Utilities: Under Pressure in Early 2018

• Earnings and dividend growth will be the story for utilities investors in 2018 and 2019, which now trade at a price/fair value of 0.97. Utilities across our domestic coverage universe 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.
• For income investors, utilities' dividend yield premium compared with interest rates has been attractive the last few years. But that premium continues to close. Since the 10-year U.S. Treasury rate climbed to 2.87% from 2.37% at the end of 2017, utilities' 3.5% dividend yield looks less attractive. However, the 63-basis-point premium remains historically attractive and should cushion the sector's sensitivity to future rate increases.
• The earnings impacts from tax reform have had little impact on utilities. Utilities with unregulated businesses benefit, but regulated utilities will simply pass tax savings to customers through lower energy bills. Renewable energy incentives remain, but falling wind and solar costs are more important to the industry's long-term health and growth prospects. Cash flow impacts have presented near-term credit concerns but do not have a material impact on our fair value estimates.

The utility sell-off that began in late 2017 continued into 2018. On a median basis, U.S. utilities now trade in line with our fair value estimates, the cheapest they've been since 2015. This is a sharp reversal since mid-November when utilities reached a peak 1.18 price to fair value ratio. Since then, Morningstar's U.S. Utilities total return index is down 10% and has underperformed the S&P 500 by 18 percentage points. No other sector has performed as poorly. The sharp rise in interest rates, in line with our outlook, appears to be the primary factor weighing on market valuations. The 10-year U.S. Treasury yield recently rose to 2.87%, the highest since January 2014, making utilities' income properties less attractive. The spread between the 10-year U.S. Treasury yield and the utilities sector's 3.3% trailing 12-month dividend yield is the tightest since January 2003 and approaching its 25-year average (16 basis points). The spread was 118 basis points as recently as mid-November.

Utility fundamentals continue to look very strong for the long run despite the sell-off. Balance sheets are strong, dividends are well covered, and many utilities have investment plans that lock in better than 5% earnings growth. Utilities in general are taking advantage of fundamental energy market opportunities to invest considerable sums in their electric and natural gas networks. U.S. investor-owned utilities plan $350 billion of investment in 2017-19, according to tabulations from the Edison Electric Institute.

Utilities' key fundamental risk is a potential cut in regulated returns, which would reduce our earnings growth outlook. Generally, regulators have been slow to pull back allowed returns in a persistent low interest rate environment. While we think rising interest rates and tax cuts will take some pressure off regulators to cut utilities' allowed returns, regulators in Virginia recently reduced rider returns highlighting the potential risk to utilities.

Developing energy market trends could support continued growth beyond 2019. Electric vehicle penetration won't help overall power demand, but it offers utilities the opportunity to invest in upgrading and installing new distribution equipment to support widespread charging infrastructure. Renewable energy growth should continue as prices for wind and solar come down and utilities invest to meet state mandates. And we see no end in sight for natural gas infrastructure development to improve safety and expand regional access to cheap and plentiful shale gas.

Top Picks

The last time the utilities sector traded at a discount to the median fair value was in mid-2015. But the sector pullback in since mid-November has created a couple of attractive buying opportunities. We think investors should focus on utilities with solid dividend yields in the 4% range and growth opportunities that can produce 5% or better earnings growth.

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $60

Fair Value Uncertainty: Medium

5-Star Price: $42

In January, Dominion stepped in as a potential savior for Scana investors who have been punished since management abandoned its new nuclear project in mid-2017. The market remains skeptical that Dominion and Scana have the charm to win over South Carolina politicians, regulators, and customers despite what Dominion called the largest proposed financial giveaway to utility customers in U.S. history. We think the companies have a 75% chance of winning support for the all-stock deal. The market appears to be pricing in a much lower probability with a 30% merger spread. The alternative is a long legal and regulatory morass as Scana tries to recover some $5 billion of sunk capital and avoid potential bankruptcy if regulators and politicians deny cost recovery and force refunds. We don’t think regulators will go that far and we like Scana’s core business, so we think this is a good risk-reward trade-off for investors.

PPL

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $35

Fair Value Uncertainty: Low

5-Star Price: $28

PPL has attractive regulated growth opportunities that could produce 6% annual rate base growth through 2022, supported by PPL's operations in constructive regulatory jurisdictions. Some 70% of PPL's planned capital expenditures will have little or no regulatory lag. During the next five years, PPL plans to spend $15.9 billion at its regulated utilities and on additional transmission opportunities, supporting our projected 5.5% annual earnings growth through 2022. The U.K. distribution utility continues to be the focus of investor concern. The first concern is currency volatility, which we think management has addressed through its conservative hedging program. The other concern is the U.K. political environment where much of the political focus has been around the electric suppliers to which PPL has no exposure, although returns are likely to decline for all utilities under the next regulatory review.

FE

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $40

Fair Value Uncertainty: Low

5-Star Price: $32

FirstEnergy's discount to our fair value estimate is primarily due to concerns that FirstEnergy Solutions, or FES, will file bankruptcy and creditors will make claims against its parent. FES' three nuclear plants—two in Ohio and one in Pennsylvania—and several coal plants are struggling because of cheap shale gas. We assume these states do not provide financial support and that FES files for bankruptcy. Our fair value estimate includes $1.7 billion of parental guarantees and $1 billion of settlement payments from FirstEnergy to FES creditors to avoid years-long litigation. After FES’ bankruptcy, FirstEnergy would be a fully regulated utility with solid growth from its distribution and transmission businesses. We estimate a fully regulated FirstEnergy will have operating earnings growth of roughly 5.5% from 2018-21, driven by the transmission segment growing more than 7% annually.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains E-commerce market share gains present challenges for some, but trends continue to support healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

Industrials: Healthy Demand, But Few Values Among a mostly fairly valued industrials sector, some good values remain.

Real Estate: Rising Rates Won't Derail Strong Fundamentals REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.