Utilities: Roller-Coaster Ride, but Strong Fundamentals

SECTOR OUTLOOK: Stock price volatility offers opportunities for investors committed to holding utilities for the long run

Travis Miller 2 October, 2014 | 11:40AM
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Since 2011, utilities have been on a wild roller-coaster ride, far outperforming the market for six to nine months, then far underperforming the market, then far outperforming. Fundamental performance has been steady, and we think most utilities are in as strong financial health as they have been since the US and European recessions began. But investors seem to be rushing in and out of the sector with every whiff of interest rate policy shift. We think this offers opportunities for investors committed to holding utilities for the long run.

In Europe, we suspect the UK general election in May 2015 will reduce some of the rhetoric from politicians calling for energy price freezes and the breakup or privatisation of large energy companies. Renewable energy continues to wreak havoc on power markets, particularly in Germany. European utilities' profit margins are stabilising, but at much lower levels than three years ago.

In the US, utilities fundamentals are generally strong. Our forecast sector average 59% pay-out for 2014 is in line with historical averages, and credit metrics are stronger than the past three years. With sustainable pay-out ratios, we think dividends could grow as much as 5% annually, better than the median 3% earnings growth during the past three years. Those utilities with a favourable combination of constructive regulation and critical infrastructure projects should provide investors the best long-run returns.

Key Points

The median price/fair value estimate for our global utilities coverage is 1.05 as at September 15, implying the global sector is marginally overvalued. The median price/fair value estimate for the 47 US utilities we cover is 1.04, while the 24 non-US utilities we cover is 1.07.

As 10-year US Treasury rates fell from 3% at the beginning of 2014 to 2.6% in June, US utilities outperformed every sector with an 18% total return. Since interest rates began climbing again, utilities have been the worst performers.

In Europe, there is increasing chatter that Continental countries might follow the UK and most of the Eastern United States into capacity markets. The first-ever auction in the UK is scheduled for December.

We continue to be bullish on US power and natural gas prices, a boon for most diversified utilities and power producers. In Europe, gas prices have collapsed and government support for renewables is waning, offering some relief for power generation margins.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Centrica PLC69.22 GBX0.26Rating
Drax Group PLC578.50 GBX2.66
National Grid PLC1,077.60 GBX-0.13Rating
Pennon Group PLC1,055.00 GBX0.00
SSE PLC1,553.19 GBX1.02Rating
United Utilities Group PLC1,063.50 GBX0.42Rating

About Author

Travis Miller  is the director of utilities sector securities research at Morningstar.