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Electric industry trends to continue in 2017, with cautious eye on interest rate

With key changes in energy policy and leadership in store for 2017, industry observers still expect electric utilities to continue investments in clean energy and infrastructure modernization, with an appetite for further consolidation. Some on Wall Street, however, believe that the sector's strong financial run is grinding to a halt.

Jefferies LLC noted that utilities have traded at a premium price-to-earnings multiple to the S&P 500 for the past five years "as investors first looked to play defense following the Great Recession" and then as interest rates dropped to historic low levels.

Jefferies analyst Anthony Crowdell said the utility sector is "likely to be out of favor with investors in the next several years" and is expected to underperform the S&P 500 in 2017.

"The sell-off went into high gear following the US presidential election as investors' expectations for a robust economy caused a rotation to [riskier] assets," Crowdell wrote in a research report.

Perhaps the biggest obstacle facing investor-owned utilities, many of which have signaled they will stay the course on future plans for their generation fleets as President-elect Donald Trump prepares to take office, is the potential for further hikes in short-term interest rates by the Federal Reserve. The Fed on Dec. 14 lifted the target range of the U.S. central bank's key interest rate by 25 basis points and said it projected three further increases in 2017.

Utility stock indexes outperformed broader market indexes the week of the hike, but analysts believe utilities "appear especially vulnerable" to interest rates.

"Unlike most of 2016, we estimate that regulated utilities are no longer pricing in a material rise in interest rates," J.P. Morgan Securities LLC analyst Christopher Turnure wrote in a research report. "Instead, we see a modest decline in rates priced into the sector and therefore see it as especially vulnerable to further increases based on historical correlations."

J.P. Morgan added that it sees "absolute and relative valuation risk for the group even in a flat interest rate environment."

Jeremy Fago, U.S. power and utility deals leader at PwC, said further interest rate hikes also could impact the appetite for mergers and acquisitions.

"I think that might certainly put some pressure on valuations, and what it may actually do is slow the pace of deals as far as activity goes. Just because you're going to start to see what I expect to be some bid-ask spread widening as valuations come down a little bit," Fago said in a recent interview.

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J.P. Morgan also highlighted concerns about corporate tax reform.

"Tax reform introduces risk for many names that may outweigh benefits, and currently the utility group appears to have little or no valuation cushion left against another interest rate move higher," Turnure wrote. "We see companies with profitable non-utility, non-renewable businesses and stronger balance sheets as best positioned."

J.P. Morgan said it is downgrading Duke Energy Corp. to "underweight" from "neutral" and Pattern Energy Group Inc. to "neutral" from "overweight," while upgrading Public Service Enterprise Group Inc. to "overweight" from "neutral" and Portland General Electric Co. to "neutral" from "underweight." The brokerage said its top picks for 2017 are Exelon Corp., Atmos Energy Corp. and PG&E Corp.

Industry trends

Industry observers do not expect much immediate impact on consolidation and industry trends from the Trump transition and changes to energy regulation, such as the U.S. EPA's Clean Power Plan.

"I still think you're going to see the shift to renewable energy and natural gas," Fago said. "The renewables may just be more state-driven in the absence of the Clean Power Plan and if in fact the Clean Power Plan doesn't come out as written."

"We still think that because of the price of natural gas, particularly, you're still going to see a lot of opportunity on that front and you're still going to see deals get completed in that area and [there's] still going to be certainly a lot of interest," he added.

Scott Smith, U.S. power and utilities leader at Deloitte, said the incoming administration and Congress "will not change the fact the utility industry is still in a period of transformation." Smith said he expects utilities to continue investments in upgrading aging infrastructure and grid modernization, while still pursuing cleaner generation and renewables.

"There's a good chance you're going to see some folks running pretty fast on renewable development," PwC's Fago said. "You may, in fact, see some deals just given access to capital and needs for capital to get those facilities up and running."

Many analysts expect tax subsidies for new wind and solar projects to survive corporate tax reform, especially since they were extended by Congress with strong Republican support. Congress voted in late 2015 to phase out the production tax credit for wind power by 2020 and to drop the investment tax credit for solar development to 10% from 30% of project costs by 2022.

"While tax reform has been a high priority of the Republican-unified government, we see the popularity of the PTC and ITC in both parties, the [schedule] to phase out/down, and their longevity and number of extensions as factors protecting them from repeal in the tax reform process," Turnure wrote.

Safe bets?

Morgan Stanley Research contends that unregulated businesses are back in favor for 2017 and has upgraded its industry view to "attractive" for diversified utilities and independent power producers.

"We think underperformance relative to regulated peers will reverse, and see a constructive backdrop driven by higher commodities prices, rising interest rates, tax reform, and potential strategic action," Morgan Stanley analyst Stephen Byrd wrote.

Morgan Stanley said its key "overweight" stocks are Exelon, Dynegy Inc. and FirstEnergy Corp., while its key "underweight" stock is Entergy Corp.

The brokerage noted that it expects higher natural gas prices in 2017 and 2018, which will benefit power producers in the PJM Interconnection LLC market, "which sits directly on top of the Marcellus/Utica region."

In addition, diversified utilities and IPPs will benefit from a reduction in federal corporate tax rates and rising interest rates "as it would improve earnings and cash flow for the unregulated businesses of many stocks in the group," Byrd wrote.

The analyst noted that low construction costs for new power generation have been a "key headwind" in deregulated power markets. "Higher interest rates increase the revenue requirement for new generation, a positive for incumbent power plant owners," Byrd wrote.

Morgan Stanley also contends that IPPs and diversified utilities could pursue strategic action to unlock value.

"Private valuations for merchant power assets, particularly natural gas plants, are at a material premium to those currently implied by the public market," Byrd wrote.