Through the first half of 2023, the S&P Utility Index returned a negative -5.7% and underperformed the rebounding S&P 500 utility index, which returned 16.9%. (See Table 1) Ten consecutive Fed rate hikes (current overnight target of 5.0-5.25%) since March of 2022 have yet to spoil the labor market and inflation remains well-above the Fed’s long-term 2.0% target. The S&P Utility and S&P 500 performance over the past six months, twelve-months and eighteen months highlight the indecisive and “see-saw” nature of investor’s economic outlook. In 2022, the 20% utility out-performance (+1.6% vs. -18.1%) reflected expectations for a recession-driven decline in interest rates, which has yet to materialize. Despite a pause at its June 14, 2023 meeting, the FOMC indicates the potential for two more rate increases by year-end 2023. The expectation for higher rates for longer and ongoing economic strength led to Fear of Missing Out (FOMO) and investors shifted funds into growth, technology and cyclical sectors to the detriment of defensive sectors.
Table 1 Utilities Over the Past Several Periods
Source: Thomson One
In the face of dramatic increases in short–term yields (0% to 5.5%) and the entire yield curve, utility stocks (-4.2%) slightly outperformed the S&P 500 (-4.3%) over the past eighteen months. The US treasury yield curve inversion (Exhibit 1) continues to indicate an impending recession, which would likely lead to lower inflation and lower interest rates. Under either a recessionary or strong growth economy, utilities would expect to deliver positive earnings and dividend growth. Further, we believe that utilities are “winners” in the long-term energy transition and the late 2022 Inflation Reduction Act (IRA) provides tax incentives for accelerated clean energy investment for decades to come.
Exhibit 1 US Treasury Yield Curve Rose and Inverted
Source: US Department of Treasury
The “Top Ten Reasons to Consider Utility Stocks” are Outlined below:
1) Defensive profile including fuel and inflation cost-recovery
2) Reasonable valuation of 16x 2023 P/E multiple, down from 23x (Table 3 & Appendix on page 19-20)
3) Competitive current return of 3.7% compared to the 10-year treasury yield of 3.8%.
4) Above historical average earnings and dividend growth potential
5) Electrification to enhance electric demand (Electric vehicle charging stations, heat pumps)
6) Renewable and net-zero carbon standards create long runway of rate base investment
7) Improving ESG profiles (great power transformation)
8) Financial engineering, including ongoing consolidation and simplification
9) Possibility interest rates have peaked and US is in recessionary environment
10) Inflation Reduction Act to drive clean energy investment for decades
Reversal: Performance See Saw
Year-to-date 2023, the best-performing S&P industry sectors were technology, telecommunications and consumer discretionary, which are growth and economically cyclical sectors. Each of these sectors was among the worst performing sectors in 2022. On the other hand, defensive sectors (utilities, healthcare and consumer staples) were among the worst performing sectors in the first six-months of 2023, but were the better performing sectors in 2022. The S&P 500 Energy sector outperformed in 2022 and over the past eighteen months due to high oil and gas prices.
Table 2 S&P 500 Sector Performance
Please see Table 3 for Utility Subgroup Metrics and appendix on pages 19-20 for more utility stock financials.
· Electric utility valuation multiples have declined from 23x forward earnings in early 2020 to 17x 2023 and 16x 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 gas utility performance reflects recovered investor sentiment partially offset by greater challenges to maintain earnings outlooks. Gas utilities currently trade at 17x 2023 and 16x 2024 earnings estimates. The median multiples had declined to as low as 15x forward earnings during the period from September 2019 through September 2021 when natural gas fell from favor given its carbon emissions.
· 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.
