Wall Street considers diversified utilities top picks in the power sector heading into 2018.
Analysts highlighted Public Service Enterprise Group Inc., Exelon Corp., NextEra Energy Inc. and Dominion Energy Inc. for their diversified platforms and ability to capture benefits from federal tax reform. Their integrated platforms and strong cash flows are also seen by many as catalysts that could attract investors to marquee names in the sector that can still offer dividends in a rising rate environment.
"Among the most investable themes for next year is continued outperformance of integrated utilities with exposure to non-regulated power markets on the strong probability for energy market reforms in [the second half of 2018]," Credit Suisse analyst Michael Weinstein said Dec. 15. "With [interest] rates rising, utilities with stronger cash flows should outperform on their ability to grow dividends and maintain payout ratios."
Credit Suisse and RBC Capital Markets pegged Exelon as their top pick in 2018, each citing upside around federal power market reforms. Morgan Stanley Research in a Dec. 13 report also affirmed its neutral outlook on electric utilities with a preference for diversifieds.
"We see both stock-specific and macro catalysts through 2018 that we expect to buoy sentiment on the group and drive relative outperformance versus regulated peers," Morgan Stanley Research analyst Stephen Byrd wrote. "Additionally, we see power price reform as a key driver of upside to estimates and valuations, with [Public Service Enterprise Group] and [Exelon] as the key beneficiaries.
The brokerage said it remains "overweight" on Public Service Enterprise Group, FirstEnergy Corp., NextEra and PG&E Corp. In the same report, Morgan Stanley upgraded American Electric Power Co. Inc. and Eversource Energy to "overweight" from "equal-weight." PG&E on Dec. 20 suspended its dividend, citing exposure to liabilities for wildfire damage, and shares have subsequently dropped.
While Morgan Stanley's 2018 outlook for diversified utilities is "partially predicated on power price reform," Byrd said this group is the subsector that will benefit under tax reform "given the earnings uplift at unregulated subsidiaries."
J.P Morgan Securities highlighted PSEG and Westar Energy Inc. as its top picks heading into 2018, pointing to upside for potential nuclear subsidies in New Jersey and pro forma synergies from the merger with Great Plains Energy Inc., respectively.
"We expect 2018 to be a reset year as the sector faces the prospect of rising long-term interest rates, subtle tax reform risk and many names are dealing with increased company-specific risk," J.P Morgan's Chris Turnure said Dec. 14.
Utilities with higher dividend growth have tended to outperform peers with below-average dividend growth during periods of rising interest rates, which could position Dominion and NextEra to outperform, according to J.P. Morgan's analysis.
Reaves Asset Management has generally "stayed away from companies with merchant generation" and is "still fairly bullish" on regulated utilities.
"I definitely agree that tax reform is a bit of a headwind, mostly from the trading side, for utilities, but where it really helps is it just eases bill pressure, right?" Jay Rhame, portfolio manager of Reaves Utilities ETF at Reaves Asset Management, said in a Dec. 21 interview. "So, if taxes come down, maybe utilities can lower rates to companies. Or they can use that room that's created, the potential lower rates, and put more CapEx to work, invest in more infrastructure."
"In a way, lower taxes help improve long-term growth outlooks by a percent or two, or something like that, but still meaningful," Rhame added.
Wells Fargo Securities LLC, meanwhile, warned that investors should "proceed with caution" in 2018.
The firm on Dec. 18 lowered its rating on shares of Alliant Energy Corp. and PG&E to "market perform" from "outperform" while raising its rating on CMS Energy Corp. to "outperform" from "market perform."
"Heading into 2018, there is still a distinct possibility that the strong macro tailwinds — and healthy sector fundamentals — persist," Wells Fargo analysts wrote in the report. "However, we see an elevated risk of multiple contraction based, primarily, on the sector's valuation relative to long-term interest rates."
Wells Fargo added that any concerns about the impact of tax reform on utilities appear overblown.
"All things considered, we expect tax reform will be earnings neutral for pure play regulated utilities, earnings positive for owners of competitive operations, and earnings negative for companies with meaningful parent drag (lower tax shield), all else equal," analysts wrote.