As volatility returns to stock markets with a vengeance, fuelled largely by growing expectations of more interest-rate hikes this year by the U.S. Federal Reserve, investors are scrambling to adjust to the ongoing disruption to the multi-year equities bull run. While some skittish investors are running for safe-haven assets, those more opportunistic are poking around for discount deals in what has become a highly overvalued market.
As a result, sectors like utilities are getting closer attention. A three-month pullback -- during which the sector in the United States plummeted 14% -- has made leading utility names the cheapest they have been since 2015. On a year-over-year basis, the S&P 500 Utilities Index has gained a measly 0.71 %, compared to the nearly 20% gains for the S&P 500, as of Feb. 27, 2018. Things become far worse on a year-to-date basis with utilities clocking a negative return of 4.6%, vis-à-vis gains of more than 4% for the S&P 500.
The sector's underperformance has created attractive buying opportunities, says Morningstar equity analyst Andrew Bischof. Prominent U.S. utility players operate in highly regulated regions of the country, have distinctive competitive advantage and are making strategic acquisitions to benefit from the newest industry trends.
These companies are strategically pivoting toward faster-growing areas like renewable energy, have a track record of increasing dividends, and offer products and services that are relatively insulated from economic uncertainties. At their current valuations, they represent attractive investment options for long-term investors, according to Morningstar equity research.
| Duke Energy Corp. | ||
| Ticker: | DUK | |
| Current yield: | 4.68% | |
| Forward P/E: | 15.9 | |
| Price: | US$76.48 | |
| Fair value: | US$87 | |
| Data as of March 5, 2018 | ||
One of the largest U.S. utilities, 
Duke Energy (DUK) delivers electricity and gas to more than 7 million customers and operates in electric utilities and infrastructure; gas utilities and infrastructure; and commercial renewable segments.
"Duke Energy is among the largest utilities by market cap in the United States and has completed its transition to a predominantly regulated utility," Bischof wrote in a Morningstar report on the stock. Duke operates in highly constructive regulatory regions, which allows the firm to recover costs in a timely fashion, the report notes.
The company's US$42 billion capital program focuses on grid modernization, renewable energy, natural gas and infrastructure investments, and supports Morningstar's 6% annual earnings growth projection.
The company's US$6.7 billion acquisition of Piedmont Natural Gas represents significant growth potential beyond Duke's existing opportunities. "Management can achieve its goal to double the earnings contribution from gas utilities and infrastructure business in the next 10 years," says Bischof, who pegs the stock's fair value at US$87.
Duke's regulatory environment outshines its peers and is underpinned by strong economic fundamentals, factors that contribute to the premium returns and constitute the most critical component of a regulated utility's competitiveness, he says.
The company's unregulated business -- commercial power -- comprises high-quality renewable energy assets in long-term contracts with commercial and industrial customers. The unit represents only 5% of earnings, but "significant ramp up in renewable development at its regulated subsidiaries in the Carolinas and Florida, which have utility-like contracted earnings," would be supportive of a stable cash flow and dividend growth, says Bischof, who calls Duke "one of our most attractive names."
| Southern Co. | ||
| Ticker: | SO | |
| Current yield: | 5.25% | |
| Forward P/E: | 14.9 | |
| Price: | US$44.95 | |
| Fair value: | US$51 | |
| Data as of March 5, 2018 | ||
The second-largest utility in the U.S. by customer count, Southern (SO) distributes electricity and natural gas to approximately 9 million customers in nine states. Its fast-expanding unregulated unit, Southern Power, includes natural gas, solar and wind projects in Texas, California and other states.
"Southern Company is undergoing one of the most dramatic transformations in the usually stodgy world of regulated utilities," says a Morningstar report. The firm generated 80% of its electricity using coal in 2000, but plans to bring it down to 20% by 2030. "Nuclear, natural gas and renewable energy are all increasing their share of generation," the report notes.
The transformation, while not without challenges, will not disrupt the estimated 5% earnings per share growth rate during the next five years, nor will it put the company's attractive and growing dividend at risk, says Morningstar equity analyst Charles Fishman, who believes "the company can exceed 6% growth in the next decade if the new nuclear units at Vogtle come in on schedule and on budget."
Southern's narrow moat is built on its excellent regulatory relationships. It derives approximately 80% of its earnings from state-regulated utilities. "Among its peers, Southern's regulatory environment stands out as the strongest and is supported by above-average economic fundamentals in its key regions," says Fishman who assesses the stock to be worth US$51. "These factors contribute to the premium returns Southern has earned and have led to a constructive working relationship with its regulators, the most critical component of a regulated utility's moat."
The company, says Fishman, may have overpaid to acquire natural-gas distributor AGL Resources, but the deal could "eventually be value-accretive if "management can leverage AGL's platform into new midstream natural gas growth opportunities."
| Dominion Energy Inc. | ||
| Ticker: | D | |
| Current yield: | 4.30% | |
| Forward P/E: | 18.0 | |
| Price: | US$73.48 | |
| Fair value: | US$87 | |
| Data as of March 5, 2018 | ||
Dominion Energy (D) is an integrated energy company with 15,000 miles of natural gas transmission, storage, distribution and gathering pipelines, and more than 63,000 miles of electric transmission and distribution lines. Dominion operates one of the United States' largest natural gas storage systems, is nearing completion of an LNG export facility in Maryland, and owns a 48% stake in the proposed Atlantic Coast Pipeline (ACP).
In a strategic shift, Dominion Energy has sharpened its focus on "the development of new wide-moat projects with conservative strategies, exited the exploration and production business, sold or retired no-moat merchant energy plants, and made significant investments in moaty utility infrastructure," says a Morningstar equity report.
Dominion's wide-moat businesses are poised to generate roughly half of the company's operating earnings by 2021, up from 30% in 2016. The remaining earnings, the report says, primarily come from narrow-moat regulated gas and electric utilities, solid sales growth and high-return investment opportunities.
The firm created Dominion Midstream Partners as a financing vehicle to provide low-cost equity-like funding for new wide-moat development projects. The cash, approximately US$7.5 billion from 2016 through 2020, will be used mainly to "reduce debt at the parent and provide 10% dividend increases for shareholders," says Fishman, who believes "these dividend increases are almost locked in for investors."
The Trump administration's focus on infrastructure should provide additional growth opportunities for Dominion over the next 20 years, which could "drive high-single-digit EPS growth, [while] the dividend yield and earnings growth could deliver double-digit total annual return for conservative investors for the foreseeable future," forecasts Fishman.
