In 2021, the S&P 500 Utilities Index (SPU) returned a strong 17.7% (including dividends) compared to an even stronger 28.7% return from the S&P 500. We attribute the relative under-performance to investor “fear of missing out (FOMO)” on the ongoing raging bull market and to a lesser degree inflation fears, higher gas prices, and higher interest rates (ten-year treasury yield to 1.5%, from 0.9%). Since the bottom of the 2020 Covid crash (March 23, 2020), the SPU has returned 69% compared to 119% return for the S&P 500. While utilities have not kept pace with the broader market, the sector delivered a solid three-year annualized total return of 14.3%, which reflects healthy financial results, strong earnings outlook and improving ESG profiles. See Table 1 and Exhibit 1 for recent and historical performance.
Table 1 Utilities Over the Past Several Periods
Appraisal: Net-Zero Carbon Targets to Drive Utility Earnings Growth
Importantly, the outlook for utility earnings and dividend growth remains strong for the foreseeable future driven by ongoing infrastructure investment. We expect favorable political and regulatory support for clean energy and storm resilience infrastructure investment. The US administration as well as most global governments promote clean energy and its associated infrastructure, including 100% renewable power and reduced carbon footprints. Our top 10 Reasons to consider utility stocks are outlined below:
1) 2019-2021 underperformance (see Table 1)
2) Competitive current return of 3.3% compared to the 10-year treasury yield of 1.5%.
3) Above-average rate base, earnings and dividend growth potential
4) Electrification to enhance electric demand (Electric vehicle charging stations, heat pumps)
5) Renewable and net-zero carbon standards create long runway of rate base investment
6) Defensive profile during a possibly weak economy and minimal COVID impacts
7) Improving ESG profiles (great power transformation)
8) Financial engineering, including ongoing consolidation and simplification
9) Potential for Build Back Better Bill includes numerous clean energy tax credits
Exhibit 1 S&P 500 Utilities and S&P 500 2021 Performance
Source: Public data
Recent Performance and Valuation
The SPU’s 17.7% total return was aided by a 23% return from NextEra Energy (NEE), which represents 18% of the index (NEE’s three-year total return was 129%). In addition, the ten largest utilities represent 64% of the index. The median electric utility returned 16.8%, including large-cap electric utility median return of 13.6% and SMID cap of 19.6%. After an unusual 2020 where clean energy stocks and large-cap utilities rose significantly while gas utility and energy-related stocks fell, 2021 saw a modest reversal with clean energy stocks declining and energy rebounding. Please see the appendix on pages 21-23 for more complete financial metrics of our utility universe.
Electric utility valuation multiples have declined from 23x forward earnings in early 2020 to 19x forward earnings 2022 estimates. Over the past twenty-five years, utility multiples have ranged between 10x and 23x forward earnings with a median of 17.1x. Large-cap and SMID capitalization electric utilities trade at similar multiples with differences reflecting growth potential and ESG profile. Given the low interest rate environment and stronger earnings potential, we believe utility stocks warrant multiples near the higher end of historical levels. See Table 2 for Utility Subgroup Metrics.
Table 2 Utility Subgroup Statistics
Top Performers; Natural Gas Stocks Rebound; Clean Energy Legislation Fails to Pass
In 2021, the top performing utility stocks, included many that were laggards in 2020 (See Table 3). Top performing Otter Tail Power (OTTR +71%; -19% in 2020) reached all-time highs driven by extraordinary supply-chain related margins at its non-regulated plastics business. First Energy (FE +41%; -34% in 2020) and Exelon (EXC +40%; -4%) benefitted from restructuring-related strategies. EXC plans to spin-off its non-regulated nuclear business and FE is reinventing itself in the aftermath of a bribery scandal as well as agreeing to sell 20% of its transmission business. Several other utilities benefitted from management changes, restructuring and activism, including Centerpoint Energy, Southwest Gas, DTE Energy and Duke Energy.
Table 3 Best and Worst Performers; (Year-Over-Year) Reversals
In 2021, gas utilities rebounded strongly with a median 24% return following a -17% decline in 2020 (Exhibit 2). National Fuel Gas (NFG; +60%, -8%) and UGI Corp (UGI +35%; -19%) benefitted from higher gas prices and improved investor sentiment. Notably, the S&P 500 Energy index rose 49% following a 37% decline in 2020. Natural gas prices rose from $3.00/MMBtu to over $6.00/MMBtu and closed the year at $3.90/MMBtu. The February 2021 extreme weather event throughout Texas and the Western US highlighted the importance of natural gas and gas infrastructure (system redundancies, supply diversity, etc.) as well as reinforced its necessity for
heating in colder regions. Societal dependence on natural gas and other fossil fuels was further highlighted by European energy shortages and price spikes over the past several months.
The future of natural gas has been under attack given zero-carbon targets, and gas utilities/midstream companies fell to discounted multiples. However, many gas utilities and midstream companies have established ESG strategies, carbon reduction targets and sustainability reports. Strategies include material methane reductions, renewable natural gas (RNG) and green and blue hydrogen. Following numerous pipeline cancellations and legislative bans on gas utilities service in several municipalities in California, New York and Colorado, at least 16 states passed legislation prohibiting the banning of natural gas. Finally, the takeout multiple of CenterPoint Energy’s (CNP’s) pending sale of its Arkansas and Oklahoma gas utilities were at significant premiums, including ~2.5X rate base and over 30X earnings, which delivered a bullish valuation marker and confirmed private equity interest in gas utility business.
Also of note in 2021, the “clean energy developer” group declined -17%, after +67% returns in 2020. (Table 3). Brookfield Renewable Energy Partners (BEP -15%; +80% in 2020) and Ormat (ORA -12%; +22% in 2020) were among the worst performers in 2021, while NextEra Energy Partners (NEP; +30%) was one of the few clean energy developers with a positive 2021 total return.
We attribute the 2021 decline to profit-taking after 2020 outperformance and disappointment that favorable clean energy legislation was not passed. The November 2021 Infrastructure Investment and Jobs Act included some clean energy benefits, but the major items are now attached to the Build Back Better bill and postponed until early 2022, including numerous tax incentives (expansions, extensions) for wind, solar, batteries, nuclear, green hydrogen, carbon capture, transmission and more. The outlook for clean energy development remains favorable and many of the elements in BBB would further enhance the outlook.
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. Canadian utilities are authorized lower ROEs and weaker capital structures than the US in Canada, but many own US utility subsidiaries.
Important Considerations for 2022 and Beyond
Investors might benefit from utilities with strong EPS growth potential based on the following characteristics: Constructive regulatory environment, affordable customer bills, economically healthy service area, customer growth, and clear path toward satisfying clean energy goals. As a guide, we have provide state PUC rankings, electric rate rankings, EPS growth outlook and ESG goals.
Originally Posted January 05, 2022 – Utilities
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 December 31, 2021, affiliates of GAMCO Investors, Inc. beneficially owned 5.09% of PNM Resources, 4.20% of National Fuel Gas, 3.14% of Southwest Gas, 2.84% of Otter Tail, 1.77% of RGC Resources, 1.70% of York Water, 1.62% of Northwest Natural, 1.60% of SJW Group, 1.0% of Black Hills, 1.0% of Hawaiian Electric and less than 1% of all other companies mentioned.
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