Utilities: Starting to look attractive after a woeful 2015 start

Utilities' 4% dividend yields still look attractive even with the chance for rising interest rates.

Travis Miller 9 July, 2015 | 5:00PM
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After nearly 18 months of waiting, it's finally time to take a look at utilities again. The sector's swoon since January has created a long-awaited opportunity for income investors. Several high-quality utilities with long histories of growing dividends, strong balance sheets and attractive growth prospects now trade well within buying range based on our fair value estimates.

The last time the utilities sector was this cheap was in late 2013, when it briefly traded below fair value. Before that, utilities last traded below fair value in mid-2010. It has been a fast and ugly fall for utilities this year since valuations peaked in January. The sector's 12-percentage-point drop from its late January peak through early June is the sector's worst stretch since the market crash in 2008-09.

Few utilities are screaming cheap, but investors seeking 8%-10% total returns with long holding periods now have some high-quality options. Stalwarts such as  Southern Company (SO),  Duke Energy (DUK),  American Electric Power (AEP) and  PPL (PPL) trade below fair value and yield 4% or better. About 20% of Morningstar's utilities sector coverage trades at 4 or 5 stars.

U.S. utilities' fundamentals remain strong. We're forecasting median 5% dividend growth for the group during the next three years, with some utilities such as  Edison International (EIX),  ITC Holdings (ITC),  NextEra Energy (NEE) and  Dominion Resources (D) well above that. Infrastructure replacement and efforts to maximize the value of low-cost natural gas supplies support this growth. A sharp uptick in interest rates could stall some of that growth as financing becomes dearer, but many of these projects have regulatory support and secure financing.

Going into the summer, we're keeping a close eye on eastern U.S. power markets, where top picks  NRG Energy (NRG),  Calpine (CPN) and  Exelon (EXC) operate. The long-developing wave of coal plant shutdowns has accelerated this year as persistently low gas prices and non-carbon emissions regulations bite. On June 10, regulators approved the Mid-Atlantic grid operator's Capacity Performance scheme to encourage power generation reliability. NRG Energy, Calpine and Exelon all should benefit from market premiums that encourage reliability and emissions-friendly generation such as gas, nuclear and renewable energy.

Top Utilities Sector Picks

Star Rating

Fair Value
Estimate

Economic
Moat

Fair Value
Uncertainty

Consider
Buying

Exelon

$37

Narrow

Medium $25.90
ITC Holdings

$42

Wide

Low $33.60
Calpine

$26

None

High $15.60
Data as of June 22, 2015. All figures are in U.S. dollars.

 Exelon (EXC)
As the largest nuclear power plant owner in the United States, Exelon long has been a profit machine and an industry-leading source of shareholder value creation. But power prices have crashed hard since their 2008 highs and appear stuck at current levels for at least the next two years. That has resulted in a sharp drop in Exelon's returns, a 41% cut in the dividend in 2013, and a shift in strategy to increase contributions from its countercyclical retail supply and regulated distribution businesses. The low operating costs and clean emission profile of its nuclear fleet make Exelon the utilities sector's biggest winner if our outlook for higher power prices and tighter fossil fuel environmental regulations materialize. Exelon's world-class operating efficiency ensures it will be able to capture that upside.

ITC Holdings (ITC)
ITC Holdings' wide moat and the financial incentives federal regulators offer to improve the U.S. electric transmission grid have produced healthy returns on capital and strong earnings growth for ITC since its IPO in 2005. We expect ITC's capital investments to support close to 9% average annual earnings growth and 13% annual dividend growth during the next five years even as regulated rates of return come down. Regulators' new methodology for calculation of allowed returns following a decision in New England is a headwind, but we think any downside is more than priced into the stock as of mid-June. Public policy promoting renewable energy should support ITC's growth investments and earned returns well above its peers.

Calpine (CPN)
Calpine is an independent power producer with 25.4 gigawatts of generation capacity throughout the United States and Canada, assuming it closes its sale of six power plants in the Southeast. The company operates in three regions: West (7.5 GW), Texas (9.4 GW) and East (9.6 GW). Its fleet is 97% natural gas generation. The rest of its portfolio comprises 725 MW of California Geyser geothermal plants and 4 MW of solar generation. Calpine's natural gas fleet is one of the most efficient and lowest-cost in the United States. We think this cost advantage positions Calpine well regardless of how natural gas prices move. Although the company would face reduced output if natural gas prices rose, its efficient fleet would still capture significant margin from higher power prices. In addition, Calpine's fleet is well-positioned in regions where electricity supply/demand conditions are tightening.

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Travis Miller

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

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