Utilities Finally Feel Heat From Rising Interest Rates

We are reaffirming our fair value estimates and economic moat ratings for all U.S. utilities after the sector fell nearly 5% on Monday. We think the sector’s 11% drop since last week offers a rare opportunity for investors to buy high-quality utilities at very attractive prices.

U.S. utilities now trade at a median 15% discount to our fair value estimates. This matches the largest discount since the market bottoms in March 2020 and March 2009. Utilities’ median 16 P/E is the lowest since exiting the 2008-09 recession.

We considered U.S. utilities 15% overvalued last August before the sector began a 25% slide through Monday, including dividends. The sector trails the Morningstar U.S. Market Index by 30 percentage points year to date after coming into the year slightly overvalued based on our fair value estimates.

The increasing probability of higher-for-longer interest rates has finally caught up to utilities. With the 10-year U.S. Treasury yield up to 4.7% from 3.3% in April, utilities’ dividend yields are less attractive and financing costs likely will climb. The sector’s 3.9% dividend yield has been lower than the 10-year U.S. Treasury yield since August 2022, the first time since the 2008-09 recession.

Despite the negative sentiment, utilities’ fundamentals are strong. We think most utilities deserve premium valuations compared with historical averages given their better growth prospects, improving rate regulation, and less-volatile earnings. We forecast a median 6% annual EPS and dividend growth across our coverage. Our top picks are utilities that we think can grow earnings and dividends faster and for longer than their current market valuations imply.

We have long warned investors that utilities with aggressive growth plans and high valuations would fall the fastest if interest rates rose. NextEra Energy (down 38% year to date) and American Water Works (down 21%) are among those that we long considered overvalued but now trade below our fair value estimates.