Table 3 Utility Subgroup Statistics
Top Performers
In the first half of 2023, the top performing utility/power stocks were non-regulated independent power producers, including NRG Energy (NRG), Vistra Energy (VST), and Constellation Energy (CEG). CEG, NRG and VST have lower capital budgets than utilities and are beneficiaries of higher power prices. CEG, the sector’s only pure-play merchant nuclear generators (spun-off from Exelon in February of 2022) agreed to acquire NRG Energy’s 44% ownership in the South Texas Nuclear Plant. In May of 2023, activist Elliott disclosed a 13% position in NRG and a desire to replace management as well as restructure the company. In addition, VST announced an agreement to buy Energy Harbor’s 4 GW nuclear portfolio in March of 2023. Other top performers include small-cap takeover candidates, Otter Tail Power Corp (OTTR) and MGE Energy (MGEE), and rebounding California utilities, Edison International (EIX) and PG&E (PCG). See Table 4.
Table 4 Best and Worst Performers
Utilities Target Above-Historical Average Earnings Growth
Based on Thomson One consensus estimates, our universe of 70 electric, gas and water utility stocks are forecast to grow EPS 4.4% in 2023 and another 5.8% over 2022-2025. The outlook follows 6.0% growth in 2022 and 3.7% annual EPS growth over the past three years (2018-2022). In Table 5, we outline recent growth track records and management published forecasted EPS growth targets.
Managements of 17 utilities target “5-7%” EPS CAGR, 12 utilities target “6-8%”, and 2 utilities target 7-9%, one (PCG) targets 10% growth (Table 5). a national scale, January and February 2023 were among the warmer on record but nearly all utilities affirmed expectations of 5-7% (some 4-6% and some 6-8%) growth. Guidance and outlooks were encouraging given mild first quarter and the challenging impacts of higher interest rates and higher inflation.
Utility management optimism underlies increasing capital investment opportunities. The August 2022 Inflation Reduction Act (IRA) provides significant incentives for accelerated clean energy investment for decades to come. The IRA established significant financial incentives ($272 billion) for clean energy investment through the extension and expansion of investment and production tax credits. Most utilities consider the IRA to offer “game-changing” incentives and plan to 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 increases. The increased rate base investment will help achieve ambitious carbon-reduction plans and aid earnings growth.
Table 5 Carbon Targets and EPS Growth Rates For Selected Utilities
Capital Investment (Rate Base) Continues to Rise and Drive 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)
Exhibit 2 Record Capital Investment
The 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.
After Decade of Real Customer Rate Declines, Customer Bills Rise
In 2021 and 2022, the average US retail price of electricity per kWh rose 5.1% and 12.1%, respectively, on a nominal basis to 11.4 cents/kwh and 12.8 cents/kwh, respectively. (Table 6). Electric rates remained relatively flat over the 2010-2020 period. Higher utility bills were due to rate adjustments to recognize inflation, higher fuel, and higher interest rates. Rate adjustments benefit earnings, but rising customer bills can be a concern to the utility investment thesis because state PUCs feel political and public pressure to keep rate increases to a minimum. Fuel clause and inflation-related increases reduce the “head-room” available for rate base and earnings growth.
Table 6 Highest and Lowest Cost Electric Utilities (2022 Ultimate/Retail Rate)
Source: Public Data
We believe electric utilities with more affordable electric rates could face less regulatory challenges. Electricity prices paid by ultimate customers vary widely on a geographic basis, with customers in Hawaii paying the highest prices, at a whopping 40 cents/kWh in 2022. Customer bills are also relatively high in California and the Northeast, including New York, Connecticut and Massachusetts. The lowest prices at the state level were in the Pacific Northwest (hydro capacity) and Midwest/Upper Midwest. (Exhibit 3 and a full list in appendix).
Exhibit 3 High and Low-Cost Electric Utilities
Fuel prices, particularly natural gas, are a major component of customer bills. The Henry Hub Natural Gas Spot Price is at a current level of $2.68, which is down from $6.09 one year ago. Spot natural gas prices have retreated from 2022 highs. Natural gas price futures (December 2023-December 2030) range between $3.80-$4.50/MMBtu. As regulated energy conduits, electric and gas utilities pass-through higher fuel costs through automatic adjustments on customer bills (margin neutral). On a positive note, the gas price retreat means fuel adjustments will offset rate base and other utility bill increases.
