Why the Banking Crisis Is a Big Deal

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights.

Recent bank failures have rocked Wall Street. Why investors should pay attention to this banking crisis. Plus, Pfizer makes a $43 billion deal as it prepares for several drugs to lose their patents. A growth opportunity could boost a sector better known for investment income. A Morningstar strategist will join the podcast and explain how. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Pfizer to Acquire Cancer Drug Developer

Pfizer’s PFE newest acquisition may help put investors at ease about upcoming patent losses. The pharma giant says it’s buying cancer drug developer Seagen for almost $43 billion. The deal will likely close in late 2023 or early 2024.

Morningstar doesn’t see the purchase creating any value for Pfizer. However, it could help the market get more comfortable with Pfizer working through major patent losses on several drugs. The list includes cardiovascular drug Eliquis and oncology drug Ibrance. If Seagen’s pipeline of early and midstage drugs develops better than Morningstar’s expectations, this could benefit Pfizer.

Morningstar expects the acquisition to bring in close to $8 billion of revenue by 2030. That’s less than Pfizer’s outlook. Seagen’s already approved cancer drugs appear to have strong growth potential. The deal doesn’t have a major impact on Morningstar’s $48 estimate of what Pfizer’s stock is worth. The shares look undervalued.

Adidas Wheezes

Adidas ADDYY reported weak sales and a massive loss in 2022′s fourth quarter. The German sportswear company’s new CEO announced the results during an earnings call. They were expected and in line with Morningstar’s estimates.

The demise of Adidas’ deal with Yeezy, the fashion brand of Ye, caused much of the losses. The designer and rapper formerly known as Kanye West made antisemitic remarks. Adidas ended its agreement with him.

The company’s sales in greater China also dropped due to competition and the country’s COVID-related restrictions.

For 2023, Adidas expects a sales decline and breakeven operating profit. It also expects to write off millions of dollars in Yeezy inventory and massive, one-off costs. There’s also some uncertainty over whether some or all the existing Yeezy products may eventually be sold to recover production costs.

Morningstar has factored these negative effects into its estimates. It doesn’t expect to change its $86 estimate of the stock’s worth. The shares look attractive for those willing to ride out more strife in 2023. Adidas’ brand remains powerful and international athletics should recover.

Squarespace Subscriptions Are Solid, but Are They Enough?

Squarespace SQSP reported solid fiscal 2022 results, despite an uncertain macroeconomic environment. The results were largely in line with Morningstar’s expectations.

The website building company saw 11% year over year revenue growth. Strong subscriber retention and other factors helped drive it. The bulk of its revenue came from subscription services in fiscal 2022. Squarespace looks to further benefit from price increases and commerce tools.

Morningstar thinks competition will limit the firm’s ability to increase prices over time. This could hurt revenue growth. Morningstar expects some margin expansion. But thinks the market is too optimistic about Squarespace’s ability to upsell customers and quickly grow in a profitable way.

Morningstar is raising its estimate of what it thinks Squarespace’s stock is worth by nearly $3 to $19.60 but still considers the shares to be overvalued.

What’s Ahead in the Utilities Sector?

The utilities sector has a reputation for being a haven. Many investors add these stocks to their portfolios for the investment income. A surge in electricity demand is presenting an opportunity for earnings growth. Morningstar Research Services’ energy and utilities strategist Travis Miller is joining the podcast to talk about it.

Hampton: Travis, the Inflation Reduction Act is targeting reducing carbon emissions. What has this move from the federal government kicked off?

Travis Miller: It used to be a bunch of states had all different kinds of rules. What the Inflation Reduction Act did is that it essentially has standardized the move to carbon emissions cuts, and it’s done so in three different ways.

One, it’s extended a lot of the federal incentives for especially solar and wind. Now developers have a lot of certainty around the financials around solar and wind projects. The second thing is it has incentivized a lot of clean energy, different types of technology. So, it’s improved the nuclear economics, which is a key part of it. It’s also incentivizing hydrogen development and, thirdly, incentivizing carbon capture and other types of clean energy that haven’t typically been defined as clean energy.

