Morningstar - Q3 2020 - 68

Investors

Lallos: So, there would need to be another serious bout
of volatility for this to be an opportunity from a
valuation standpoint.

Miller: Yes. Several of the high-quality names that
have traded at extremely high valuations got
down to near fair value back in late March. What's
remarkable about that is that it took a 40% drop
in the sector to get a lot of these names just back
to historically normal valuation levels. There
was a brief period where a lot of the high-quality
names did look reasonable, but in April and
May, we saw them jump back up to what we think
are some pretty overheated valuations.

Utilities to Watch Here's how these promising picks were priced at the end of June.
Company

Price

Fair Value

Price/Fair Value

AES AES

$14.49

$20.00

0.72

QQQQQ

Duke Energy DUK

$79.89

$95.00

0.84

QQQQ

Edison International EIX

$54.31

$70.00

0.78

QQQQ

$240.17

$203.00

1.18

QQ

Southern SO

$51.85

$60.00

0.86

QQQQ

Xcel Energy XEL

$62.50

$50.00

1.25

Q

NextEra Energy NEE

Morningstar Rating

Source: Morningstar. Data as of 06/30/2020.

Lallos: This sector is still a go-to for income-oriented

investors in this environment. Most U.S. utilities
maintained their dividends, while European utilities
were cutting them earlier this year. What can
dividend-oriented investors expect going forward?

Miller: We think the U.S. utilities, in general,
are in a great financial position right now.
The European utilities went into the downturn with
a lot of question marks. Those that were in
the worst positions ended up having some issues
sustaining their dividend. That hasn't happened
in the U.S. for the most part, and the reason is that
the U.S. utilities went into this with very strong
balance sheets, and the yields are extremely
favorable relative to where interest rates are right
now. Utilities have really benefited from
refinancing and investing and raising capital at
very low costs in the market. Similarly, utilities
investors have and are benefiting from historically
high yields relative to interest rates right now.
So, we still think the utility sector on a
fundamental basis looks very attractive for income
investors, given the sector's strong financial
position and the relative attractiveness of the
dividend yields versus interest rates.
Lallos: Any particular names you'd recommend to an

investor focused on dividends?

Miller: I think income investors should take
a look at Southern Co. SO. It also has plans for a
large amount of investment, but it has good
regulatory support and has projects that it can turn
into earnings and dividends at good conversion
rates. With the stock yielding 4.5% right
now, that's one of the better yield plays while still
getting some valuation benefits and earnings
growth opportunities.

68

Morningstar Q3 2020

One of the fastest-growing dividends in the
sector likely will come from NextEra Energy NEE.
We expect it can grow its dividend 11.5%
annually over the next five years. NextEra benefits
from constructive regulation and growing
electricity usage in Florida, its primary service
territory. NextEra also is the largest renewable
energy developer in the U.S. and will
retain that title for many years based on its huge
renewable energy growth plans. In addition
to NextEra's earnings growth potential, it has
a lower dividend payout ratio than peers, giving it
flexibility to continue growing the dividend
even if earnings growth doesn't meet our forecast.
Investors will have to pay a rich price for
the stock, but they could be rewarded if NextEra
hits its growth targets.
Lallos: What are you worried about for the sector ahead?

Miller: If there's a second wave of the pandemic
in the fall and winter, we're going to be
watching the energy demand trends very closely
for utilities. I think most utilities investors right
now are not pricing in a substantial second wave,
and that could have big impacts on 2020
earnings if we have another COVID-19-related
economic downturn in the third and fourth
quarters. If there is no second wave, we think
utilities are fairly well positioned. But if
there is, they will face some challenges in the
capital markets and in the energy markets.

A lot of utilities have investment plans that stretch
five years or more, so there's a chance that
utilities could shift their capital investment plans.
However, that also shifts the growth potential for

earnings and dividends. The risk here is that
a second COVID-19 wave could delay a lot
of the growth investment that utilities are planning
and that investors are counting on right now
based on the valuations in the market. If utilities
have to push back some of their investment,
and thus some of their growth because of
pandemic-related risks later this year, I expect that
will weigh on valuations, as investors will have to
wait longer for dividend and earnings growth.
One long-term risk that investors should consider
is the role fossil fuels will play in the U.S.
during the coming decades. In particular, natural
gas faces some political opposition that could limit
demand growth in certain areas. Many
utilities have sizable natural gas distribution
businesses that could suffer if customers switch
to electricity powered by renewable energy
for heating and cooking. This threat likely
is a decade or more away, but the markets are
already assigning valuation discounts to
any utility or midstream company with sizable
natural gas exposure. K
Laura Lallos is managing editor of Morningstar magazine.
Morningstar - Q3 2020

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