Our outlook for utilities stocks

The abrupt market response could leave some utilities investors wondering how far the sector might fall if interest rates climb from 2% now to their long-term average near 4%. Our analysis thus far says not much. We looked at changes in interest rates and utilities sector returns during two-year periods going back 20 years to see what the future might hold if interest rates rise from here. There's good news and bad news. The good news is that even when interest rates rose more than 20% in a two-year period, utilities still produced 7% annual returns. The bad news is that the S&P 500 produced 24% average annual returns during those same periods.

Industry-level insights

The unique characteristic of this market cycle is that utilities' average 4% dividend yield remains as attractive as it has been in more than 20 years relative to the 2% rates offered by U.S. Treasury bonds. That yield spread has fallen from its peak of nearly 300 basis points in June 2012 to 200 basis points now, almost entirely due to rising 10-year Treasury rates. Despite the rising rates, utilities' absolute return since last June is 12%. However, like in past cycles, utilities' returns pale in comparison with the S&P 500's 29% total return and lagged every other sector during the past year.

Looking forward, utilities investors face the same conundrum. The still-wide yield spread suggests to us that utilities could offer positive absolute returns even if interest rates rise as high as 4%. But as in past periods of rising interest rates, there will probably be better returns elsewhere in the stock market. On the flip side, if interest rates level off or even fall from here, utilities could be in for a phenomenal absolute and market-beating run.

We think this market dynamic--in which utilities are set up to produce decent if not spectacular returns regardless of interest rate movements--is what spurred Warren Buffett's Berkshire Hathaway to offer US$5.6 billion and a 23% premium for NV Energy STEC (NVE/NYS) in late May. NV is set to become a cash-rich utility after completing a huge investment program and achieving significant regulatory improvements that should enhance cash flows. TECO Energy STEC (TE/NYS) also last month made a US$1-billion bid for a cash-rich gas utility in New Mexico. We think both deals come with rich valuations that show the premium investors are placing on steady, growing cash flow.

In the shorter term, we're watching summer weather to determine this year's winners and losers. Texas regulators are increasingly concerned that a heat wave like in August 2011 could lead to power shortages across the state, given a load base that is growing faster than generation supply. NRG Energy STEC (NRG/NYS) and Calpine (CPN/NYS) bear watching. In Southern California, Edison International's STEC (EIX/NYS) decision to shut the San Onofre nuclear plant leaves a big hole in the generation base and has regulators worried about effects on the power grid if temperatures spike. And as natural gas prices rise off their 2012 lows, we'll be watching to see if coal regains some of the market share it lost in 2012.

Our top utilities picks

With utilities' falloff since April, we think valuations for some high-quality utilities are starting to look attractive. On a market capitalization-weighted basis, the average sector price/fair value estimate ratio is 0.90, down from 0.93 last quarter. The utilities sector's 1.05 median price/fair value still shows the valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities.

Those regulated utilities are looking more attractive, however. The group of the 30 largest U.S. regulated utilities is now only 8% overvalued as of mid-June, down from 16% overvalued on May 1. Southern Company SO, which fell 8% in May, now trades in line with our fair value estimate for the first time in three years. Other large-cap utilities trading near our fair value estimates include American Electric Power AEP, Duke Energy DU and Dominion Resources D. We also think ITC Holdings ITC, our only wide-moat regulated utility, is one of the cheapest among its peers, given its sector-leading growth prospects.

We think the cheapest utilities remain those with exposure to wholesale power markets. Severe conditions in Texas and Southern California favour incumbent power producers such as NRG Energy and Calpine, both of which trade at more than 10% discounts to our fair value estimates. We think nuclear operator Exelon EXC remains the best positioned to benefit from environmental regulations that will raise costs or shut down its coal-burning competitors. European utilities such as RWE, GDF Suez and ENEL already price in the worst-case economic scenarios and offer significant upside if the European economy improves.

