Regardless of the state of the economy, consumers need the products supplied by utility companies. For that reason, utilities tend to be relatively insulated from economic weakness.
However, even though utilities are known for their defensive characteristics, they also outperform the broader market at times. In fact, they were one of the top-performing sectors in 2014. As a group, Canadian utility stocks had a total return of more than 16% last year, while their U.S. counterparts gained about 24%.
But since the start of 2015, utility stocks as a group have given back much of these gains. This pullback has created some attractive buying opportunities in selected stocks, according to Morningstar equity research:
| ITC Holdings Corp. | ||
| Ticker | ITC | |
| Current yield | 2.07% | |
| Forward P/E | 15.7 | |
| Price | US$32.68 | |
| Fair value | US$42 | |
| Data as of Sep. 23, 2015 | ||
ITC Holdings Corp. (ITC) owns no generation capacity, but transmits more than 26,000 megawatts at peak load on its transmission systems in the United States. Morningstar analyst Charles Fishman says the company's transmission infrastructure gives it a wide economic moat, or competitive advantage. ITC is expected to benefit from new natural-gas-fired power plants and wind farms replacing coal-fired plants in the coming years. This, and an increasing capital expenditure, should allow earnings to grow at an 8% compound annual rate, and drive approximately 13% annual dividend increases during the next five years.
ITC benefits from regulatory protection, since the Federal Energy Regulatory Commission is not eager to approve new transmission lines. This favourable regulatory framework covers 100% of ITC's revenue and provides predictable earnings and cash flow.
Additionally, says Fishman, management has showed exemplary discipline in completing development projects on budget and on schedule or abandoning them early in the process to keep write-offs to a minimum.
| Fortis Inc. | ||
| Ticker | FTS | |
| Current yield | 3.61% | |
| Forward P/E | 17.0 | |
| Price | US$36.52 | |
| Fair value | US$37 | |
| Data as of Sep. 23, 2015 | ||
Fortis Inc. (FTS) manages electric and gas regulated utilities in Canada, the U.S. and the Caribbean. Management recently shed non-core hydro assets in New York valued at $77 million and also agreed to sell the company's commercial real-estate portfolio, Fortis Properties, for $430 million. The proceeds from the sales will be used to pay down borrowings that were used to fund the acquisition of Arizona-based UNS Energy in a push to expand U.S. operations. With 40% of Fortis's operating assets now being U.S.-regulated utilities, management is focusing on growth opportunities through electric and natural-gas distribution in North America.
Morningstar equity research pegs the company's earnings growth at 6% through 2018, supported by its $9-billion, five-year spending plan. Increased consumption and customer growth resulting from healthier economy could further push growth to 7.5%. Fortis has paid consecutive quarterly dividends for four decades and raised the dividend faster than most of its peers in recent years, including a recent 6.25% dividend increase.
| Duke Energy Corp. | ||
| Ticker | DUK | |
| Current yield | 4.65% | |
| Forward P/E | 14.3 | |
| Price | US$69.09 | |
| Fair value | US$83 | |
| Data as of Sep. 23, 2015 | ||
Duke Energy Corp. (DUK) became the largest utility in the U.S. after it merged with Progress Energy in 2013. Based on Duke's second-quarter results this year, Morningstar equity analyst Andrew Bischof increased the fair-value estimate for the stock to US$83 from US$81. The company's president and CEO, Lynn Good, announced in August 2015 an approximately 4% increase in the quarterly dividend payment, reflecting management's confidence in the strength of the company's core businesses and cash flows.
Duke has plans to invest an estimated US$41.8 billion through 2019, of which nearly US$30 billion is allocated to growth and expansion. Based on these spending figures, the company is projected to generate long-term normalized earnings growth of 6% annually.
Duke's main competitive advantage comes from territorial monopolies and economies of scale. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on the capital they spend to build, operate and maintain their distribution networks.
| Southern Co. | ||
| Ticker | SO | |
| Current yield | 4.97% | |
| Forward P/E | 14.6 | |
| Price | US$42.95 | |
| Fair value | US$46 | |
| Data as of Sep. 23, 2015 | ||
Atlanta-based utility giant Southern Co. (SO), whose primary business is electricity sales, recently agreed to buy natural-gas utility AGL Resources Inc. for about US$8 billion. The move would double the number of Southern's customers to nine million, making it the second-largest utility in the United States. The deal will also increase the company's exposure to the booming U.S. natural-gas market and will help expand its natural-gas infrastructure.
Morningstar equity analyst Mark Barnett says the company is planning to invest roughly US$24.5 billion in its business from 2015 to 2019, which can deliver 4% average annual earnings growth during the period. Barnett also noted that Southern plans to increase its dividend by 4% annually during the next few years.
One of Southern's main competitive advantages, and a crucial driver of utility returns over the long run, is its strong working relationships with its regulators. Management places high priority on preserving goodwill with regulators. The company's competitive edge also rests on its transmission and distribution assets, which are extremely difficult and costly to replicate.
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