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Utilities' high valuations crawling toward end in 2020: Guggenheim

The U.S. utility sector will remain a stock buyers' market in 2020, but it may be approaching the end of high valuations among electric and gas utilities, according to a sector outlook from Guggenheim Securities LLC.

Utility stocks made a 23% gain in value in 2019, and those companies are continuing to trade above expectations in 2020, Guggenheim analyst Shahriar Pourreza said in a Jan. 7 note. However, "valuation can only stretch so far for so long … and we believe we are likely going into a reversal for the regulated utility rally now."

Global macro and policy concerns, mixed economic data and central bank policy uncertainty propelled investors to go after utility stocks in 2019, but Pourreza said there will likely be more clarity in 2020 on those issues. That is pushing Guggenheim to be more bearish on traditional regulated utilities that have been viewed as "bond proxies," such as American Electric Power Co. Inc., Portland General Electric Co. and Southern Co.

"Regulated utilities have had a solid multi-year run, but as we continue in a period of low interest rates with an end in sight … we believe investors will now likely tend to discount utilities that represent bond surrogates, turning their focus to utilities with strong, visible growth to overcome expectations for higher yield elsewhere," the analyst wrote in the note.

Moreover, regulated electric and gas utilities may become less desirable in the market unless these companies highlight potential opportunities to improve their finances or trade at "unjustified" premium valuation levels.

Instead, investors will likely move capital toward utilities and merchant power providers with more cyclical characteristics within the energy value chain, such as DTE Energy Co., Public Service Enterprise Group Inc. and NRG Energy Inc., Pourreza said. Wall Street is also moving toward not viewing price-to-earnings ratios in isolation with more "bellwether" utilities such as NextEra Energy Inc. and Sempra Energy because cash flows are becoming more relevant factors in evaluating companies in the sector.

Beyond stock valuations, utilities will likely continue to see a slower M&A market through 2020 before it becomes more active. Santee Cooper's potential sale remains one of the most visible large-scale utility deals. While PPL Corp. Chairman and CEO William Spence has said the company does not need M&A to execute its business strategies amid reports of a potential $67 billion merger with Avangrid Inc., Guggenheim still views a deal with another large international company as a possibility.

"We believe investors will increasingly be on the hunt for ideas within the sector — stock picking will continue to matter in 2020, as was the case in 2019," Pourreza wrote.