Morningstar Advisor - October/November 2013 - (Page 69)

Rating for stocks, setting the screen for companies with at least a 4- or 5-star rating. A number of components drive this score, including our estimate of the stock’s intrinsic value based discounted cash flows and how attractive its discount is to current market prices. The score also incorporates the margin of safety bands we apply to our fair value estimate. Firms trading below our consider-buying prices receive our highest rating of 5 stars. And Dividend Yield % TTM > 4% Finally, we screened for firms with dividend yields of at least 4%. Regulated utilities can pay out upwards of 60% to 70% of their earnings, which is what their shareholder base prefers given that they are relatively defensive firms with predictable cash flows. The average dividend yield for utilities currently sits at 4%, which remains as attractive as it has been for more than 20 years relative to 2% U.S. Treasury rates. Utilities have a distinct relationship with interest rates, as low interest rates lead regulators to cut allowable returns to offset favorable financing costs and low inflation. Conversely, rising interest rates raise the cost of equity, increasing regulatory lag as allowed returns trail rising costs of capital. We ran this screen in August using Morningstar Office. Here are some of the results. Exelon Corp EXC Considering Exelon’s full suite of businesses, we think its position as the leading nuclear power producer in the United States makes it the only utility with a wide economic moat. All nuclear operators have two primary competitive advantages. First, nuclear plants take more than seven years to site and build, cost several billion dollars, and typically face community opposition. These are significant barriers to entry, giving operators an effective low-cost monopoly in a given region. In addition, Exelon’s large fleet gives it scale advantages that allow it to add capacity at a fraction of the cost of a greenfield project. Second, no other reliable power generation source can match the cost or scale of a nuclear plant. Nuclear plants’ low variable costs and low greenhouse gas emissions relative to competing fossil-fuel sources such as coal and natural gas reduce substitution threats. As long as electricity remains a critical energy source in the U.S., nuclear plants will maintain a substantial low-cost advantage and generate high returns on capital. We believe Exelon’s regulated distribution utilities deserve narrow moats. Regulatory caps on profits offsets the service territory monopolies and network efficient scale advantages. Utility regulation in the United States aims to fix customer rates at levels that ensure capital providers earn fair returns on their investments while keeping customer costs as low as possible. We believe this regulatory compact ensures Exelon’s utilities will earn at least their costs of capital in the long run. of its sensitivity to commodity prices, we consider nuclear generation to have a wide economic moat as it is the lowest-cost, most reliable power source in the region. Existing nuclear plants face virtually no substitution threat because no other power generation source can match the cost or scale of an existing nuclear plant. Additionally, high capital costs are a significant barrier to entry for new nuclear plant developers. E.ON SE EONGY E.ON’s worldwide mix of regulated utility operations, merchant power plants, and other energy operations maintain solid market positions but remain subject to commodity price volatility and potential entrants. Regulated utilities in Europe maintain narrow moats because of the implicit contract between regulators and capital providers that seeks to maximize investor returns while minimizing customer rates. E.ON’s merchant energy operations have weaker economic moats because of their sensitivity to worldwide commodity markets. However, many of E.ON’s merchant energy assets have low-cost profiles and entrenched geographic advantages that contribute to its narrow economic moat. PPL PPL CPFL Energia SA CPL We think PPL’s regulated utilities and low-cost merchant power generation combine to give it a narrow economic moat. PPL’s utilities own a difficult-to-replicate network of regulated power generation, transmission, and distribution assets. In exchange for its monopoly position, regulators set PPL’s returns at levels that aim to keep customer costs low while providing adequate returns for capital providers. This implicit contract between regulators and the utility should, in the long run, allow PPL to earn its cost of capital. We believe CPFL Energia CPL, Brazil’s largest private power distributor, offers an attractive means for risk-tolerant investors to benefit from the country’s economic growth prospects. During the next decade, forecasts suggest that consumer electricity demand in Brazil will grow 5% annually. CPFL Energia is well positioned to capture this growth. We also expect Brazil’s regulatory structure will allow it to maintain an economic moat through this growth period. On a constant-currency basis, we would be buyers at $15 per share, given the high uncertainty in the Brazilian real exchange rate and higher political and economic risk than U.S. peers. PPL Supply owns a merchant generation fleet with a mix of fossil fuel and nuclear power plants that make it one of the lowest-cost power providers in the Eastern United States. Although we consider fossil fuel generation to be a no-moat business because John Zecy is an associate equity analyst with Morningtar. 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Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2013

Morningstar Advisor - October/November 2013
Contents
Contributors
Letter From the Editor
How to Make Social Media Work for You
Do Mutual Funds Still Have a Role?
More Personal Than Finance
How to Handle Your TIPS Positions
A Real Estate Veteran Starts From Scratch
Investments á la Carte
Investment Briefs
When to Say No
Take a Guarded Approach to Homebuilders
Fund Distribution Has Been Turned on Its Head. Now What?
Winning the Distribution Battle
Active ETFs Wait for Their Heyday
A Fund Firm Defies Indexing Trend
Piloting New Channels
A Good Fit
The Predictive Power of Fair Value Estimates
Does Being Prudent Pay Off?
Utilizing Utilities’ Total Return
Stuck in the Middle Is Not a Bad Place to Be
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Good Guys Win

Morningstar Advisor - October/November 2013