Morningstar - Q3 2020 - 66

Investors

Bright Horizon for Utilities
Demand is down, but renewable energy
should drive long-term growth.

SECTOR RAP

Laura Lallos

Utilities are traditionally a safe haven in
tumultuous times, but they whipsawed with the
rest of the market when the coronavirus hit
earlier this year. Volatility created buying
opportunities in a sector that had been largely
overvalued for years. While many names had
rebounded by the end of May, attractive options
remained for both long-term growth and
income-oriented investors.
In a recent report,1 Morningstar analysts
identified three critical investment themes for the
sector: valuations, capital investment, and
renewable energy. I spoke with co-author Travis
Miller on June 1; our conversation reflects
valuations as of that date.
Laura Lallos: Why was the utilities sector hit hard
by the coronavirus?
Travis Miller, equity strategist with
Morningstar Research Services.

Miller: There's a lot of uncertainty around energy
use in the new world of people working from
home and at least near-term business disruptions.
Investors are trying to make sense of what
that means for utilities. As with other industries,
the pandemic and the resulting impacts really
have not been seen before since the modern era of
utilities began. We typically consider it a big

move if electricity demand is up or down by 2% in
a year, and what we saw in March, April, and
May was upward of 5% to 10% swings in demand.
We're seeing big declines in commercial and
industrial demand, which is not much of a surprise
when shops and factories are shutting down
temporarily. But on the other side, we're seeing a
big increase in residential demand as more
people use electronic devices at home, keep the
lights on longer, and run the air conditioning
throughout the day. The declines in commercial/
industrial use are outpacing the increase
in residential demand such that total electricity
demand is down between 3% and 5% for
most utilities.
Lallos: What about the issue of residential customers

being unable to pay their bills?

Miller: All U.S. utilities, very early on, decided
as a group that they would not initiate any
shutoffs as long as this crisis continued. So, no
one is at risk of losing their utility services, which
means that utilities are bearing any kind of
financial implications of customers not paying bills.
It's something we're going to watch over the
coming months. If there's any good side of
this for utilities, it's that the crisis emerged during
the spring, when customer bills are the lowest
because many people are running neither their
heat nor their air conditioning because the
temperatures are mild. We're going to have a more
dire situation if customers are still struggling
economically when we get to the summer
months, such as July and August, when bills tend
to peak because more people are using air
conditioning, primarily.

1 Bischof, A., Miller, T., & Fishman, C. 2020. "U.S. Utilities in a Post-Pandemic World." Morningstar Select Presentation, June 2.

Morningstar Q3 2020

Lallos: Do you think this change in demand might
persist, that there may be structural changes in how
some industries operate?

Miller: Morningstar's macroeconomic analyst,
Preston Caldwell, has suggested that GDP
would take a near-term hit, but he expects a
relatively mild long-term hit to growth.
I think you'll see a similar impact for energy use.
I think you will see a sustained increase in
residential demand, which had been falling for
the last several years, due to energy efficiency,
primarily. But you also might see a continued
decline in industrial demand, if factories find ways
to be more efficient, or if there is consolidation
in the commercial and industrial sectors.
You might see a firmer trajectory for residential
demand and still quite a bit of uncertainty on
the commercial/industrial side.
Lallos: What is Morningstar's demand forecast?

Miller: On the electricity side, we think the
U.S. long-term average growth rate for electricity
will be a little more than 1 percentage point
per year. That's fairly bullish versus what we've
seen in recent years as energy efficiency cut
into core demand growth. Our bullish thesis is that
there are new use cases for electricity that
we haven't seen in the recent past. That includes
electric vehicles. It also includes growth in
the energy-intensive cannabis market and an
increase in data center energy needs. Those three
alone contribute a material amount of annual
growth. But they also are somewhat at risk
in a slower-growing economy, so we're watching
some of those emerging energy demand sources
very closely.
Lallos: There haven't been many valuation

opportunities in utilities in recent years; how does
the sector look today?

Miller: Valuation is such an intrinsic part of
investing, but utilities investors had paid
very little attention to valuation over the last three
years. Valuations had reached record highs
and just continued to climb as investors sought
yield and felt that the sector had no substantial
risk around it. That obviously changed.
Utilities as a sector went from 22% overvalued

Morningstar - Q3 2020

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