Hampton: The law includes credits for energy-saving home improvements and electric vehicles. How are utilities preparing for the rise in electricity demand?

Miller: You wouldn’t think about it, but it’s actually a pretty exciting time to be in the utility sector because there is so much new stuff coming out. It’s not just your old “provide electricity, turn on the lights, and the company’s done.” What’s really happening now is the utilities are participating in a big way in clean energy. What that’s doing is leading not just to electricity demand growth, but to building all of the infrastructure that goes into delivering electricity and natural gas to some extent, too.

But the real interesting and exciting part right now in utilities is all of the infrastructure that needs to be built to handle electricity demand from electric vehicles, from buildings switching from gas to electric, for water heating and space heating. So, a lot of big, fundamental, long-term growth drivers that are going to require a lot of infrastructure buildout.

Hampton: What kind of financial support will utilities need to carry out this plan?

Miller: Well, that’s why we think utilities are really critical to the clean energy movement because utilities have the capital. They have the access to the capital markets, whether that’s equity, whether that’s debt. They are the leading infrastructure, both financial capital raisers and they have the knowledge how to put infrastructure into the ground. That’s their primary business. We think utilities are going to lead to almost 75% of the carbon emissions cuts in the economy by 2050. If you think about that, that’s renewable energy, which carbon emissions from power generation are about a third of total carbon emissions in the U.S. Electric vehicles, so transportation right now, especially small and medium-duty trucks and cars, that’s about a third of carbon emissions. So, if we go to electric vehicles in the U.S., that requires a huge buildout of utilities infrastructure.

Then buildings, especially residential and commercial buildings are another call it 15% or so of carbon emissions in the U.S. And utilities are going to have to have the infrastructure in place to handle more electricity demands and clean energy electricity demand to buildings.

Add all that up, and utilities are essentially the gatekeepers for 75% or so of carbon emissions cuts in the U.S.

Hampton: That’s good to know because right now high inflation and rising interest rates are creating a tough environment, and utilities’ payouts don’t look as high as compared to bonds. Why should investors consider earnings growth, too?

Miller: That’s the big story and why it’s more exciting again. Utilities aren’t often thought about as exciting, but the growth element is the real exciting part because a lot of people turn to utilities for the dividend yields. Those still are very good right now. We see good safety in the dividend yields, very strong financials in the utilities sector right now. The yield isn’t quite as attractive at 3.5%, not quite as attractive as it was a year ago relative to interest rates, but still some of the best yields you can get in the sector.

If you combine that with some of these fundamental growth drivers, we think investors are in line for something around 9% or 10% total returns, and that’s a fairly attractive total return for a relatively low-risk type of stock investment.

Hampton: What are your expectations this year for dividends?

Miller: Dividends, like I said, very, very strong. We’ve seen growth from 90% of U.S. utilities are growing the dividends. A lot of them have grown the dividend 5%-plus over the last year. So, you’ve got this real broad range of utilities across the U.S. who see and have enough fundamental strength both in the balance sheet and their earnings growth, that they can translate that into returning capital to shareholders through the dividend, and that’s what shareholders want from utilities.

Hampton: If investors are looking to invest in utilities, where should they look?

Miller: We think the biggest combination is both yield and growth, so these two big themes we’ve talked about. On the yield side, we think you have to find the utility that’s yielding more than 3.5%. That’s about the median right now for the sector. There are about a dozen out there right now that are yielding above 3.5%. That gives you a really good relative return, even as interest rates go up in terms of cash return.