Exhibit 4 Natural Gas Prices Spot
State Public Utility Commissions As Important As Ever For EPS Growth
State political and regulatory environments are as important as ever in determining the performance of individual utility stocks. Utility regulation generally remains supportive of investment, but some PUCs are more constructive than others. (See Exhibit 5) Many jurisdictions have adopted changes to rate design, such as forward test years, rate mechanisms and adjustment clauses to allow timely recovery and return on costs associated with various capital investment programs (environmental, pipe replacement) and weather normalization. The allowed returns on equity (ROE) set by PUCs play a major role in utility earnings growth.
Exhibit 5 State PUC Regulatory Rankings
Source: Regulatory Research Associates (Part of S&P Global Market Intelligence SPGMI)
ROEs Constructive (Higher Equity Ratios) Relative to Interest Rates
In the first quarter of 2023, the median ROE authorized in all electric utility rate cases was 9.68%, versus 9.50% in full-year 2022; for gas utilities, the metric was 9.60% in both the first quarter of 2023 and full-year 2022. In recent quarters, utility allowed ROEs have begun to rise (albeit modestly), after declining over the past 30 years as U.S. Treasury yields declined. The spread between the allowed-ROE and the 10-year U.S. Treasury yield is currently 600-basis points, and it has ranged between 600-900 basis points over the past few years. During the 1990s, the utility sector averaged a roughly 400-600 basis points spread. Given the dramatic rise in interest rates, we expect allowed ROEs to rise but note that PUCs historically have taken a gradual and measured approach to changes in authorized ROE levels.
Exhibit 6
Political Support for Clean Energy (AKA, Rate Base Growth)
The global and US economy is in the early stages of a long-term power transformation. Many US states (29) have set renewable energy standards, including 22 with 100% clean energy targets. The more aggressive include Rhode Island (2030), D.C. (2032), Connecticut (2040), Minnesota (2040), New York (2040), Oregon (2040), California (2045), Hawaii (2045), New Mexico (2045), and Washington (2045). Please see Exhibit 7.
Exhibit 7 States With 100% Renewable Commitments
Source: EIA, Census Data, Clean Energy States Alliance
All of the US electric and gas utilities target ambitious carbon reductions and renewable energy standards, and publish sustainability reports. Many call for carbon neutrality by 2050, and 100% renewable energy by 2035-2040. Further, many major investors, activists, lending institutions, political groups, and corporations are calling on all of society to make the environmental pledge.
The Great Power Transformation
In 2022, the US electric fuel mix was 40% gas, 20% coal, 18% nuclear, 20% renewable (10% wind, and 6% hydro) and 2% other, which means 60% fossil-fuel fired and 40% zero carbon. In the mid-1980s, US power generation was nearly 60% coal-fired. Over the past decade, less-efficient nuclear and gas power plants have beer retired and replaced with highly efficient natural gas plants and renewable. In 2021, the two-decade-long declining trend for coal generation (and carbon emissions) experienced a “hiccup” driven by high natural gas prices and renewable intermittency. (Exhibit 8).
Exhibit 8 Fuel Mix Changes; Coal Falls to 16% in 2022, and Gas Rises to 38%
Source: EIA
However, we expect coal’s rapid decline to continue. All new capacity will be renewable, battery-storage and/or natural gas-fired (excluding the 2.2 GWs Vogtle nuclear expansion scheduled for 2023-24). EIA’s June 2023 Energy Outlook forecasts that the 2023 fuel mix will be 23% renewable energy (wind, solar, hydro, and battery storage) and 24% in 2024, while coal declines to 16% in 2023 and 2024. U.S. natural gas generation will average 41% in 2023 and 39% in 2024. In 2023, wind, solar and battery storage account for 82% of the new, utility-scale generating capacity. (EIA June Update).
Table 7 Proposed New Power Capacity Additions
As of January 2023, the US currently had ~1,200 GWs of power capacity, including 215 GWs of renewables (74 GWs of utility-scale solar and 141 GW of wind capacity (12%). According to EEI (April 2023), developers plan to add 478 GWs of capacity over 2023-2027, including 228 GWs of solar, 104 GWs of wind and 101 GWs of storage. Over the same period, EEI projects 102 GWs of capacity retirements (42 GWs of coal, 40 GWs of gas, and 16 GWs of oil).
De-carbonization of the US Economy Requires $4 Trillion of Capital Investment
To achieve the ambitious goals of 100% renewable power and a net-zero carbon economy requires 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 GW of new wind and solar generation and a nearly doubling of high voltage transmission (HVT). NextEra Energy (NEE) forecasts that de-carbonization of US economy by 2050 would require $4 trillion of investment in clean energy infrastructure.
· According to NEE, de-carbonization of the US power sector requires the addition of 3,550 GWs of wind, solar and storage at a cost of $2 trillion.
· Over 2022-2025, NEE forecasts the demand for 160-GWs of US renewables, which includes 30-50 GWs per year. Over 2026-2030, the US requires 70-100 GWs per annum and 100-140 GWs per annum over 2031-2035.
· Full de-carbonization of the US economy requires another $2 trillion investment including in the transportation, industrial and agricultural sectors through electrification and low-carbon fuels largely being powered by renewables.
Renewable development challenges include 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.
Renewable Development Costs Are Now Economical and Represent Rate Base Growth
Regardless of policy incentives, utilities benefit from adding renewable generation due to cost declines that have made new wind and solar generation more economical than older fossil-fired and nuclear generation. We highlight Lazard’s April 2023) Levelized Cost of Energy Study (LCOE) , which reinforces previous conclusions that renewables are cost competitive and fossil fuel generation should continue to be replaced by renewables. The Lazard study does note that diversity of fuel mix improves reliability and the recent increases in inflation, interest rates and supply chain resulted in negative impacts to renewable development costs. The Lazard LCOE for unsubsidized and subsidized (IRA tax credits are highlighted in Exhibits 9 and 10).
Exhibit 9 Declining Renewable Costs Relative to Other Fuel Types
IRA’s investment tax credits (ITCs) and production tax credits (PTCs) make renewable generation even more competitive. IRA solidified, expanded and extended 30%- ITCs and 2.6 cent PTCs for existing wind (on-shore and offshore) and solar generation and established new credits for nuclear, geothermal, storage, carbon capture, hydrogen as well as others. The ITCs can be increased to 40% based on domestic content and certain other conditions. The credits are in place for at least ten years and phase out in 2032 but only if electric sector emissions fall by 75% compared to 2022 levels. Further, the credits are marketable and can be bought and sold, which simplifies the previous complex tax-equity structures.
Exhibit 10
In addition, NEE estimates of the economics of power generation by fuel type. At $4.50/MMBtu gas, wind is the most economical at $25-32/MWh; followed by solar ($30-37/MWh), existing gas ($35-47 MWh), existing nuclear ($34-49/MWh), existing coal (443-74/MWh), and new gas combined cycle ($56-69 MWh).
US Wind Capacity to Accelerate With Offshore Development
Offshore wind is becoming an increasingly important form of renewable generation primarily due to geography and NIMBY limitations as well as improved economics. Offshore wind is a key element to many European and Asian nations clean energy strategies and is expected to play a major role in the US Northeast. The US has laid out plans to achieve 30 GWs of operating offshore wind capacity by 2030. More aggressive state offshore wind targets are New York at 9 GWs by 2035, North Carolina at 8 GWs by 2040, and New Jersey at 7.5 GWs by 2035. Other states with requirements include Connecticut (2 GWs), Massachusetts (4 GWs), Maryland, and Virginia. The California Coast has deeper water and targets 3 GWs of floating offshore wind by 2030.
