Utilities: Investors Once Again Treating U.S. Utilities as a Safe Haven

Utilities are throwing a surprise party going into 2019. After the sector’s first-quarter collapse and lackluster midyear, utilities have roared back and are set to outperform every sector and market indexes in 2018 (Exhibit 1). This is a remarkable turnaround, particularly in the U.S., where utilities were trailing the S&P 500 by 11 percentage points in March but are set to outperform the index by 9 percentage points for the year, topping every other sector.

Exhibit 1: Utilities' first-half swoon flipped into a second-half rally

We think investors are once again treating U.S. utilities as a safe haven when fears of global trade wars, economic slowdowns, and political upheaval spook the market. The more diversified European utilities have missed out on the party, as many are struggling to avoid political and regulatory uncertainty across the continent.

Even after U.S. utilities’ late-year rally, valuations aren’t nearly as stretched as they were at peaks in mid-2016 and late 2017. We think U.S. utilities are only modestly overvalued going into 2019 (Exhibit 2), a big shift from their record-high valuations in late 2017. Dividend yields above 3% still look attractive even though interest rates have caught up (Exhibit 3).

Exhibit 2: Utilities are modestly overvalued but offer some select buys

Exhibit 3: Dividend yields have shown resilience as interest rates climbed

Global capital investment in renewable energy, smart grid, safety, and reliability provides a long runway of earnings growth potential (Exhibit 4). Strong balance sheets and generally constructive regulation, especially in the U.S., should support robust payout ratios and continued dividend growth. We expect U.S. utilities can grow earnings and dividends near 5% annually for at least the next three years, and many can top that rate.

Exhibit 4: Electricity demand growth creates investment opportunities

But utilities investors still face risks going into 2019. Natural disasters and regulatory shifts on both sides of the Atlantic showed how quickly utilities can go from darlings to dogs. At the sector level, rising interest rates and accelerating global growth could weigh on utilities in 2019. U.S. utilities have not outperformed the S&P 500 in successive years since the 2007-08 recession, so a repeat performance of 2018 could require continued macroeconomic uncertainty.

Top Picks

Dominion Energy D

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $84

Fair Value Uncertainty: Low

5-Star Price: $67.20

Tax reform, a surprise FERC ruling for MLPs, and the Scana acquisition required Dominion to rethink its financing plans, but we think its core profitability is intact. The company has divested most of its no-moat businesses while investing heavily in wide-moat projects like the $4 billion Cove Point LNG export facility and the $7 billion Atlantic Coast Pipeline. Both projects illustrate Dominion’s conservative strategy pivot. We expect wide-moat businesses will generate half of operating earnings by 2022. Even if dividend growth slows, we think Dominion can deliver low-double-digit total annual returns during the next five years.

Entergy ETR

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $96

Fair Value Uncertainty: Low

5-Star Price: $76.80

Our narrow moat and $96 fair value estimate for Entergy are based on two attributes. First, we have confidence that Entergy can exit its merchant nuclear business without a material drop in cash flow. Second, we consider the regulatory frameworks for its Southeast U.S. utilities constructive enough to support growth investment. We believe the market is too concerned about Entergy’s declining EPS as it divests the nuclear plants. Instead, we think investors should focus on the underlying strength of Entergy’s utilities, which support its dividend growth outlook and its 4% yield as of late December.

Enel ENEL

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: EUR 5.70

Fair Value Uncertainty: Medium

5-Star Price: EUR 3.99

Enel is one of the most undervalued European utilities we cover. We see further upside potential after the recent rerating of the stock following the release of the 2019-21 business plan and the agreement between the Italian government and the European commission on the 2019 Italian budget. Enel is the second-cheapest European utility we cover in terms of estimated 2018-19 P/E, despite boasting 10% average annual EPS growth through 2022, which is the second-highest growth rate. Dividend growth of 10%/year through 2022 is also one of the highest among our European coverage and will be largely covered by organic free cash flow.

Exhibit Sources: Morningstar. Data as of Dec. 20, 2018.