So, yields above 3.5%, and then growth is the big story here that we’ve been talking about recently. That growth, we want to find not just the utility that’s going to grow at 6% or 7% for the next year or two. We want to find the utility that’s going to grow at 6% or 7% for 10 years or 15 years, the utility that’s really involved in the clean energy movement, maybe in a state that is trying to accelerate clean energy development, a state where there’s going to be increasing electricity demands because of fast moves to clean energy and home and business electricity use. We want to find a utility that’s, again, yielding more than 3.5% and offering 6% to 7% growth for 10-plus years.

Hampton: And stock picks?

Miller: A couple that we like, NiSource NI. NiSource is a combination, both gas and electric utility, in the Midwest. The big growth driver is in Indiana, and Indiana has been very supportive around clean energy. They’ve been a very large coal generation state, and they’re moving very quickly over to especially solar and wind. Like we talked about, that takes a lot of infrastructure, not just building the solar and wind, but building all of the infrastructure, all the wires, the distribution network, everything that comes around retiring coal plants and replacing them with solar and wind. So, a big investment opportunity there in NiSource.

On the gas side, which a lot of people get worried about, because gas is a fossil fuel, so there’s some uncertainty about how long gas will stick around. The key is that they’re in Midwest and in Northeastern areas. Right now, gas as a heating source is far more efficient than electricity. When you get to some of the colder climates, there is really no way to substitute natural gas as a heating source right now. So, we think that business is intact. We also think that regulators are going to support infrastructure upgrades, maybe not growth, but certainly making the system safer. NiSource benefits on both sides, both from a region where natural gas we think is going to continue to be a heating source, and also, and especially in Indiana, the electricity demand growth. That’s one name we like.

Duke Energy DUK is also, I think, an interesting name, again, yielding above that 3.5%. So, you get a good yield out of them. They’ve really improved their growth profile, we think. They’re located in mostly the East Coast and the Carolinas is their big service territory, and Florida. So, a lot of electricity demands from core growth and from the clean energy move in those areas away from coal to solar and wind. Duke’s going benefit from all of that infrastructure build, and they offer a really nice yield right now.

Hampton: Well, thank you, Travis, for talking to us about the potential exciting energy growth that’s coming ahead in utilities.

Miller: Yep. It’s great to be talking the story about an exciting sector now, not just the old yield-and-wait sector.

Don’t Ignore the Banking Crisis

The nation’s second and third-largest bank failures have rattled Wall Street. This week, I sat down with Morningstar’s chief markets editor and Smart Investor newsletter editor Tom Lauricella to discuss the fallout.

Hampton: The current banking crisis is triggering flashbacks to the financial one of 2008. Silicon Valley Bank SIVB and Signature Bank SBNY have collapsed. Federal regulators have seized control of both regional banks, and there are several reasons why investors should pay attention. Morningstar’s chief markets editor and Smart Investor newsletter editor Tom Lauricella is here to explain why.

Tom, investors might think that this is just about banks. Why would that be a mistake?

Tom Lauricella: The reason is because banking crises are never just about the banks. Banks are the critical linchpin in moving money through the economy, and without money moving through the economy, everything breaks down. The health of the banking sector is one of the most important things for any investor to consider. So, when we start to talk about the health of banks, it’s something that has potential implications far beyond the banks.

Hampton: Well, if that’s the case, how does something like this spread?

Lauricella: The word that people don’t like to talk about is contagion, but that’s the question here: Will we have contagion from this? Is there a knock-on effect from the banks where this has begun? That’s what happened 15 years ago when the financial crisis kicked off. It started off with Bear Stearns, and then it took a while. That was 15 years ago, and Lehman Brothers didn’t collapse until the fall. So, these things can trickle through the financial system for quite some. And the issue is with banks because they’re so interconnected with the economy and with each other. Banks are linked to each other, they lend to each other, they support each other. A problem with one bank can quickly spread to another, if investors begin to get worried. The worry here is fear. And going from one bank to another.

Hampton: What areas of the market should investors focus on then?