There are currently numerous proposed projects along the Northeast Coast in advanced stages of development, totaling over 16 GWs, and another 16 GW’s in early development. The largest is the 2.4-GW Beacon Offshore Wind Project (Equinor and BP PLC) off the coast of MA. There are two major projects (Vineyard Wind and South Fork) under construction. In September 2022, AGR and Copenhagen Infrastructure Partners (CIP) began construction of Vineyard Wind I (VW1; 800 MWs) with COD expected in 2024 (Table 11).
However, the business of offshore wind development appears more appropriate for large oil and gas companies and faces the challenges of long development and approval processes. The 2022-23 interest rates and inflation have hampered expected returns. AGR is attempting to restructure a contract with the state of Massachusetts for its 1,200-MW Commonwealth project given rising costs associated with inflation and interest rates.ES expects to complete the strategic review (announced May 4, 2022) of its offshore wind program, which includes the potential sale of all or part of its 50% interest in JV with Orsted, by year-end 2022. The JV includes three contracted projects totaling 1,758 MWs, and 175,000 acres available for development. The projects are located on the same 250-square mile tract: 30-miles east of Long Island’s Montauk Point.
Table 8 Offshore Wind Project Development (Major Global Players and Oil Co’s)
Adding Wind and Solar is Not Enough; Battery Storage is the Key to Aggressive Renewable Goals.
Carbon reduction targets will require not only significant investment, but technological breakthroughs in batteries, green hydrogen, carbon sequestration and fuel cells. We see the potential for the US natural gas industry to reinvent itself using green hydrogen, renewable natural gas, and carbon capture. Existing infrastructure can be upgraded to blend hydrogen and RNG with natural gas in increasingly higher levels.
· Battery Storage: According to EEI, 74 GWs of storage capacity is expected to come online from 2023-2027 (previous forecast was 56 GWs over 2022-2026). In 2023 US utility-scale battery storage totaled just over 9 GWs (near-zero in 2019). Over the long term, we expect widespread utility-scale battery usage and growing efficiencies as larger batteries piggyback the auto industry. The IRA now offers stand-alone storage credits and existing wind and solar projects can be retrofitted to include new utility-scale batteries.
Exhibit 11 Rapid Utility Scale Battery Storage Growth
· Renewable Natural Gas (RNG) is a pipeline quality gas captured from dairies, animal/food waste, wastewater treatment plants, and landfills. Most natural gas utilities are investing in RNG and requesting PUC permission to blend with existing natural gas supply to serve customers. In addition, many are investing in non-regulated RNG production. According to the American Gas Association (AGA), the US currently operates 189 RNG production facilities, and there are 146 under current construction, along with 96 planned for future construction. RNG can be compressed (CNG) for truck and bus vehicle fleets and for liquefied natural gas (LNG).
· Green Hydrogen: Hydrogen can be used as a zero-carbon fuel in hydrogen-compatible turbines to produce electricity, power fuel cells to drive passenger vehicles, heavy-duty trucks, ships and even airplanes, and to heat and light buildings. Importantly, hydrogen can be blended with natural gas and transported through existing gas infrastructure. Hydrogen technology appears to be a promising pathway to enabling longer-term storage of renewable power and decarbonizing industry and transportation. The November 2021 Infrastructure Investment and Jobs Act allocates $8 billion over five years for the DOE to develop clean hydrogen hubs, a network of regional suppliers and consumers, and the infrastructure necessary to connect them. IRA provides a $3/kg hydrogen credit and the 2021 bill allocates $1 billion for a program to improve and reduce the costs of electrolysis.
