Utilities: Still High Even After Bonds' Withdrawal

• On a global basis, utilities are undervalued for the first time since February, with a 0.97 market-cap-weighted price/fair value ratio as of Nov. 30. U.S. utilities have a 1.11 equal-weighted median P/FV, down from their peak 1.21 P/FV in early July. We see more value among the large European diversified utilities, but those come with higher uncertainty ratings and weaker economic moats.
• We've long told investors that a wide spread between utilities' dividend yields and interest rates would dampen the market's reaction to rising rates. That played out when utilities stocks held firm even as the 10-year U.S. Treasury yield rose to 2.6% as of mid-December and the yield spread closed below 100 basis points for the first time in three years. With a tighter yield spread now, utilities stocks could become more sensitive to future rate moves.
• We don't expect the Trump administration's political rhetoric opposing climate change regulations in the U.S. to affect utilities much. Cheap natural gas remains the overwhelming factor driving utilities' investment plans and earnings growth. Gas's low-carbon profile and improving renewable energy economics mean the U.S. might achieve carbon-reduction goals even without regulations.
• We think the rampant pace of utilities sector mergers and acquisitions will slow as the list of acquirers shrinks. During the past two years, the five largest U.S. utilities and several large European utilities have executed or are near to closing transformative deals. We don't expect them to drink from the M&A well again any time soon, capping any M&A-related valuation premiums for small- and mid-cap utilities.

For the third time this decade, utilities have dispelled the long-held idea that rising interest rates are necessarily bad for the sector. In this most recent period, 10-year U.S. Treasury rates shot from 1.8% just prior to the U.S. presidential election to 2.6% in mid-December. However, the Morningstar Utilities Sector Index is actually up during that same time period, including dividends, and the sector yield remains at 3.5%, its lowest since mid-2015. Yields fall as prices rise.

We think investors should watch two other metrics to better understand how interest-rate moves in 2017 could affect utilities stocks. The first metric is relative performance. Recent history--including the post-election period--shows utilities underperform nearly every other sector and diversified index when rates are rising. During the past 20 years, utilities underperformed the S&P 500 by an average of 10%, including dividends, when interest rates rose more than 30% in two years. Utilities still posted positive absolute returns in every period.

The second metric we think utilities investors should watch is the spread between utilities' dividend yields and interest rates. We've long asserted that the wider the so-called yield spread, the less sensitive utilities stocks will be to interest-rate moves. This proved true following the election. With the yield spread holding near historic highs at 200 basis points throughout much of 2016, the post-election jump in interest rates had little impact on utilities. Now, with utilities' dividend yield at 3.5% and Treasury rates at 2.6%, the spread is the tightest it has been since January 2014. With less yield cushion, utilities could remain under pressure throughout 2017 if interest rates hold or rise.

From a fundamental perspective, we don't expect any immediate impacts on utilities as the Trump administration takes office. The proposed appointment of Scott Pruitt to head the U.S. Environmental Protection Agency is a sharp rebuke of the Obama administration, especially its climate-change regulations, of which Pruitt has been a vocal opponent. We expect he and Trump will find a way to bury the Clean Power Plan regulating carbon emissions, either through the courts, legislation, or indefinite implementation delays. This offers slight relief for unregulated coal power plant owners but won't stop them from losing market share to natural gas generation and renewable energy.

We expect natural gas and renewable energy will be key growth drivers, based on utilities' investment plans stretching well into the next decade. We see little risk to federal tax incentives for renewable energy, which are already scheduled to phase out. Solar credits, which aren't scheduled to fully wind down until early next decade, may be more at risk, but solar economics are improving. We don't expect much change to state-level laws and regulations that have driven most of the renewable energy development. We think these investments will be enough to bring U.S. carbon emissions down to 1980s levels without federal regulation.

We see little appetite for continued deal activity in the sector. In the U.S., we think utilities are mostly satisfied with their portfolio mixes and organic growth potential. We think accretive M&A growth opportunities are mostly gone. In Europe, all of the large utilities have accomplished their strategic repositioning goals, notably

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We expect the sector to retrench in 2017. This could be the year that utilities investors must pay more attention to valuations, yields in a rising-rate environment, and management teams' ability to turn investments into dividend growth. We think this will be the year that quality trumps all other factors.

Top Picks

Calpine

CPN

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $20.00

Fair Value Uncertainty: High

Five-Star Price: $12.00

The market continues to underappreciate Calpine's consistent, growing free cash flow, which management is dutifully returning to shareholders at a rate that exceeds regulated utilities' returns. Calpine's competitively advantaged fleet and attractive markets and management's smart capital allocation make it the only power producer with a positive moat trend rating, supporting continued cash flow generation and shareholder returns. With a 5.7 times price/free cash flow valuation, Calpine offers investors an opportunity to pick up a consistent, cash-producing generator at a substantial discount to our $20 per share fair value estimate.

RWE

(

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Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: 18.50 EUR

Fair Value Uncertainty: High

Five-Star Price: 11.10 EUR

Following RWE's Innogy share issue in early October, RWE now owns a 75% stake in the regulated grid infrastructure, renewable energy, and supply businesses. It retained the conventional generation, trading, and gas midstream businesses, which we think the market underappreciates. Our EUR 18.50 per share consolidated RWE fair value estimate implies a EUR 36 per share value for Innogy. The key uncertainty for RWE is the economic value of its future nuclear decommissioning costs and other provisions. A recent settlement with the German government eliminates some of that uncertainty, but we expect RWE's stake in Innogy will remain an important source of capital to fund any nuclear-related cash needs. We still think the stock has upside if the market realizes the long-term capacity value of its legacy conventional generation fleet.

Duke Energy

DUK

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $84.00

Fair Value Uncertainty: Low

Five-Star Price: $67.20

Duke Energy became the largest utility in the United States after it merged with Progress Energy in 2013. We think the market has focused too much on the weak Latin American unit and pricey Piedmont Natural Gas acquisition. We believe investors should pay attention to Duke's strong management team, which has long focused on regulated capital investment opportunities. Management also is creating shareholder value by divesting noncore no-moat assets, and driving efficiencies across all of its businesses. In 2016-20, we anticipate $42 billion cumulative capital investment, of which nearly $30 billion is growth capital, supporting our 5.5% annual earnings growth estimate. We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes. Adding Piedmont boosts its growth potential further.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire