US Utilities -10-Year Treasury Highest Since 2007
Year-to-date (October 6, 2023), the utility sector has been among the worst performing of the S&P 500 sectors. The S&P Utility Index returned a negative -16.9%, which compared to the +13.7% return of the S&P 500 Composite. (See Table 1). The decline included an -11.9% drop in the two-week aftermath of the Federal Reserve’s September 20th meeting. The Fed held the overnight rate at 5.25-5.50% and outlined its expectations for the rate to be 5.6% at end of 2023; 5.1% by end of 2024; and 3.9% end of 2025. Previous expectations for a “near-term recession” gave way and finally capitulated into the harsh reality that interest rates could remain elevated rates for an extended period. The proverbial frog had boiled. The 10-Year US Treasury Yield climbed to nearly 4.9%, the highest level since 2007, from 3.9% at year-end (1.5% at year-end 2022; at year-end 2021).
Higher interest rates hurt utilities (and all investments) by lowering the discounted present value of future cash flows. In addition, the higher interest rate/lower stock price environment makes it more challenging for capital intensive utilities (and many companies) to finance growth. On September 27, 2023, NextEra Energy Partners (NEP), 55%-owned by utility bell-weather NextEra Energy (NEE), lowered its distribution CAGR to 5-8%, from 12-15%, due to the higher cost of capital. NEP is non-regulated and more vulnerable to higher rates than regulated utilities, but the action resonated throughout the sector and exacerbated concern that utility growth rates could moderate from historical median highs of 5-7%. The associated utility share price decline brought utility valuation multiples to under 15x, down from over 22x.
The Good, the Bad & the Ugly…How is There a Good?
Utility stock performance has been bad and ugly. So how is there a “good”? The risk-reward outlook for utility stocks has improved given year-to-date under-performance, lower valuation multiples, healthy earnings and dividend growth and the possibility that interest rates have peaked. We consider it likely that the rate “hike” cycle is nearly complete, and that the impact of the Feds eleven rate hikes since of March of 2022 have yet to be fully-realized. We expect recent EPS growth targets of 5-7% and 6-8% to moderate due to the higher cost-of-capital to fund rate base growth (and refinance existing fixed cost debt) to mid-single digit (4-7%) CAGR’s. Lower growth is likely reflected in lower valuation multiples. Utilities remain positioned to grow earnings and dividends given monopoly service areas, rate adjustments to recognize higher costs/cost of capital, and political and regulatory support for infrastructure investment. Over the longterm, utilities are “winners” in the continuing energy transition and the late 2022 Inflation Reduction Act (IRA) provides tax incentives for accelerated clean energy investment for decades to come.
The Bad….Regulated Utilities Down Less Than the Ugly
The S&P Utility Index returned a negative -16.9% year-to-date and a negative -15.6% since year-end 2021. In 2023, defensive sectors (utilities, healthcare, telecom and consumer staples) were among the worst performing sectors, while the better-performing S&P industry sectors were technology, consumer discretionary and industrials (growth and economically cyclical sectors). The reversal of performance reflects the shifting economic outlook. The S&P 500 Energy sector outperformed in 2022 and over the past 21-months due to higher oil and gas prices. See Table 2
Over 2021-2023, many traditional high quality regulated utilities declined ~15-40% from all-time highs to more recent lows. (See Exhibit 2 below) Higher quality regulated utilities (ATO, SO, IDA, WEC, LNT, AEE, XEL, PEG, DUK) that operate in more constructive regulatory environments are better able to manage and recover the higher cost of capital through general rate cases. However, most utilities carry some earnings headwind related to variable rate short-term debt, refinancing maturing debt and the timing of rate adjustments. Regulated California utilities EIX, PCG and SRE have outperformed the utility indices as “wildfire discounts” diminish and the benefits of pending 2024 ROE adjustments (formulaic 70% basis point increase in allowed ROEs related to higher interest rates) are recognized.
The Ugly…
The biggest share price decliners were utilities/companies that require capital to grow, including clean energy developers (NEP, AQN, BEP, AES, CWEN, AY) and utilities with subsidiaries engaged in clean energy development (NEE, AGR, ES). (See Exhibit 3) The commonly used clean energy index, the iShares Global Clean Energy ETF (ICLN) declined 31% year-to-date, including a -12.3% drop following the September 20th Fed meeting and 40% since year-end 2021.
Non-regulated NextEra Energy Partners (NEP), 55%-owned by utility bell-weather NextEra Energy (NEE), experienced a share price “free-fall” as investors lost confidence in the company’s ability to finance growth following a downward growth revision. On September 27, 2023, NEP lowered its distribution growth rate to 5-8%, from 12-15%, due to the higher cost of capital. The action raised concerns whether renewable developers could grow in the higher interest rate environment. NEE, and other renewable development companies, also declined significantly. Over the long-term, there is a huge demand for renewable power projects, and IRA-related tax credits were designed to help fund/finance growth.
Higher Cost-of-Capital Likely to Result In More Moderate EPS CAGR’s
As noted earlier, we expect current EPS CAGR targets of “5-7%” and “6-8% to moderate due to the higher cost-of-capital to fund rate base growth (and refinance existing fixed cost debt). We expect a healthy, but more moderate mid-single digit growth of 4-7%. Given that the “run-up” in rates occurred over the past few weeks, we expect many utilities to reiterate existing strong EPS CAGRs (with cautionary statements) during the upcoming third quarter earnings. As of the second quarter, managements of 17 utilities target “5-7%” EPS CAGR, 12 utilities target “6-8%”, and 2 utilities target 7-9%, with one (PCG) targeting 10% growth (Table 3). Following the second quarter 2023 earnings calls, utilities “across the board” affirmed 2023 guidance and affirmed long-term growth rates despite mild weather and rising interest rates,
Strong utility growth was driven by increasing capital investment opportunities and several years of optimizing low-cost capital. The August 2022 Inflation Reduction Act (IRA) offers “game-changing” financial incentives ($272 billion) for clean energy investment through the extension and expansion of investment (30-40% investment tax-credits) and production tax credits. Many utilities consider the IRA funding as something that will accelerate already ambitious infrastructure plans. The tax credits allow the utilities to lower the development, construction, and operating costs of renewable energy generation, which means lower future customer bill hikes. The increased rate base investment will help achieve ambitious carbon-reduction plans and aid earnings growth.
Capital Investment (Rate Base) Continues to Rise and Drive Healthy Earnings Growth In 2023, EEI member electric utilities forecast capital investment of nearly $160 billion, which would mark the eleventh consecutive year of record investment. This compares to an estimated 2022 record investment of $148 billion ($134 billion in 2021) in utility infrastructure, including distribution ($51 billion, or 33%), generation ($37 billion, or 24%), transmission ($32 billion, or 20%), gas-related ($22 billion, or 14%) and other ($13 billion, or 8%). We expect increasing utility capital needs for the following:
• Clean energy transformation (coal retirements, on/off-shore wind, solar, and storage)
• Electric transmission and distribution (grid modernization, hardening, undergrounding)
• Electrification, EV charging, efficiency, etc.
• Natural gas infrastructure (pipeline expansion and replacement, green hydrogen, and carbon capture)
Achieving the ambitious goals of 100% renewable power and a net-zero carbon economy will require massive investment and significant technological advancements. A Wood Mackenzie study estimated that the cost of transforming the U.S. to renewable energy in the next 10-20 years would be $4.5 trillion (translates to $300 billion annually over 15 years) given current technology. In addition, the 100% renewable target requires the building of 1,600 GWs of new wind and solar generation and a nearly doubling of high voltage transmission (HVT).
The regulated utility sector remains well-positioned to finance record capital programs given strong balance sheets, reasonable payout ratios, healthy valuations over book value, and the industry’s high investment grade credit-rating (BBB+). The industry has maintained an S&P Credit rating of BBB+ average (25%-A- or higher; 70%-BBB-, BBB, or BBB+) since increasing from a BBB average in 2014.
More Ugly Interest Rates, Inflation Hamper Climate Goals
Non-regulated renewable development companies (and subsidiaries) face challenges related to higher interest costs, inflation, tariff and supply chain issues as well as integrating into the existing transmission system. The transmission system was not designed to accommodate the massive renewable additions, particularly given wind/solar intermittency. Developers face clogged interconnection queues, permitting delays and a congested power grid. Regulated utilities Consolidated Edison, Eversource, Duke Energy and American Electric Power have strategically chosen to divest non-regulated renewable development businesses to focus on the regulated business.
The Northeastern Offshore Wind target of 30 GWs by 2030 are likely unachievable given the challenges. Several of the awarded major projects have terminated purchased power contracts and or requested price negotiations. Many projects are at risk of stalling because states’ ratepayers may be unable to absorb these significant new costs alone. The Biden Administration announced a memorandum of understanding between nine states (CT, MA, MD, ME, NC, NH, NJ, NY, and RI) and four federal agencies, pledging to coordinate efforts to identify and address domestic resources for steel, vessels, port infrastructure, and components for offshore wind resources.
There are currently numerous proposed projects along the Northeast Coast in advanced stages of development, totaling over 16 GWs, and another 20 GWs in early development. There are two major projects (Vineyard Wind and South Fork) under construction. However, the business of offshore wind development appears more appropriate for large oil and gas companies (most utilities have opted out of offshore wind) and faces the challenges of long development and approval processes.
• Electric and gas utility valuation multiples have declined from 23x forward earnings in early 2020 to 15x 2023 and 14x 2024 earnings estimates. Over the past twenty-five years, utility forward multiples have ranged between 10x and 23x earnings with a median of 17.1x. The power developer subgroup’s more significant decline reflects more exposure to earnings headwinds from higher funding costs.
• The water utility under-performance reflects the impact of higher interest rates on higher multiples stocks. Water utilities trade at the highest multiples due to their scarcity, small size, takeover premium, ESG value, and long-term growth potential through consolidation and privatization.
• The six Canadian electric and gas utilities have outperformed in 2023, after underperforming in 2022. Canadian provincial regulatory environments are more challenging (lower allowed ROEs and equity ratios) than many US utility jurisdictions.
Our universe of utility stocks is currently trading below 15X forward earnings after having reaching a pre-COVID high of over 22X. The electric utility multiples climbed from roughly 10x forward earnings during the credit crisis and market crash of 2008 driven by improving fundamentals, higher growth rates and low interest rates (Exhibit 5).
Given that long-term interest rates (specifically the 10-year and 30-year Treasury yields) have risen dramatically to nearly 5.0% following a long-term secular decline since the late 1980’s, we measure the earnings yield (1/P/E) as a percent of the 10-Year T-Bond Yield to gauge interest rate adjusted valuations. As can be seen in Exhibit 1, the current ratio of 155% indicates the sector P/E is modestly higher than its historical median relationship with the 10-Year T-Bond Yield.
Interest Rates and the Fed
While utility stocks are not bond proxies, and share prices are a function of earnings and dividend growth rates, higher (lower) rates negatively (positively) impact equities, given that future cash flows are impacted by the assumed discount rate. 9 In Table 5, we highlight the significant impact that a change in interest rates can have on a stock. A stock price as mathematically determined by the standard two-stage dividend discount model (DDM) changes dramatically when moving the risk-free rate (Ten-Year Treasury Yield) from 2.0% to 5.0%. Equally notable, companies with higher growth rates are more sensitive to changes in interest rates. On the left side, we assume a stock grows its $1.00 dividend at 5% during the five-year stage one and then 3.5% terminal growth. Changing the risk free rate from 2.0% to 5.0% results in a 55% change in stock price and P/E multiple change from 30X to 13.5X. The same change to a higher growth stock (8% stage 1 and 4% terminal growth) results in a -78% change in stock price. We believe the model can be applied to utility stocks in a more effective manner than other stocks because of more predictable variables (monopoly means stable demand, stable product prices, ROE determined by regulators, dividends that grow over time). In addition, each individual stock has its own set of benefits and cons, but we simply wanted to offer a backdrop as to “mathematically” trying to understand the weakness
In addition, current utility dividend returns become less compelling when returns on other investments increase, including Treasury yields. The current 6-month Treasuries yield over 5.5% and US Treasuries hold even greater defensive appeal than utilities. The factors below mitigate the negative impact of higher rates.
• Annual dividend hikes: Utilities target annual dividend increases, which serve to mitigate the negative impact of higher rates. In 2023, electric utilities increased the annual dividend by a median of 5.0%.
• ROE is set based on interest rates: A utility’s cost-of-capital, including equity returns (ROEs), is set by state PUCs and increases (decreases) as interest rates rise (fall).
• Annual riders minimize inflation risk: State PUCs and FERC regulatory principles have improved to include more frequent rate adjustments, which mitigate inflation risk.
• Utility stocks pay higher dividends than other sectors: The present value of a higher near term dividend stream is less impacted by changes in interest rates than a lower near term dividend stream.
While utility dividend yields and 10-year U.S. Treasury yields are highly correlated and will likely remain so in the future, utility dividends have risen over time (most on annual basis) while the Treasury yield remains fixed. Utility stock prices, unlike Treasury bond prices, are likely to rise should earnings and dividends grow over time.
ONE CORPORATE CENTER RYE, NY 10580 Gabelli Funds TEL (914) 921-5100
This whitepaper was prepared by Timothy M. Winter, CFA. The examples cited herein are based on public information and we make no representations regarding their accuracy or usefulness as precedent. The Research Analysts’ views are subject to change at any time based on market and other conditions. The information in this report represent the opinions of the individual Research Analysts’ as of the date hereof and is not intended to be a forecast of future events, a guarantee of future results, or investments advice. The views expressed may differ from other Research Analyst or of the Firm as a whole.
As of June 30, 2023, affiliates of GAMCO Investors, Inc. beneficially owned 4.06% of National Fuel Gas, 3.23% of PNM Resources, 3.09% of Southwest Gas, 2.34% of Otter Tail, 1.90% of RGC Resources 1.51% of York Water, 1.38% of Northwest Natural, 1.37% of Northwestern Energy, 1.11% of Black Hills, 1.01% of MGE Energy, and less than 1% of all other companies mentioned.
One of our affiliates serves as an investment adviser to Hawaiian Electric or affiliated entities and has received compensation within the past 12 months for these non-investment banking securities-related services.
Funds investing in a single sector, such as utilities, may be subject to more volatility than funds that invest more broadly. The utilities industry can be significantly affected by government regulation, financing difficulties, supply or demand of services or fuel and natural resources conservation. The value of utility stocks changes as long-term interest rates change