· Carbon Capture Utilization and Storage (CCUS) directly reduces emissions and removes CO2. CCUS technologies will play an important role in meeting net zero targets, including natural gas pipelines, midstream and power generation, as well as heavy industry. Major oil companies like Exxon, Chevron, Marathon, Dow, and Phillips 66 among others are investing heavily, which could make technologies economically viable.
Electrification Means Strong Electric Demand Growth
Ambitious de-carbonization plans mean society “electrifies everything” or converts residential, industrial, commercial, and transportation energy use to electric because electricity is the only quickly decarbonizing, widely available and scalable fuel option. In 2022, US electric output rose 2.8% to 4.1 million GWhs, which is a record annual high. Electric vehicle (EV) adoption represents the first major catalyst to power demand since air conditioning. There are 3 million EVs on the road today and EEI projects that there will be nearly 26 million in 2030. EEI forecasts the need for 140,000 EV fast charging ports, which would boost load by 1% annually. Further, new large load data centers are sprouting up all over the country to support the growing use of data/content/technology and artificial intelligence will further enhance growth. Other electrification opportunities include replacing natural gas heating and appliances.
FERC-Regulated Transmission
The net-zero goals also mean “power-grid” investment opportunities. Massive renewable development plans require an expanded transmission and distribution system. In 2022, EEI member utilities invested $31.7 billion in electric transmission compared with $29.7 billion in 2021. Over the next few years, we expect FERC to solidify numerous policy directives and incentives, including ROE methodology, transmission planning and the interconnect process, as well as the need to alleviate the clean energy logjam, and gas pipelines. In mid-2022, the Midwest Independent System Operator (MISO) approved Tranche 1 of its $100 billion long-term planning projects, which included 18 transmission projects, totaling $10.3 billion and spanning IA, IL, IN, MI, MN, MO and WI. Winning bidders, included:
– Ameren (AEE) ($1.7-1.8 billion)
– Fortis (FTS )$1.0-1.5 billion
– WEC Energy Group ($800 million)
– XEL ($1-2 billion)
The projects are expected to be in service in 2028 – 2030. LRTP projects are significant because they will help accommodate the influx of renewables needed to meet state and utility clean energy goals.
Corporate Strategies Simplifying, Transforming, and “Greening”
Since 1995, the US electric utility sector has experienced over 145 acquisition announcements and over 120 completed deals. From 2016-2020, 23 deals were announced. Merger activity declined during the pandemic-impaired 2020-21 COVID-19 era. In 2022, five “whole” company mergers closed, including Hawaii Gas (Argo Infrastructure), Centerpoint’s Arkansas and Oklahoma gas utility subsidiaries (sold to Summit Utilities), Narragansett Electric (PPL Corp), Corning Gas (Argo Infrastructure), and Dominion’s WV gas utility (Ullico). On February 1, 2023, by Infrastructure Investment closed on the acquisition of South Jersey Industries (SJI) was acquired for $8.1 billion in enterprise value, or $36.00 per share. The price represented a 53% premium and a 21.7X P/E multiple on consensus 2022 earnings and ~15X EV/EBITDA multiple.
One deal was terminated. On April 17, 2023, AEP and Algonquin (AQN) announced a mutual agreement to terminate the Kentucky Power transaction. AEP had initially announced the sale of its Kentucky assets in October 2021 and revised the agreement in September 2022 to total $2.646 billion in enterprise value (estimated $1.2 billion debt). In December of 2022, FERC denied the sale.
The pending Avangrid acquisition of PNM Resources (PNM) continues to drag on. On June 20, 2023, they extended the merger agreement through December 31, 2023, with a six-month option. The extension comes after the New Mexico Supreme Court rejected the parties’ request to remand the merger case back to the PRC for reconsideration. On October 21, 2020, AGR agreed to buy PNM for an enterprise value of $8.3 billion, or $50.30 per share.
The electric and gas utility sector remains fragmented and we expect ongoing consolidation.
