Utilities: Tough to Stop This Sector's Powerful Performance

• On a global basis, utilities continue to be overvalued, with a 1.12 market-cap-weighted price/fair value ratio as of the end of May. On an equal-weighted basis, U.S. utilities' 1.15 P/FV and 21 forward P/E as of mid-June are down from their mid-2016 peak but still far above what we consider reasonable. We see more value among the large European diversified utilities, but we caution those come with higher uncertainty ratings and few 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. This continues to play out. In June, the 10-year U.S. Treasury rate fell again to 2.2%, yet utilities' dividend yields have held near 3.5%, with dividend growth offsetting still-climbing stock prices. The 130-basis-point spread between Treasuries and dividend yields remains a bullish signal.
• Despite the Trump administration's recent decision to exit the Paris agreement, we continue to see strong renewable development opportunities for utilities. We continue to forecast U.S. renewable energy capacity doubling during the next eight years. State renewable portfolio standards, or RPS, and other local policies remain the industry's primary growth driver, not federal environmental policy.
• Rising interest rates and a dearth of potential acquirers has quashed the regulated M&A market, but depressed independent power producer valuations have received interest from private equity firms that have the appetite to stomach near-term volatility for long-term upside.

Utilities continue to buck conventional stock investing wisdom. The Morningstar U.S. Utilities Sector Index continues to hit all-time highs despite talk of rising interest rates and investors' turn toward high-growth sectors. Utilities are up 13% in 2017 as of mid-June, beating the S&P 500 (10%) and every sector except healthcare and technology. The current spread between utilities' 3.5% average dividend yield and the 2.2% 10-year U.S. Treasury yield remains historically wide, suggesting utilities could still produce attractive returns even if the Federal Reserve continues to raise rates. Attractive dividend growth is a key component.

The Trump administration made headlines in early June after announcing plans to exit the Paris Climate agreement. Despite the withdrawal, we continue to forecast U.S. renewable energy capacity doubling during the next eight years. State RPS and other local policies remain the industry's primary growth driver, not federal environmental policy. Our analysis indicates that renewable energy, including hydro, will grow to meet nearly 20% of U.S. electricity use by 2025, up from 15% now, based solely on existing state RPS.

We think Trump's move to abandon the Paris Agreement could even embolden states to strengthen renewable energy standards, offering upside to our forecasts. Supportive tax policy and pro-manufacturing initiatives also offer upside. And corporate renewable energy purchases should continue to grow as businesses realize the economic and public perception benefits. Thus, we are not surprised that many business leaders denounced Trump's decision.

Regulated utility consolidation has cooled, with even pending mergers facing tough regulatory scrutiny. Kansas regulators surprised us--and the market--by rejecting

While regulated utility consolidation appears to have subsided, activity among independent power producers has heated up.

We think utility investors should invest in utilities with constructive regulation and a strong pipeline of organic growth opportunities, which should drive strong annual earnings and dividend growth the next five years.

Top Picks

Dominion Energy

D

Star Rating: 3 Stars

Economic Moat: Wide

Fair Value Estimate: $85.00

Fair Value Uncertainty: Low

Consider Buying: $68.00

Dominion Energy's investments in energy infrastructure projects in the Eastern United States should result in wide-moat businesses generating approximately 50% of earnings by 2021, up from about 40% in 2013. The remaining earnings are primarily from narrow-moat regulated gas and electric utilities in states with long histories of constructive regulatory frameworks, industry-leading sales growth, and high-return investment opportunities. In addition, the 2016 Questar acquisition added a 2,700-mile pipeline network in Utah, Wyoming, and Colorado that we believe will offer wide-moat investment opportunities into the next decade. These opportunities and the earnings power of its core businesses should allow Dominion to increase its dividend over 8% annually during the next five years. Dominion's wide moat, secure and growing dividend, and long-term earnings growth outlook should allow it to outperform its peers even if rising interest rates weigh on all utilities' returns.

Duke Energy

DUK

Star Rating: 3 Stars

Economic Moat: Narrow

Fair Value Estimate: $86.00

Fair Value Uncertainty: Low

Consider Buying: $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.

Calpine

CPN

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $19.00

Fair Value Uncertainty: High

5-Star Price: $11.40

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 $738 million free cash flow before growth in 2017, an effective 21% yield.

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