(By Travis Miller)
- Increased scrutiny that nuclear operators could face worldwide following the disaster in Japan should not have a long-run impact on valuations.
- Washington continues its push to reduce environmental impacts from power plants, creating industry winners and losers.
- Even with dividend yields near decade highs, the last six months have been a tough period for regulated utilities as investors rotate back into riskier holdings.
Before disaster hit Japan, all eyes in the utility sector were on Washington, waiting for the Environmental Protection Agency's landmark power plant environmental regulations. But when the earthquake and tsunami disabled two of Japan's nuclear plants, focus immediately turned to the costs and benefits of nuclear power. Once considered big winners as environmental standards tightened worldwide, nuclear operators now could face higher operating costs, capital investment requirements, or plant shutdowns.
So instead of a clearer long-term outlook for the sector following the EPA's mid-March proposal limiting hazardous air pollutants, we now see even more uncertainty ahead. We think the market generally has overreacted to nuclear fears while underestimating the EPA's impact. Thus, we continue to believe merchant nuclear operators such as Exelon (EXC), NRG Energy (NRG), and FirstEnergy (FE) present compelling risk-return profiles at current prices. They stand to benefit the most from tightening EPA standards targeting coal plants. Entergy (ETR), the second-largest U.S. nuclear operator also stands to benefit from higher power prices and coal plant closures, but we think its heightened nuclear re-licensing risk should give investors caution.
The utility sector as a whole has produced virtually no net returns for investors since September 2010. With the threat of rising interest rates and inflation, we continue to believe investors must choose carefully within the sector to realize attractive returns.
Power prices remain stagnant across the U.S., hurting the near-term outlook for independent power producers such as GenOn Energy (GEN) and NRG Energy, and diversifieds such as Exelon, FirstEnergy and Entergy. Natural gas prices, which drive power prices in most regions, are at the same level as they were in early 2009. The EPA proposals in March did nothing to move power prices, and forward curves continue pricing in virtually no change in power supply or demand.
We think the disconnect is widening between pricing signals and recent developments in the market. First, demand appears to be on the rebound. During the first quarter, seasonally adjusted generation output for the trailing 12 months was at its highest level in two years and was up 3% from its low in late 2009. Industrial demand is leading the way, up 5% from its lows in late 2009. Coal prices are up almost 70% from their lows in early 2009, raising costs in coal-heavy regions such as the Midwest and Mid-Atlantic regions and favoring low-cost generators. Gas oversupply concerns are beginning to subside as rig counts fall and drilling activity slows.
In addition, the EPA estimated its hazardous air pollutant proposal could shut down 10 gigawatts of coal plants, 3% of the fleet, as soon as 2014. We think this underestimates the actual impact, which could be closer to 50 GW. Political pressure to limit job losses in coal-heavy regions likely contributed to the EPA's low-ball estimate. All of these supply-demand drivers eventually should boost power prices and margins for low-cost operators like Exelon, NRG Energy, and GenOn Energy.
Among regulated utilities, the consolidation wave continued in the first quarter. Duke Energy (DUK) made the biggest move yet when it proposed acquiring Progress Energy (PGN) in a $25.7 billion deal that would make it the largest U.S. utility. PPL (PPL) closed its $7.6 billion acquisition of E.ON's (EOAN) Kentucky utilities and made a $6.4 billion bid for E.ON's U.K. Central Networks regulated distribution utility. Northeast Utilities (NU) and NSTAR (NST) cleared several hurdles toward their marriage and AGL Resources (AGL) is waiting on Illinois regulators to affirm its Nicor (GAS) purchase. We think capital-hungry utilities such as Westar Energy (WR) and Portland General (POR) could be attractive targets for capital-rich acquirers.
Deal valuations support our view that regulated utilities are about 10% overvalued on average. Since we began calling regulated utilities overvalued in October 2010, the group has produced just 3% total returns with dividends offsetting negative price performance. Regulated utilities still yield 4.4% on average. But with rising Treasury yields since mid-2010, utility yields look much less attractive. We think rising Treasury yields will pressure regulated utility stock prices the rest of the year.
Our Top Utilities Picks
We remain bullish on utilities with exposure to a rebound in wholesale power markets, such as 5-star picks Exelon, NRG Energy, and GenOn Energy. All three own low-cost generation fleets in high-demand regions that can benefit from a cyclical rebound in natural gas and power prices. All three also have environmental profiles that could make them net beneficiaries from the proposed non-carbon EPA regulations. GenOn has no nuclear risk.
Among regulated utilities, we see buying opportunities in utilities yielding more than 5% with regulation that allows them to pass along higher costs on a timely basis. This combination of higher-than-average yield and timely rate recovery offers protection from higher interest rates and inflation, the key threats we see on the horizon. The only undervalued regulated utilities in our coverage universe as of late March are American Electric Power (AEP), National Grid (NGG), Westar Energy, and PG&E (PCG).
