Utilities: Is a sector-shaking pile-up coming?

Nothing has been able to halt a historic utilities sector rally since mid-2015, but when will the music stop?

Travis Miller 8 July, 2016 | 5:00PM

U.S. utilities are up 18% year-to-date through mid-June, far exceeding the returns for any other sector. Another jump in early June leaves the sector up 26% since last June, among the best trailing 12-month returns for the sector in at least the past 25 years. And with the U.S. Federal Reserve seemingly content to maintain a near-zero interest rate policy, the rally might continue. Utilities' dividend yields are exceedingly attractive relative to long-term bond yields.

We think deal activity in the sector is both a product of and a cause of the high valuations in a low-interest-rate world. In the sector's latest deal,  Great Plains (GXP) proposed buying  Westar (WR) for mostly cash at a 50% premium to our fair value and an implied 25 times our projected 2017 earnings. Five of the seven largest U.S.-based utilities have a pending acquisition or recently closed one. Six utilities we cover have agreed to an acquisition proposal that could close in the next 12 months. Other utilities are adjusting their portfolios with cash-fueled asset sales and purchases.

Mid-cap utilities in constructive and fundamentally attractive markets are prime targets. We wouldn't be surprised to see firms like  Alliant Energy (LNT),  CMS Energy (CMS),  New Jersey Resources (NJR) or  Portland General (POR) entertain suitors. All of them already appear to enjoy an M&A premium, trading at valuation multiples above their peers, dividend yields below their peers, and 20%-30% above our fair value estimates. However, the sector is running out of big fish, and European utilities aren't likely to look West like they did a decade ago given their own cash constraints at home.

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Travis Miller

Travis Miller  Travis Miller is an energy and utilities strategist for Morningstar.