Morningstar - Q3 2020 - 67

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in late February to 25% undervalued by late March.
They've since rebounded to about fairly valued,
based on our fair value estimates.
This atypical volatility in the sector means
that there are both buying and selling
opportunities when the market gets overheated.
The excessive valuations that have come
on both ends in February through April show that
it's important to watch for extremely high and
extremely low valuations, even for utilities.
We do think the sector is about fairly valued
right now, but some of our top picks are
still trading at 20% discounts to fair value and
haven't recovered much from late March.
One of those is Edison International EIX. Investors
have soured on this Southern California utility,
fearing it could face the same wildfire risks and
political animosity that sent its northern neighbor
PG&E PCG into bankruptcy. However, Edison's
situation is much different. It operates in an area
with low fire risk, it has a strong balance sheet,
regulators generally support its investment
plan, and political changes in the state following
the PG&E bankruptcy have reduced legal risk.
The biggest opportunity is growth investment
to support California's move toward 100%
renewable energy, electric vehicles, and energy
storage. That's going to drive substantial
earnings and dividend growth that we think the
market does not appreciate right now.
Another one we like is AES AES. It's going to be
one of the largest renewable energy developers
for its size in the U.S., and that's where we
think there are very good returns right now in the
energy market. It had widespread international
operations for a long time, but the current
management group has pulled that back, and we
expect half of its earnings will come from the
U.S. by 2024. That combination of lower-risk
operations, reduced currency risk, and renewable
energy growth makes it a good investment at
the price where it trades right now.
Duke Energy DUK is one of the traditional grandma
stocks in the utilities sector. It has substantial
investment opportunities in natural gas service
and in renewable energy. The market isn't pricing
in the growth potential. In the near term, it's

SCA N T R I GGE R
LAU NCH COM PANI ON V I DE O

going to be slower growing than most of the other
utilities as it ramps up these long-term
investments, but I think investors will be happy
with the returns they get from growth over
the next five to 10 years. And it trades at over a 4%
yield, which is very attractive for the industry
right now. It's more than double the S&P 500 yield.
Lallos: Why do you see capital investment as a key
theme for the sector?

Miller: We think utilities will invest upward
of $700 billion over the next five years in
the U.S., primarily in renewable energy and the
infrastructure that supports renewable energy.
Almost all states have some kind of renewable
energy target that is policy-based, so regardless
of how the economics trend in the renewable
energy industry, utilities are going to have
to invest billions of dollars in it. This is going to be
a 10- to 15-year runway, so utilities have a lot
of transparent earnings growth potential.

Even the utilities that aren't investing directly in
renewable energy have a lot of investment
to incorporate renewable energy into the overall
energy system. The sun doesn't shine and the
wind doesn't blow all of the time, and that creates
the need for investments in a system that
typically depends on electricity being available
from power plants anytime.
Lallos: Is there a risk that these public policy targets
might be weakened in this economic environment?

Miller: The economy certainly is a risk in any
policy decision, but we're seeing that renewable
energy can lower customer bills in many parts
of the country. I have very high confidence that
the existing renewable energy standards
that states have passed aren't going to change
that much.

We're watching New York and California closest,
where policymakers are aiming for 100%
renewable energy. It's going to take incredible
amounts of network infrastructure investment to
get to that point, and that's going to affect
customer bills more than the actual renewable
energy cost. It's going to take an incredible
amount of investment in the distribution system
and the transmission system to be able to
handle a fully renewable energy or no-carbon

energy mix. California and New York are going to
be big test cases in terms of whether they can
get to an exceptionally high penetration of
renewable energy without raising customer bills
to unsustainable levels.
Lallos: What companies aren't well positioned in
this environment?

Miller: For utilities to turn investment into
earnings, they must have constructive partnerships
with regulators and policymakers. That can vary
by utility and by state. The utilities that we
think are going to lag the rest of the industry are
ones that face bigger challenges from regulators
and politicians.

We think there's a lot of regulatory risk and
growth risk in companies like Consolidated Edison
ED, which is the primary utility serving New
York City. It has a substantial investment mandate,
yet New York regulators have been historically
quite tough in terms of limiting returns for
investors and monitoring customer bill increases.
Evergy EVRG is also one we're watching
closely. Historically, the Missouri and Kansas
territories that it serves have not been
very friendly to investors. As it goes into investing
in renewable energy in that area, and
the infrastructure to support renewable energy,
it's going to have to improve its partnership
with regulators.
Xcel Energy XEL is different; this is a valuation
concern. It is going to be a leading renewable
energy developer and has strong regulatory
support, but the market is much more excited
about the company than we think it deserves
relative to its peers. It currently trades at
24 times this year's earnings, and that's almost
30% higher than the median of the rest of
its peers in the U.S.

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