Dividend-Stock Deep Dive: Utilities
David Harrell: I'm David Harrell, editor of Morningstar DividendInvestor newsletter. And I'm here today with Travis Miller from Morningstar equity research.
You are a utility strategist for Morningstar equity research. Can you talk a little bit about your role and Morningstar's coverage of utility stocks?
Travis Miller: Sure. We have two primary utilities analysts, myself and my colleague Andrew Bischof. We cover the 39 largest utilities, publicly traded utilities, in the U.S. and Canada. Recently, it was really exciting to hire a clean energy analyst. He doesn't work directly with us, but certainly, we share a lot of ideas and a lot of insights, and he covers primarily the solar companies, other clean energy investment firms. It's really a potpourri of coverage, but it's really good to have him on board. And then, we also have a European utilities analyst who covers the largest European names. We've a good crew to cover all the developed countries. But here in the U.S., Andrew Bischof and I cover about 39 of the largest. Harrell: Got it. In the headlines today, we've seen a lot of about inflation, and obviously, in addition to the humanitarian crisis that Russia's invasion of Ukraine has caused, we're seeing economic fallout with higher commodity prices and supply chain disruptions that could potentially push inflation rates, which are already quite high, even higher. Now, you and your colleague Andrew recently published a report on utilities and inflation. Can you explain why this sector is particularly vulnerable to higher inflation rates?
Miller: We've had, like you say, a confluence of events here that really nothing good comes of it when you're a utility--inflation, higher interest rates. Even the defensive nature of utilities, when you have a situation like Ukraine and Russia where it's hitting energy prices, that also is not good for utilities. So, we've got really, really a tough situation, both fundamentally and for investors right now in utilities.
For inflation, in particular, a couple of key reasons why utilities are really at a disadvantage when you have high levels of inflation. One is energy costs are a huge portion of the utility bill for all customers. So, as we've seen, one of the biggest drivers of inflation here in the last three months has been energy prices. To the extent that energy prices are flowing through customer bills, customer bills are higher because of energy prices, utilities make less money on the portion of the bill that covers their capital and operating costs. So, that's one primary disadvantage.
The second, on a more fundamental basis, is operating and capital costs are huge for utilities. It takes a lot of capital and a lot of people and a lot of materials to run the electricity, gas, and water networks in the U.S. and really worldwide. When we looked at the data, the average utility spends 70% of net revenue, so this is sundry gross margin, after accounting for energy costs. Seventy percent of their costs are either maintenance capital or operating costs--materials, labor, and just keeping the system operating. So, a huge amount of capital and operating costs. When materials prices go up, when labor costs go up,that hits a huge portion of the cost structure for utilities and obviously, hits earnings and ultimately the dividends.
Harrell: And as you wrote in the report, it's difficult for utilities relative to other industries to pass those increased costs on to their customers.
Miller: The structure of driving revenue for utilities is essentially customer rates runs through state and sometimes federal regulators. So, the utility has to petition regulators, either at the state or federal level, to raise those rates. That becomes a much more political process when customers are seeing their utility bills rise because of energy prices or when utilities face higher costs because of higher material prices or labor costs. So, it becomes a very political situation when you have customer bills going up, and that's essentially what happens for utilities when you have high inflation rates.
Harrell: And even if they're able to raise their prices, it's going to take months to do so.
Miller: Yeah, these are long drawn out, and again, political, contentious--really, almost legal types of events that they go through when they're trying to request rate increases. So, that's a key part of the utility analysis that we look at is how constructive is the regulatory environment in a given state where a utility operates.
Harrell: But just in general they don't have the pricing power that you're going to see.
Miller: You can think about it as fixed revenues, essentially. It's not necessarily the exact case but think about it that way relative to certainly many other companies.
Harrell: Right. Now, so in your report, you highlighted a handful of the companies under your coverage--three that you thought were somewhat well insulated, at least relative to the rest of your coverage list, from higher inflation and then three that seemed particularly vulnerable to you right now. Can you discuss these?
