Utilities: Valuations Still Running Out of Control

• On a global basis, utilities are approaching valuation peaks last seen in mid-2016. The sector has a 1.08 market-cap-weighted price/fair value ratio as of Aug. 31. On an equal-weighted basis, U.S. utilities' 1.15 P/FV and 21 forward P/E are only slightly off 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.
• Despite the elevated valuations, low market interest rates make utilities' dividend yields look relatively attractive for income investors. The 10-year U.S. Treasury rate continues to hold near 2.2%, and utilities' dividend growth is holding their average yield at 3.5% despite the sector's rally. The 130-basis-point spread between Treasuries and dividend yields remains a bullish signal.
• Renewable energy growth remains a long-term opportunity for utilities struggling with weak customer usage growth. Electricity demand has been mostly flat since 2011. We think demand growth will climb to 1.25% in the long run, but it could be several years before that happens. State renewable portfolio standards and other local policies remain the primary growth driver for renewable energy, not federal environmental policy.
• Utilities M&A remains active and likely will continue as long as interest rates stay low.  WGL Holdings ,  Great Plains Energy ,  Westar Energy (WR),  Sempra Energy (SRE), and  Calpine are all involved in proposed deals. In Europe, deal-making rumors continue to swirl. Calpine was the latest independent power producer to fall into private equity hands when Energy Capital Partners and others offered a 51% premium. This boosted values for peers  Dynegy and  NRG Energy (NRG), but we don't see either of them as private equity targets.

Utilities' valuations don't seem to be stopping investors. In mid-September U.S. utilities' valuations reached a 14-month high when the median P/FV ratio hit 1.17 for the 40 U.S. utilities in Morningstar's coverage. This is the highest median price/fair value ratio for U.S. utilities since the all-time peak of 1.21 in July 2016.

Other valuation metrics such as price/earnings (22) and price/book (2.1) for U.S. utilities also hit 2017 highs in September and are approaching peak levels from mid-2016. Morningstar's U.S. Utilities Sector Total Return Index hit an all-time high, up 15% year to date through mid-September, including dividends. This was outpacing the S&P 500 (up 13%) and all sectors except healthcare and technology.

Even though utilities' valuations appear exceedingly rich on an absolute basis, the sector's yield paradox--as we call it--continues to give bullish signs. Impressive dividend growth has kept the sector's average yield near 3.5% even with the runup in utilities' stock prices. This is a historically attractive yield premium to market interest rates. During the past 30 years, utilities' average dividend yields have been in line with 10-year U.S. Treasury yields, now near 2.2%. If this historical relationship holds, utilities could have another leg of upside. Alternatively, the sector shouldn't suffer much on an absolute basis if interest rates rise.

On a fundamental level, the sector remains very healthy. Low interest rates have helped boost earnings and cash flow growth. Relatively steady regulation has supported growth projects with attractive returns. Even the lowest allowed returns regulators have awarded recently, near 8%, are a premium to what we think is a fair long-term cost of equity and imply an equity risk premium well above what we think is fair. This financing advantage also is driving earnings growth.

There are two primary sources of moderate uncertainty in the sector. The first is executing on exceptionally large projects, notably the new nuclear units that  Southern Company (SO) and  Scana  are building. Scana management recently proposed abandoning its project in South Carolina, opening itself to political and regulatory scrutiny that could end up costing shareholders through unrecovered investment. This uncertainty has depressed Scana's valuation and performance to the point where we now think it presents a good risk-reward trade-off. Southern Company is moving forward with its project but still suffers the depressed valuation because of cost overruns.

The second source of uncertainty is among the few utilities still left with merchant generation businesses.  Exelon (EXC) has shown its political clout by winning subsidies in Illinois and New York to support what it claims are uneconomic nuclear plants. Public Service Enterprise Group (PEG) is angling for similar favors. We don't expect either one to divest its merchant generation business, but investors must watch these carefully.

