Utilities: Is There Enough Growth to Offset Higher Interest Rates?

• On a global basis, utilities continue to be overvalued, with a 1.07 market-cap-weighted price/fair value ratio as of mid-March. U.S. utilities have a 1.13 equal-weighted median P/FV, down from their peak 1.21 P/FV in mid-2016. 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 has played out. Even as 10-year U.S. Treasury rates have climbed to 2.6% in early March, utilities' average dividend yields fell to 3.5% now.
• Rising interest rates and a dearth of potential acquirers has quashed the M&A market, which could pressure the premium valuations that many small- and midsize regulated utilities have enjoyed for several years.

Utilities have cast aside conventional stock investing wisdom. Defensive income-oriented stocks like utilities should be suffering in this market. The economy shows signs of improving, interest rates are rising, the U.S. Fed remains hawkish, and politicians appear set to implement expansionary fiscal and tax policies.

Yet utilities have been keeping pace with the market. The Morningstar U.S. Utilities Sector Index hit an all-time high on March 15. Utilities are up 6% year to date and 10% since the U.S. presidential election, both in line with the S&P 500.

So, what's the catch? One catch is that utilities' relative performance has suffered since interest rates started rising. Utilities are mostly flat since interest rates bottomed in mid-2016, while the S&P 500 is up 15%, both including dividends.

The other catch is that utilities have lost their yield cushion and could become more sensitive to interest-rate changes going forward. When interest rates bottomed last year, utilities' 3.6% dividend yield was 220 basis points higher than the 10-year U.S. Treasury yield. As interest rates have climbed, that spread has closed. The current spread between utilities' 3.5% average dividend yield and the 2.5% 10-year U.S. Treasury yield is still higher than long-term historical averages but is in line with spreads since interest rates began falling in 2008.

Going forward, we think utilities investors should keep a couple of points in mind:

First, relative performance likely will continue to suffer. Two thirds of the U.S. utilities we cover trade at more than a 10% premium to their fair value estimates. This is above Morningstar's overall market valuation after adjusting for the low uncertainty ratings we assign to most utilities.

Second, investors should be able to earn solid cash returns from utilities based on the combination of current dividend yields and our projected dividend growth. Among the U.S. utilities we cover, we forecast 5.5% median annual dividend growth during the next four years. Combining this growth with the sector's 3.5% average dividend yield produces cash returns that exceed what we think is a fair equity return for utilities. The risk is that valuations will contract and falling stock prices will sap some of that cash return when an investor sells.

Third, U.S. utilities in general are in excellent financial health, and we have high confidence that most utilities can meet our dividend growth forecasts. All have taken advantage of this long stretch of low interest rates to refinance debt and issue new debt for value-accretive investment. Most utilities have another half-decade of good visibility into growth investment. Renewable energy and gas-related infrastructure are key investment areas that typically receive support from all stakeholders.

Fourth, keep a cautious eye on politics.

(

) and

) have the most to lose if Marine Le Pen is elected France's new president this spring and implements her proposed retail gas and electricity tariff cuts. We estimate that a 5% cut in tariffs could represent 17% downside for EDF and a 4% downside for Engie. In the U.S., President Donald Trump will appoint three new commissioners to the five-person Federal Energy Regulatory Commission. We expect a conservative-leaning FERC will be more likely to support energy infrastructure growth and competitive markets, both positives for our top utilities picks.

Top Picks

Calpine

CPN

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $19

Fair Value Uncertainty: High

5-Star Price: $11.40

Calpine's competitively advantaged fleet and management's smart capital allocation make it the only power producer with a positive moat trend rating. Management plans to ease balance sheet worries by paying down $2.7 billion of debt by 2019. Calpine also continues to build out its retail platform, which should provide a strong natural hedge to Calpine's generation fleet in a stubbornly low commodity environment. The disconnect between private market transactions and Calpine's public market valuation remains. Comparable power generation fleets have sold in the private market for nearly $750 per kilowatt, well above the market's current implied $425/kw Calpine valuation. Our $19 per share fair value estimate values Calpine's fleet at approximately $525/kw.

RWE

(

)

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: EUR 18.50

Fair Value Uncertainty: High

5-Star Price: EUR 11.10

After 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: 3 Stars

Economic Moat: Narrow

Fair Value Estimate: $86.00

Fair Value Uncertainty: Low

5-Star Price: $68.80

Duke Energy became the largest utility in the United States after it merged with Progress Energy in 2013 and has completed its transition to a predominantly regulated utility. We believe investors should pay attention to Duke's strong management team, which has long focused on regulated capital investment opportunities. In 2017-21, we anticipate $42 billion of capital investment in grid modernization, new power generation, and natural gas infrastructure. We anticipate that Duke will be able to recover these costs through constructive regulatory outcomes, supporting our 6% annual earnings and dividend growth outlook.

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