Morningstar Magazine - August/September 2018 - 66

Investors

Value and Income
Utilities offer a range of opportunities.

SECTOR RAP

Laura Lallos

Morningstar's summer 2018 utilities outlook
revealed some opportunities. For the first time in
about three years, U.S. utilities were fairly
valued by Morningstar measures-after being
almost 20% overvalued just late last year.
I spoke with strategist Travis Miller about the
economic, political, and secular backdrop
for the sector. We also discussed our analysts' top
defensive picks and value plays.
The discussion has been edited for length and
clarity. Our conversation took place June 5, and
valuation data is as of that date.
Laura Lallos: What's driven the change in
utility valuations?
Travis Miller is a strategist with
Morningstar Research Services.

to hold utilities for a long time, through many
interest-rate cycles. Granted, utilities have
significantly outperformed and also lagged the S&P
500 over shorter periods of time, but on
the whole, for investors who are looking for stable
income and growth, utilities are still a good
place to be.
What are other headwinds facing the sector?

Miller: The biggest thing is slowing energy usage
growth. More-efficient lightbulbs, such as
CFLs and now LEDs, take just a fraction of the
amount of electricity that incandescent lightbulbs
do. Refrigerators, furnaces, air-conditioning
units are all becoming much more efficient, and
that is hurting the utilities that are still collecting revenue based on usage. But we're seeing
regulatory developments to create ways
that utilities can keep their profitability, their profit
margins, and their revenue growth even in this
period when their core products, electricity
and natural gas, are either flat or even declining
in some states.
What is the effect of natural gas prices?

Travis Miller: Utilities are very sensitive to interest
rates, both on a fundamental basis and on
a market basis. Look at what's happened to the
10-year Treasury: It's now up near 3%. So,
utilities have suffered, especially relative to the
S&P 500. We use a consistent interest-rate
assumption on a long-term basis. As prices of
utilities have come down relative to the rest
of the market, utilities look more attractive than
they have in a long time.
Do long-term investors need to worry about
interest rates?

Miller: If you look back since 2011, utilities have
performed almost exactly the same as the
S&P 500 in terms of total return. Investors tend

Morningstar August/September 2018

Miller: Natural gas prices have had a unique
impact on utilities. For the past decade, we've had
a substantial decline in natural gas prices,
particularly through the shale revolution in the U.S.

On the distribution side, that's created an
incentive for customers to switch over to natural
gas heating. For electric utilities, natural gas has
become more economic to use to generate
electric power than coal and even nuclear, in
some cases.
Natural gas has created an opportunity for some
states that rely on coal generation for the
economy to improve their environmental standards
and reduce emissions. Natural gas generation
has about half of the carbon emissions of a

coal plant. We're seeing environmental benefits
just through pure economics with cheap
natural gas.
The current administration is increasingly
adamant about encouraging or even
forcing use of coal. Will that affect demand for
natural gas?

Miller: It makes good headlines. Renewable
energy and gas generation made good headlines
for the previous administration, and now coal
and nuclear make good headlines for the current
administration. But the fact of the matter
is that economics will trump environmental issues
in any kind of regulation, whether it's at the
state or federal level.

Right now, natural gas prices are just so low that
it's by far more economic to run natural gas
plants than coal. Nuclear is kind of in between.
Nuclear has some very good fundamental benefits.
Once you put enriched uranium into a nuclear
plant, it can run for 18 months or more
without any additional fuel. A natural gas plant
requires access to gas through a pipeline,
and coal plants must have supply available on-site.
Nuclear is a unique type of generation-
and yet it's still more costly to run than natural
gas generation.
What are the prospects for nuclear?

Miller: The current administration is trying
to promote nuclear's reliability benefits.
New York, Illinois, and New Jersey have decided
to effectively subsidize their nuclear plants.
Those are states where the nuclear plants were
suffering the most economically.

The key thing here is economics and also the
economy within local areas. The nuclear
industry is a large employer, particularly of highly
skilled workers. So, we've seen a lot of
local momentum behind saving nuclear plants
even though the economics might be bad,
and even though there are environmental issues
in terms of waste fuel disposal.
Apart from one new nuclear plant under
construction in Georgia, new nuclear plants are
not in any utilities' plans right now. The efforts
right now are just to save the existing fleet.

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