month, 14% nosedive. A reversion to historical average 16 P/E would impair shareholders' total returns for many years.

As interest rates stay low, earnings and dividend growth become less certain for many utilities. Regulators are cutting customer rates or limiting rate increases by adjusting utilities' allowed costs of capital, a key building block for utilities' earnings. We think annual electricity usage growth will remain near 1% for the foreseeable future, making it difficult for utilities to sustain 5% earnings growth if regulators push back.

Several recent regulatory rulings have included allowed returns on equity at 9% or lower. We assume allowed ROE on average reach 10% on a normalized level by 2020, but that could be too high if interest rates and inflation remain low. This uncertainty is leading larger utilities to pursue growth through acquisitions, which at today's valuations are very difficult to make value-accretive.

European utilities continue to struggle with energy market uncertainty. We think this is a dangerous place for income investors. Renewable energy growth, slack demand, and populist regulation have led to company transformations like we saw in September with

's (

) Uniper spin-off and

) move forward with new U.K. nuclear development. RWE's Innogy spin-off later this quarter will complete its transformation after many years of lost shareholder value.

Top Picks

Even though utilities have slowed their ascent the last three months, we still have no 4- or 5-star regulated utilities. Instead, we think investors have to move up the risk spectrum to find attractive valuations in the sector. Two of our three top picks--

(

) and

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 only 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 new-build 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.

RWE

(

)

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: EUR 18.00

Fair Value Uncertainty: High

Consider Buying: EUR 10.80

Germany's RWE is one of the largest electricity and gas suppliers and power generators in Europe but has plans to split into two publicly traded companies 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. Our sum-of-the-parts analysis values legacy RWE at EUR 3 per share and spin-off Innogy 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.

Dominion Resources

D

Star Rating: 3 Stars

Economic Moat: Wide

Fair Value Estimate: $76.00

Fair Value Uncertainty: Low

Consider Buying: $60.80

Dominion's investments in Eastern U.S. energy infrastructure during the next five years should result in wide-moat businesses generating more than 50% of earnings by 2020. The remaining earnings are primarily from narrow-moat regulated utilities in states with long histories of constructive regulation, industry-leading sales growth, and high-return investment opportunities. In Virginia, much of its new investment in generation and transmission enjoys rate rider treatment with near-11% allowed returns on equity, well above the national average. Virginia legislation freezes base rates until 2022, a positive with forecast long-term 2% annual usage growth. In addition, Dominion's Marcellus/Utica service territories support investments in wide-moat gas pipelines and the $3.5 billion Cove Point LNG export facility. We also think the recently closed Questar acquisition, which included a 2,700-mile interstate pipeline with wide-moat characteristics, will provide another leg of investment growth during the next decade as a western hub for supplying natural gas to utilities retiring coal plants and building gas-fired plants. Dominion's growth plans should produce 7% dividend growth if management sticks to its 70%-75% payout target.

More Quarter-End Insights

Stock Market Outlook: A Little Too Buoyant?

Credit Market Insights: Leaving Brexit Behind

Basic Materials: China-Dependent Producers Largely Overvalued

Consumer Cyclical: Poised to Perform in the Second Half

Consumer Defensive: A Handful of Values in an Overheated Sector

Energy: Rally in the Works, but It Won't Last Long

Financial Services: Berkshire Is Bigger Than Buffett

Healthcare: We See Value in the Drug and Biotech Industries

Industrials: Weak Commodity Prices Weigh

Real Estate: Expect Some Choppy Waters Ahead

Tech & Telecom: Opportunities in Smartphones and IT Services