Similarly,  FirstEnergy (FE) is the latest to give up on the merchant generation business. We think it is unlikely that Ohio and Pennsylvania will pass legislation like in New York and Illinois allowing subsidies for its three nuclear plants. This will likely result in bankruptcy for its merchant unit before its next large bond payment in April 2018. Once this uncertainty is resolved, we believe FirstEnergy will be a successful fully regulated utility again.

Top Picks

 Dominion Energy (D)  
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $85.00
Fair Value Uncertainty: Low
5-Star Price: $68.00

Dominion's investments in Eastern U.S. energy infrastructure should result in wide-moat businesses generating more than 50% of earnings by 2021. Its narrow-moat regulated utilities produce the balance of earnings with operations in states with constructive regulation, industry-leading sales growth, and high-return investment opportunities. In Virginia, Dominion benefits from rate riders; incentive allowed returns on equity; and state legislation that 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. The 2016 Questar acquisition includes a 2,200-mile interstate pipeline with wide moat characteristics that could provide a decade of additional growth investment. Dominion's growth plans should produce 10% dividend growth if management sticks to its 70%-75% payout target.

 Scana  
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $64.00
Fair Value Uncertainty: Medium
5-Star Price: $44.80

Scana's new nuclear project has weighed on the stock for several years. A brief relief rally followed management's decision to cancel the project, but now investors are scared that Scana could have to fund as much as $4 billion of sunk capital. We think the market is too pessimistic. We applaud management for securing the best possible legal and regulatory backstops for a project that could cost some $20 billion. We assume Scana shareholders lose $1 per share of value from concessions to ratepayers as part of our $64 fair value estimate. However, the market is far more punitive, given the nosebleed valuations at which Scana's peers are trading. As nuclear project concerns ease, Scana's 20% discount to peers should shrink.

Veolia Environnement (Paris: VIE)
Star Rating: 3 Stars
Economic Moat: None
Fair Value Estimate: EUR 21.50
Fair Value Uncertainty: Medium
5-Star Price: EUR 15.05

Veolia's resumption of revenue organic growth in the first quarter of 2017 is sustainable and positive for the equity story, in our view. It was fueled by higher growth in waste activity since the beginning of 2010. We expect organic growth of 2% over the full year versus negative 1.2% in 2016. This is slightly below the 3.1% posted in the first quarter, as comps will be less favorable over the next quarters. Still, this organic growth resumption is positive for the equity story, as the disappointment on that front in 2016 weighed heavily on the share price. We think Veolia is particularly attractive relative to peer Suez. Veolia typically trades at premium multiples to Suez but now trades at a 14% discount P/E. We think Veolia's fundamentals are more appealing than those of Suez with higher ROIC, lower leverage, better capital allocation, and higher dividend growth. Veolia increased its 2016 dividend 10%, and we assume that the firm will continue to increase it by 9% per year on average through 2019, versus 2% for Suez.

More Market Outlooks

Stock Market Outlook: China Rebalancing Presents Winners and Losers

Credit Market Insights: A Solid Quarter for the Bond Markets

Basic Materials: Valuations Propped Up by Shaky China Fundamentals

Communication Services: Smaller Rivals Call the Shots in U.S. Wireless

Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season

Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat

Energy: All Roads Point to Oversupply in 2018

Financial Services: Banks Can't Rest Easy

Healthcare: Stock Selection Key as Valuations Rise

Industrials: Worldwide Growth Is Resilient, But Valuations Look Full

Real Estate: Enter With Caution

Technology: Valuations Painting Overly Rosy Scenarios

M&A Outlook: High Prices Impede Dealmaking in the U.S.

Private Equity Outlook: Larger Funds, Larger Deals

Venture Capital Outlook: Exits Come Into Focus as Valuations Continue to Climb

U.S. Stock Funds: Steady as She Goes

International-Stock Funds: The Beat Goes on

Bond Funds: A Period of Relative Calm