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Utilities: A Weak December Could Foreshadow a Tough 2018

Utilities valuations appear to have peaked, but investors should remain cautious.

Travis Miller
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  • Earnings and dividend growth will be the story for utilities investors in 2018 and 2019. Utilities across the world have aggressive investment plans with mostly constructive public policy support. As long as energy prices remain stable, we expect 5%-7% annual earnings and dividend growth across the sector during the next few years.
  • On a global basis, the utilities sector had a 1.08 market-cap-weighted price/fair value ratio as of Nov. 30, unchanged from the third quarter. A swoon in December brought down U.S. utilities' valuations, but prices remain rich.
  • For income investors, utilities' dividend yield premium to interest rates has been attractive the past few years. But that premium is closing. Since the 10-year U.S. Treasury rate climbed to 2.4% from 2.1% in late 2017, utilities' 3.4% dividend yield looks less attractive. However, the 100-basis-point premium remains historically attractive and should cushion the sector's sensitivity to future rate increases.
  • Utilities involved in M&A are still trying to secure regulatory sign-offs. We expect  WGL Holdings (WGL),  Great Plains Energy (GXP), and  Westar Energy (WR) to close their deals in the first half of 2018 but still face challenging regulatory hurdles. Likewise,  Sempra Energy's (SRE) bid for Texas utility Oncor will face tough regulatory scrutiny in early 2018. We think rumors about an acquisition of beleaguered  Scana (SCG) are unrealistic.
  • The new U.S. tax regime shouldn't affect utilities much. Utilities with unregulated businesses should benefit, but regulated utilities will simply pass tax savings to customers through lower energy bills. Lower rates could provide headroom for utilities to accelerate capital investment, leading to earnings growth. Renewable energy incentives will remain, but falling wind and solar costs are more important to the industry’s health. 

 

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Travis Miller does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.