Miller: So, in terms of those best protected--and again, I have to say, no utilities are well protected from inflation. This is across the board and negative, right? But if you are looking for utilities, and you want to look for something that might weather the storms, so to speak, better than others, look for utilities with constructive regulatory environments, places where regulators have supported policies that allow utilities to pass through those higher costs to customers. Look for places where they have low energy costs. There's a wide range of energy costs across every state, region in the U.S., places where energy costs are very high for various reasons, very low for various reasons. So, look for utilities in places with low energy costs. Those, all else equal, will keep customer bills lower.
And then, you're also looking for utilities that have different types of growth programs. So, there are a lot of ways utilities can invest capital. They can invest in maintenance. They can invest in the green. So, they put a lot of stuff in that bucket: renewable energy, clean energy, energy efficiency. Or they can invest in large power plants that may be natural gas or coal, maybe not as environmentally friendly. What we're doing is looking for utilities with constructive regulation, with good projects, and I put good in terms of support for projects, and then energy costs.
So, three names. Dominion Energy, Entergy. Dominion Energy is in the Virginia area. So, they have a very constructive and 100% renewable energy target in Virginia. So, a lot of political momentum to support investment. Entergy is in the Southeast. So, you think about what's going on in the southeast right now--huge demand for energy, not just from the U.S., but globally. So, the Southeast complex, industrial, oil, petroleum products, a lot of electricity demand down there. Entergy is at the center of that, and there tends to be pretty low energy costs down there. So, those are the two primary ones.
Wisconsin Energy or WEC Energy Group, WEC, that's another one where there's not as many great drivers, not like Entergy and Dominion, but they do have an excellent regulatory construct in Wisconsin. They have relatively low energy prices and some decent support for renewable energy.
Harrell: And then, you said there were several that you thought were sort of the most vulnerable right now because of this higher inflation environment.
Miller: So, if you take those positives and kind of flip that.
Miller: Right. Think about places where there's less constructive regulation, where the utilities have had a tough time passing rate increases through to customers, oftentimes a very politicized regulatory environment. So, you look for that. You look for places where utilities are spending a lot of capital without necessarily the political support behind it. And then, third, you're looking for also in terms of inflation and how investors are thinking about it, high valuations. So, to the extent that inflation starts to hurt earnings, earnings growth, even dividend yields, having a more attractive valuation right now is going to be an inflation hedge. The opposite of that, high valuations are going to hurt utilities, all else equal.
So, Eversource Energy is one. They're up in Connecticut and Massachusetts. Very tough regulation, especially in Connecticut. Eversource has never had a very good time trying to pass through rates. Very tough and political environment there. High energy prices. That whole region heavily dependent on natural gas and even oil to produce electricity. And they're also doing a project with offshore wind right now. So, they're going to be the largest offshore wind investor in the Northeast ultimately; $5 billion they want to invest in offshore wind. These are not protected in terms of regulated rate type of investments. These are essentially themselves putting capital into the ocean and hoping they get a return on that.
Harrell: So, there's some risk there.
Miller: There is risk, and inflation. We've seen inflation already hit all of the renewable energy segments substantially.
Harrell: You mentioned interest rates earlier. I think it was on March 16 that the Fed announced a 25-basis-point increase in the federal-funds rate. I think that was the first rate increase we've seen in three years, but we also expect multiple rate increases throughout 2022. Now, in your report, you spoke about several things. One, that higher interest rates can be a drag on utilities' earnings because it increases their borrowing costs, higher interest rates can also make the dividends, the yield of the utilities, less attractive to income-focused investors. On the flip side, if these rate increases have their intended effect and actually tame inflation, that's a positive for utilities. So, how do you see things shaking out over the next year with these increasing interest rates and the utilities sector.
Miller: It's an interesting confluence of events here, right? So, just taken separately, inflation would be bad; taken separately, higher interest rates would be bad; taken separately, higher energy costs would be bad, right? So, all of these things when you come together, again, what does it mean for utilities? The worst of them is inflation.
So, if you're going to rank, kind of, what's the worst thing that could happen to utilities is inflation. Interest rates is an interesting dynamic because we've been for the last two decades in such a low-interest-rate environment, we really don't know what happens to utilities when you have interest rates that are in the 3%, 4%, in terms of the 10-year Treasury, 4% or 5% range. We just haven't seen that for 20-plus years. So, we think that's less of a threat of higher interest rates. We're at such low interest-rate levels right now, if you look over that last 20 years, we actually had utilities increasing substantially the amount of debt on their balance sheet and capital investment, and you've had interest costs on their income statements going down. Investing more and your costs are going down in terms of interest. Utilities are the second-largest borrowers of publicly traded debt behind banks. So, any incremental increase in interest rates will hit the bottom line. So, what you were saying earlier, inflation is the number-one enemy.