Table 9 Recent Utilities Transactions
Another ongoing theme is simplification and focus on the core business. Over the past few years, many utilities have restructured, including sales of fossil generation assets, natural gas midstream operations, international operations, and non-utility subsidiaries, and the spin-off of competitive generation. Some have been the subject of activists including Jeff Ubben through Value Act and Inclusive Capital, Elliott Management (EVRG and NRG), Bluescape (EVRG), and Carl Icahn (First Energy and Southwest Gas). More recently, private infrastructure funds and investors, have taken advantage of the opportunity by buying gas utilities and gas infrastructure.
– On June 20, 2023, NiSource (NI-27.38) reached agreement with Blackstone’s dedicated Infrastructure group to sell a 19.9% equity interest in NIPSCO for $2.150 billion. NIPSCO is Indiana’s largest vertically integrated electric and gas distribution company with 1.3 million customers. The transaction implies an equity value of $10.8 billion and enterprise value of $14.3 billion for 100% of NIPSCO. Other NI highlighted multiples: 32.5x LTM P/E and 1.85 x rate base ($4.9 billion electric and $2.0 billion gas). Close by the end of 2023. NI to sell 19.9% of NIPSCO.
– On June 12, 2023, Duke reached an agreement Renewables business (3,400 MWs) to Brookfield Renewable for $2.8 billion, with net proceeds of $1.1 billion to strengthen its balance sheet and avoid additional holding company debt issuances.
– On June 1, 2023, NRG agreed to sell its 44% stake in the 2,645 MW nuclear plant to Constellation Energy for $1.75 billion. The price implies 11.7x EV/EBITDA. Transaction to close by end of 2023 subject to NRC and PUCT. Proceeds to be used to buy back shares. Authorized an additional $650 million bringing total to $1 billion.
– On May 15, 2023, Elliott announced that it sent a letter and presentation to NRG’s Board outlining a clear path to shareholder value after meaningful under-performance. Elliott claims to own 13% of shares. Elliott seeks (1) to add new independent board members, (2) push for $500M of cost reductions, (3) conduct a strategic review of the home services strategy including Vivint, and shift to returning at least 80% of FCF to shareholders vs. NRG’s target of 50%
– On May 30, 2023, US debt ceiling agreement cleared a path to complete $6.6 billion Mountain Valley Pipeline (MVP). MVP is a FERC-regulated 300-mile gas pipeline system running from northwestern West Virginia to southern Virginia designed to bring Marcellus and Utica gas to the Mid- and South Atlantic regions. MVP received its FERC CPCN in October 13, 2017 and began construction began in 2018 after with an estimated cost of $3.5 billion. By spring 2021, total project work for MVP was roughly 92% complete. The project has faced challenges, starts and stops as opponents litigate previously authorized and issued permits. The project is 94% COMPLETE. Equitrans (ETRN-6.09) 48.5% NextEra Energy (NEE-73.92) 31% Consolidated Edison (ED-92.69) 12.5% AltaGAs (ALA-23.68-TSE) 7% RGC Resources (RGCO-18.91)1%
– On May 25, 2023, EverSource (ES) agreed to sell its offshore land lease and expects winning bids for its 50% interest in three offshore wind projects (South Fork Wind, Revolution Wind, and Sunrise Wind) totaling 1,758 MW by the end of June 2023. The $625 million ($7,100/acre) price tag was lower than we had anticipated, but removes construction/inflation risk of the large capital projects. ES announced that it expects to complete the strategic review (announced May 4, 2022) of its offshore wind program, which includes the potential sale of all or part of its 50% interest in JV with Orsted, by year-end 2022. The JV includes three contracted projects totaling 1,758 MWs, and 175,000 acres available for development. The projects are located on the same 250-square mile tract; 30-miles east of Long Island’s Montauk Point.