Lauricella: What we should be looking at are the indicators within the financial system of money moving around, of the ability of banks to lend to each other, of banks to borrow. We can watch signs of this. Some of this stuff is a little bit hard for the typical investor to see, but you can see clear signs in something like the U.S. Treasury bond market, where we’ve seen this week a rush to safety, as people would call it a flight to safety. Bond yields have dropped sharply, that’s because investors, and probably a lot of banks, are rushing in to buy the safety of government bonds because they know this is money good. When you start to see that, people avoiding riskier parts of the markets, it tells you that there’s warning signs out there that people are really beginning to get concerned.

Hampton: What could this crisis mean for the economy?

Lauricella: This is a really big question here. The idea is that if banks start getting worried about protecting themselves. So, if you’re a bank and you have to shore up your own deposits, you have to shore up your own financials, what you’re going to do is you’re going to stop lending. You’re going to stop lending first to the riskier borrowers and start working way through the system. They’ll stop lending to other banks, and as that begins to happen, you choke off the supply of credit to the economy. That’s when the real problem starts. If the supply of credit gets choked off, then businesses can’t borrow money. Businesses can’t repay money that they already have. Maybe they have debt that they need to roll over. They need somebody else to loan them more money. If the bank won’t lend them, they’re out of luck. Or if somebody wants to open a new business, a small business, you know, they want to get money to start up a dry-cleaning business, then they’re not going to get that loan, and gradually it just pinches things off, pinches off economic activity.

Hampton: The Fed is scheduled to meet next week. How does this affect the outlook for their policy and interest rates?

Lauricella: This is a very open question. We’re not really sure. The Fed’s in a blackout period, which means that Fed officials aren’t talking right now. We don’t know what they’re thinking. There’s different ways to look at this. In the financial markets, the thinking is that this has taken a much more aggressive series of interest-rate hikes off the table. We had another bad inflation reading just this morning. It was as expected, but it’s not good news. Inflation is stuck at 6%. The Fed doesn’t want inflation at 6%, it wants inflation at 2%. We had a very strong jobs report. All things being equal, up until the middle of last week, it looked like the Fed was going to raise rates more and keep it there for a lot longer. Now people are calling that into question, saying that the Fed might only raise rates just a little bit and in fact begin to cut rates in the second half of the year, which is a completely different outlook. However, there’s another way to look at this, and Morningstar’s economist Preston Caldwell thinks that if the Fed and other regulators are successful in containing this banking crisis that it actually gives them room to go along with more aggressive interest-rate hikes. It will be very interesting to see the messaging out of the Fed right now. We just really have to wait for the meeting.

Hampton: What’s the final takeaway for investors?

Lauricella: The final takeaway is pay attention to this. This is important. It could turn out to be nothing. But this is the type of event that tends to have ripples. This is the kind of event that tends to happen at this point in the economic cycle. Interest rates have risen a lot more than people expected, and you’re starting to see things break out there. So, it’s time to really pay attention and make sure portfolios are the way you want them to be, that you can handle any losses that might come up if things do get worse. But it’s really just not the time to close your eyes and think this doesn’t bother me.

Hampton: Well, thanks Tom for breaking down this banking scare.

Lauricella: Glad to be here.

Hampton: Subscribe to Smart Investor newsletter to read a weekly rundown of Morningstar’s insights on big market trends and investment opportunities. Also subscribe to Morningstar’s YouTube channel to see new videos.

Thanks to video producer Daryl Lannert and senior video producer Jake Vankersen. And thank you for tuning into Investing Insights. I’m Ivanna Hampton, your host and a senior multimedia editor here at Morningstar. Take care.

Read About Topics From This Episode

Utilities Suddenly a Growth Sector?

Why Investors Should Care About the Banking Scare

Pfizer’s Seagen Deal Should Help Offset Upcoming Patent Losses; No Fair Value Estimate Impact

Much Has Gone Wrong for Adidas Recently, but Its Status as a Popular Global Sportswear Brand Holds

Squarespace Earnings: Resilient Retention and Strong Bookings Growth Even After Price Increases