If as the Fed has suggested, rising interest rates can solve the inflation problem and bring that down to 2% or 3%, then you have a net benefit for utilities. But certainly, there's no good situation where you have rising interest rates, inflation, and higher energy costs …
Harrell: All three.
Miller: ... for utilities.
Harrell: Got it. So, I'm going to circle back to dividends because almost all utilities under your coverage pay dividends, and many of them have fairly attractive yields, and if you look at the portfolios of many if not most income- or dividend-focused investors, you're going to see a fairly large, relatively large, exposure to utilities. Just sort of looking at the sector as a whole, and this higher inflation environment, do you believe that utility dividends are generally secure in this environment?
Miller: Generally, the utilities' dividends are very secure. I've not said that for 15 years that I've been covering the sector. I have very, very strong confidence in the dividend payments.
Now the interesting part is, one, dividend growth, and two, what's your real in terms of interest rate and inflation-adjusted dividends yield. What we've seen here over the last 10 years or so, a huge dividend premium for utilities. And when we think about that, we plotted the dividend yield for utilities versus the 10-year U.S. Treasury yield. At some points here within the last couple of years, you've reached a 200-basis-point premium such that …
Harrell: Because the Treasury yield has been so low.
Miller: Treasury yields have come down and utilities' dividend yields have really stayed pretty strong. They've continued to grow. So, you continue to have utilities' dividend yields above 3%, which is at times has been, again, 200 basis points above yields. It's a huge premium. We haven't seen premiums like that in more than 30 or even 40 years of history. So, utilities in terms of their dividend yields start in a really good spot.They start with a very good premium to interest rates. So, again, one of the things where if interest rates were to go up, historically speaking, utilities are really still the only place to go for a very attractive dividend yield.
Miller: Now inflation would be the driver and higher interest costs would be the driver that could slow dividend growth. In terms of yields, still a very attractive yield, over 3% right now.
Harrell: Great. And just looking at your coverage list as a whole, are there any names right now that you'd sort of think of as your picks from both a valuation and a current yield standpoint?
Miller: What we're telling people right now is pick a utility that has a 3.5% yield or greater. Again, I think yields right now and dividends, the actual dividends, are very, very secure. You've got very strong balance sheets right now in the sector. A lot of that's because you've had low interest rates for a long time. So, you look for the utility with over a 3% yield, 3.5% would be great, and you look for utility that's going to grow and has political and regulatory support for 6%- to 7%-type earnings growth and then, ultimately dividend growth.
Harrell: So, the dividend growth could stay in line with that earnings growth.
Miller: We expect most of the dividend growth across the sector is going to be in line with earnings growth, and that's going to range in the 5% to 6% if we just look generally. Now, what you want is the utility that's going to grow faster than that and has a more attractive yield.
Harrell: Are there any specific names that you'd sort of point out then that fall into that sort of category?
Miller: So, a couple that we like. I mentioned Entergy, so again, the Southeast utility. They yield well over 3% right now and we think their growth is going to be in the 6%, possibly even up to 8% type range between usage growth and all of the investments they are making in renewable energy in the Southeast. We also like NiSource. This is a bit of an unusual pick. The valuation is a little more attractive, again, well over a 3% yield. It's a gas utility primarily based in the Indiana and Midwest region and also is a very large electric utility in Indiana. Now, you wouldn't necessarily think about Indiana as the center of green energy. But they're actually one of the most progressive states in terms of moving from coal, which for many, many years has been the predominant energy source in Indiana, to winds. Indiana is obviously a very good place for wind resource and even solar. So, NiSource is a good one in terms of a higher dividend yield, a more attractive valuation, and some really good earnings growth that come out of especially the Indiana electric utility and also gas utilities doing safety investments.
Harrell: That's great. Travis, thanks for being here and sharing your insights. It's been good talking to you.
Miller: Thanks for having me.