	Top Utilities Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Yield
	Exelon Corp.		$42.00	Wide	Medium	4.0%
	Ormat Technologies		$27.00	Narrow	Medium	0.7%
	American Electric Power		$48.00	Narrow	Low	4.3%
	ITC Holdings		$98.00	Wide	Low	1.7%
	Calpine		$26.00	None	High	NA
	Data as of 6-14-13

Exelon  EXC
Even with a greater share of earnings from countercyclical retail supply and regulated distribution businesses, Exelon still can't escape its overwhelming leverage to Eastern and Midwestern U.S. power prices. These power prices, highly correlated with sluggish natural gas prices, continue to drag down Exelon's earnings prospects for the next three years. Facing a cash flow crunch as early as mid-2014, Exelon's board cut its dividend 41% in the second quarter to US$1.24 annualized. But leverage works both ways, and Exelon is the utilities sector's biggest winner if environmental regulations stiffen against its coal plant competitors. We think Exelon's mid-cycle earnings power is US$4.25 per share, nearly double our 2014 mark-to-market earnings estimate. For power market bulls, we think Exelon is among the cheapest utilities we cover, trading at just 7.5 times our 2016 mid-cycle earnings estimate and offering a 4% dividend yield.

Ormat Technologies  ORA
Ormat's geothermal plants offer utilities a more appealing renewable resource than wind and solar generation, which are less reliable and more expensive--provided you can find the geothermal resource. Ormat's growth from development at more proven geothermal sites will be impressive, but we expect a bumpy ride as growth becomes more dependent on exploration. The company's portfolio provides a consistent profit stream and should grow at a rate unmatched by its peers without dependence on fossil fuels, supporting consistent cash returns on invested capital. Reservoir issues at Brawley caused fears about the land portfolio that we think are overblown, despite the hit to recent profits. New projects will help ease concerns. Investors looking for an established, pure-play renewable energy developer should find Ormat enticing. Ormat also has significant exposure to emerging markets, supporting long-term cash flow growth.

American Electric Power AEP
With diverse operations, strong earnings growth prospects and a 4.3% dividend yield, American Electric Power is among the most attractive regulated utilities in the sector, in our view. Ohio regulators approved AEP's revised electric security plan, allowing AEP partial recovery for generation investments until deregulation in 2015 and reducing uncertainty. The deal postpones AEP's plans to close some of its coal plants, but poor economics and environmental liabilities still likely will result in a significant reduction in its coal generation capacity. Despite this, we think AEP remains well positioned to benefit from a recovery in Midwest power prices, especially if commodity price inflation accelerates. We forecast 6% consolidated earnings growth during the next five years, with 9% earnings growth at the company's regulated utilities based on its aggressive investment plans offsetting the near-term weakness at its Ohio generation fleet.

ITC Holdings  ITC
Our only wide-moat regulated utility and the only pure-play electric transmission utility has produced healthy returns on capital and strong earnings growth since its initial public offering in 2005. ITC has benefited from incentive rates of return that the Federal Energy Regulatory Commission has used to attract investment in the U.S. electricity transmission grid. Although returns are likely to decline as growth shifts to ITC's transmission businesses with lower allowed returns on equity, we believe earnings growth and returns will be higher than for most utilities. We expect annual dividend increases exceeding 10% for the next five years. The FERC is driven by public policy to increase grid reliability, enhance wholesale market competition, and facilitate transmission of wind and other renewable generation to customers. We believe these trends are likely to continue for the foreseeable future, keeping ITC's wide moat intact and providing returns well above the company's cost of capital.

Calpine  CPN
Calpine is uniquely positioned among its independent power producer peers as the industry's only predominant natural gas generator, with the most efficient fleet in the United States. This positions Calpine to benefit from favourable power market trends across its operating regions, particularly in Texas and California, where the company should benefit from tightening supply/demand conditions. Both regions are struggling to provide market incentive for new build expansion and pending emissions regulations that we estimate could force 53 gigawatts of coal plant capacity off line throughout the U.S. We expect this to create supply constraints across Calpine's core operating regions, allowing it to capture significant margin expansion independent of natural gas prices. We believe the stock looks cheap, trading at 5 times our 2014 EBITDA estimate, although we require a significant margin of safety given our high uncertainty rating.