– On March 6, 2023, Vistra Energy (VST) announced a transaction to buy Energy Harbor’s nuclear (4.0 GW’s, including Beaver Valley 1 and 2, Perry, and Davis Besse) and retail businesses for $3.4 billion and combine to form “Vistra Vision” (VV). Vistra will own a controlling 85% ownership interest in Vistra Vision; Nuveen and Avenue Capital will own the remaining 15%. VV will include 6.4 GW of nuclear generation, ~5 million retail customers, and ~2.4 GW of online and near-term pipeline of renewable and storage assets. The transaction is expected to close in the second half of 2023.
– On March 1, 2023, Consolidated Edison sold its Clean Energy Businesses (4 GWs of renewables) to RWE Renewables Americas for $6.8 billion.
– On February 22, American Electric Power (AEP) agreed to sell its 1,365-megawatt (MW) unregulated, portfolio to IRG Acquisition Holdings, a partnership owned by Invenergy, CDPQ and funds managed by Blackstone Infrastructure, at an enterprise value of $1.5 billion including project debt.
– On December 15, 2022, Southwest Gas (SWX) announced plans to sell 100% of its Mountainwest Pipeline (MW) to Williams (WMB) for $1.5 billion in total enterprise value (8x EV to $188 million 2023 EBITDA) and spin-off non-regulated Centuri to existing shareholders. Upon completion of both transactions, SWX would be a fully regulated gas utility operating in AZ, CA and NV. The transaction is expected to close in 2023. Icahn was influential in getting four (of 11) new board members and lobbying for the sale of MW.
Utility Valuations Reasonable Relative to Interest Rates Valuation Multiples
Over the past twenty years, electric utility multiples climbed from roughly 10x forward earnings to over 23x, driven by improving fundamentals and higher growth rates (Exhibit 12). Electric utilities trade at 16.5x consensus 2023 earnings estimates which is modestly above the historical median. We consider the multiple reasonable considering higher utility earning growth rates and strong fundamentals.
Exhibit 12 Absolute P/E Multiple Range
Source: Thomson One, Company documents, Gabelli Funds estimates
Given that long-term interest rates (specifically the 10-year and 30-year Treasury yields) have risen dramatically to nearly 4.0% following a long-term secular decline since the late 1980s, 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 13, the current ratio of 176% indicates the sector P/E is in line with its historical relationship with the 10-Year T-Bond Yield.
Exhibit 13 Utility Earnings Yield as a Percent of 10-Year T-Bond Yield
Source: Thomson One, Company documents, Gabelli Funds estimates
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. 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 5.4% 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 2022, electric utilities increased the annual dividend by a median of 5.1%.
· 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.
Conclusion
The utility sector offers a 3.7% current return and many utility managements target 5-7% annual earnings and dividend growth. The utility business model represents a safe-haven in the face of recession and/or inflation fears. In addition, the transformation of the utility sector from fossil fuel-fired to renewables provides the environment for strong annual earnings and dividend growth. We believe that the combination of strong utility fundamentals, and the potential for escalating geopolitical volatility and/or domestic economic slow-down bode well for the relative performance of utilities.
Table 10 Ranking of 2022 Average Price To Ultimate Customers (c/kWh)
Source: S&P Global Market Intelligence
Appendix 1: Large, Small/Mid Cap & Canadian Utilities Select Statistics
Appendix 2: Clean, Independent Power, Gas & Water Selected Statistics
IMPORTANT DISCLOSURES
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 represents 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 investment advice. The views expressed may differ from other Research Analysts or of the Firm as a whole.
As of March 31, 2023, affiliates of GAMCO Investors, Inc. beneficially owned 3.98% of National Fuel Gas, 3.42% of PNM Resources, 2.84% of Southwest Gas, 2.51% of Otter Tail, 1.53% of York Water, 1.38% of Northwestern Corporation, 1.37% of Northwest Natural, 1.12% of Black Hills, 1.10 of MGE Energy, 1.05% of RGC Resources, 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
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