On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.94, up from 0.91 last quarter. Several large undervalued diversified utilities skew this average lower. The median price/fair value ratio for the sector is 1.06, the same level it was in October 2010. This reflects our view that the smaller, fully regulated utilities could underperform their larger, diversified peers. The median price/fair value ratio for independent power producers in our coverage universe is 0.72.
The utilities we highlight below feature high-quality assets, strong management teams, and good earnings-growth prospects. The 4- and 5-star names look attractive at today's market prices, while the 3-star pick reflects a name we think investors should keep high on their watchlists.
| Top Utilities Sector Picks|
| ||Star Rating||Fair Value|
|NRG Energy || 5 || $39.00 || None ||High||NA|
|GenOn Energy || 5 || $7.00 || None ||High||NA|
|Exelon|| 5 || $67.00 || Wide ||Medium||5.3%|
|American Electric Power|| 4 || $40.00 || Narrow ||Low||5.2%|
|National Grid|| 3 || $51.00 || Narrow ||Medium||6.0%|
|Data as of 3-21-11. |
NRG Energy (NRG)
We think NRG is an excellent pick for investors looking for an independent power producer with a high-quality management team and asset profile that will benefit from an improving U.S. economy and rising power demand. Its low-cost legacy power plants in Texas, California, and the Northeast still represent the bulk of its long-term value. But after nearly $3 billion of acquisitions during the past year, management has diversified its earnings profile with more natural gas generation, renewable energy, and countercyclical retail businesses. We think these moves preserve the firm's option-like upside in more favorable commodity cycles while reducing its exposure to tighter environmental regulations. Its $3 billion of cash at year-end 2010 enhances its financial flexibility.
GenOn Energy (GEN)
GenOn's creation from the December 2010 merger of Mirant and RRI Energy gives investors a diversified portfolio of power plants and upside from management's projected merger synergies. We estimate the $150 million of annual projected synergies are worth nearly $2 per share if they are fully realized. Synergies notwithstanding, GenOn's prospects remain closely tied to power markets in the Mid-Atlantic region. Current forward power markets are pricing in no demand recovery and no change in supply, but we believe coal plant closures and a return of economically sensitive demand growth should drive up power and capacity prices. Its most valuable coal plants have state-of-the-art environmental controls, protecting it from EPA regulations. GenOn's current hedges lock in what we estimate will be trough EBITDA in 2012, unless power markets deteriorate materially. Our net asset value calculation suggests the company is worth $8 per share with synergies.
Operating leverage from the largest nuclear fleet in the U.S. is key for our only wide-moat utility. Despite today's weak power prices and prospects for a 20% earnings drop by 2012, we believe Exelon's long-term value remains intact, and its 8 times EV/EBITDA market valuation ignores this upside. We are most focused on the company's ability to hedge in favorable economics for 2013 and beyond. A rebound in Midwest industrial power demand, higher gas prices, and strict environmental regulations would help. We estimate a 10% move in 2013 power prices from today's levels translates into $500 million of incremental EBITDA. Proposed non-carbon emissions regulations could add $600 million of incremental pre-tax margin ($0.60 per share aftertax) by 2014, and carbon caps could add another $900 million of pre-tax margin ($0.83 per share aftertax). Our primary concern is M&A risk and increased nuclear oversight.
American Electric Power (AEP)
After a period of slow earnings and dividend growth, we think American Electric Power has the potential to grow faster than most other regulated utilities during the next several years. With significant investments in new generation, transmission, distribution, and environmental upgrades, we expect regulators to grant rate increases that will support 5%-7% ongoing earnings growth between 2010 and 2014, and likely faster growth thereafter given favorable regulation for its transmission investments. AEP is one of the few utilities in our coverage universe that is free cash flow positive, and we expect it to remain so throughout our forecast period. In addition, AEP's 5.4% dividend yield is quite attractive, and we expect dividends to grow at a pace in line with earnings growth.
National Grid (NGG)
This U.K.-based regulated utility should benefit substantially from a shift away from fossil fuels and toward renewables in the U.K. and U.S. Northeast. Building high-return transmission grids on both sides of the Atlantic should drive strong earnings growth while favorable regulated rate structures protect those earnings from inflation through automatic adjustments. With a dividend yield near 6% and management's 8% dividend-growth target through 2012, we think National Grid offers one of the most attractive total-return packages among regulated utilities. We expect the annual fiscal 2011 dividend to climb to GBX 36.37 per share ($2.87 per ADR share), a 6.0% yield as of mid-March.