Our Outlook for Utilities Stocks 'Til death do us part: Merger partners now tied, but power prices still deadly. (By Travish Miller - Morning Star)

• Although natural gas and power prices stabilized in the second quarter, they remain at levels that are compressing margins for coal and nuclear power producers. 
• Utilities are still doing exceedingly well with mergers this cycle as Northeast Utilities and Exelon closed their multibillion-dollar deals last quarter. Duke appears set to close its merger by July after receiving key federal go-ahead. 
• The sector's average 4.2% dividend yield still offers a historically attractive spread over U.S. Treasuries, suggesting regulated utilities could continue their phenomenal three-year run. 

For several quarters now, utilities investors have woken to the same story. Low interest rates continue to offer an impressive tailwind for utilities that can drive earnings higher with low borrowing costs and offer investors attractive dividend yields with growth. But market-exposed power producers continue to suffer from persistently low power prices that are compressing margins for coal and nuclear operators.

For regulated utilities, the near-term outlook remains bright even as valuations stretch well beyond historical norms. A group of the 31 largest U.S.-regulated utilities returned 5% between March and June, handily beating the S&P 500's negative 3.5% return and all 11 market sectors, yet have trailed nearly all other sectors year to date. For utilities that can avoid punitive regulation, we think investors could still realize 4%-6% dividend growth to go with near-4% yields.

For power producers, fundamental changes are taking hold in power markets as coal plant shutdowns accelerate, natural gas generation skyrockets, and reserve margins face dangerous tightening during the next three to five years. We now count 35 GW of planned or executed coal plant shutdowns since late 2010, up from 30 GW last quarter and closing in on our 53 GW estimate. Gas generation in March hit its highest share of total U.S. generation in at least 40 years at 30%, while coal's share fell to its lowest level at 34%, based on the most recent government data. In May, the Texas grid operator's semiannual long-term outlook projected state reserve margins tightening below its target range as soon as next summer.

Industry-Level Insights
Languishing power and gas prices continue to weigh on earnings for diversified utilities and power producers. Year to date, gas prices are down 13% and power prices are down 6%. We now think earnings for most utilities with power market exposure will hit troughs in 2013-14. Coal plant operators are facing shrinking dividend coverage, liquidity concerns, and even restructuring from compressed margins and fast-approaching environmental compliance requirements.

We believe political and regulatory uncertainty are depressing power and capacity prices. Two key environmental regulations finalized in 2011 face legal challenges and political uncertainty going into the November elections. We believe power prices reflect very little of the full impact we expect from these regulations. Political intervention also appears to be depressing capacity values for emissions-controlled and clean incumbent generators. Subsidized projects in New Jersey and Maryland cut 2015-16 Mid-Atlantic capacity prices in half from our normalized estimates for certain regions, and New York is assessing subsidized generation options. Depressed power and capacity prices hurt utilities such as Exelon (EXC), GenOn Energy (GEN), and NRG Energy (NRG) the most because of their large exposure to competitive power markets.

Even if power, gas, and capacity prices stay low, we think tighter power markets and increased reliance on gas generation could lead to more volatile power prices. This should favor the largest, most diversified utilities such as Exelon, NRG Energy, and FirstEnergy (FE). These utilities moved early to pair their wholesale generation with a growing retail supply business. This pairing gives them a cost and liquidity advantage over other retailers, offering a rare competitive advantage that could lead to industry consolidation and margin expansion. Exelon in early June projected $100 million of revenue synergies from its combination with Constellation's retail business. NRG Energy is realizing similar benefits in Texas.

For all utilities, we think regulatory risk remains the key threat. The 770-basis-point spread between recently awarded allowed returns and U.S. Treasury rates is the widest in at least 20 years and 190 basis points above the 20-year average. Mean reversion would hit earnings hard. Merger approval also has been difficult, albeit successful. Regulators required rate credits, rate freezes, and/or commitments to uneconomic investments before approving Northeast Utilities' (NU) $9.5 billion acquisition of NSTAR and Exelon's $7 billion acquisition of Constellation, both of which closed this spring. These concessions will make it difficult for the companies to create value from the deals.

Similarly, Duke Energy's (DUK) $17.9 billion acquisition of Progress Energy (PGN) appears set to close by July 1, but only after the companies offered enough concessions to receive sign-off from federal regulators. Entergy's (ETR) proposed acquisition of ITC Holdings (ITC) also faces a difficult regulatory path.

Our Top Utilities Picks
 

On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.87, down from 0.90 last quarter. But the utility sector's 1.05 median price/fair value still highlights the sharp valuation divide we see between the relatively cheap, large diversified utilities and the relatively pricey, smaller regulated utilities.

Only two of the 33 regulated utilities we cover are trading below our fair value estimates as of mid-June. Yet paradoxically, dividend yields and growth prospects for many of those utilities still look attractive. The spread between the 4.2% utility sector average dividend yield and 10-year U.S. Treasuries at 260 basis points is the widest in at least 20 years, and most domestic utilities have no exposure to Europe's financial woes. For safety-minded, yield-seeking investors, we continue to point toward National Grid (NGG), American Electric Power (AEP), and Alliant (LNT).

Among diversified utilities and independent power producers, we still favor those with low-emissions baseload generation assets like Exelon and Ormat Technologies (ORA). As power markets tighten, we think GenOn Energy, NRG Energy, and Public Service Enterprise Group (PEG) can be winners.