While utilities trade at low multiples and offer high dividend yields, this is only because of limited growth prospects. At a time when the global economy is improving, utilities are unlikely to outperform broader indices given their suppressed correlation with growth. On the other hand, if there is a double dip (and some economists have argued that weak job results suggest this scary scenario), utilities will help you retain wealth and accrue stable income streams. Moreover, value funds are hot on utilities with the Russell 1000 Value Index Fund (NYSEARCA:IWD) holding 12.9% of its assets in the sector.
It's hard to say where exactly the economy will go, but I remain bullish on the market overall. Utilities are amongst the safest companies and, naturally, are limited in generating risk-adjusted returns. Moreover, I do not find the sector as undervalued as some think. I do find, however, that the sector requires a market correction to achieve justified capital prices. Duke (NYSE:DUK), for example, trades at nearly one-fifth more than its historical 5-year average PE multiple. This is complicated by poor growth forecasts: -8.3% is expected for 2Q12 and only 4% is expected for FY2013. But Duke has delivered an average of 9.5% above consensus over the last 5 quarters
Consensus estimates for Duke's EPS forecast that it will decline by 2.7% to $1.42 in 2012, and then grow by 4.9% and 6.7% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $1.43, the stock would hit $22.88 - already below the current valuation. Discounting backwards by just 5% yields a price target of $20.75. Over the same time, however, the firm will have yield 8.6% worth of dividend distributions. For single digit gains at a time when the economy is turning around, I do not find risk/reward compelling right now.
Exelon (NYSE:EXC) is cheaper than Duke and comes with just slightly lower EPS growth. It trades at a respective 12.3x and 12.9x past and forward earnings versus corresponding figures of 21x and 15.6x for Duke. Analysts expect Duke to yield less than 10 basis points more in annual EPS growth over 5 years. Moreover, Exelon offers a dividend yield that is meaningfully higher at 5.6%.
If Exelon yields the expected 3.96% annual 5-year EPS growth and trades at 16x earnings, its future stock value will hit $72.80. Discounted backwards by 5% yields a target price of $57.04. Put differently, there is more than a 50% margin of safety that this stock could nearly double. This comes on top of a very high dividend yield that has experienced a 5% 5-year growth.
Consensus estimates for Exelon's EPS forecast that it will decline by 26.9% to $3.04 in 2012 and then grow by 0.7% and 7.2% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $3.02, the stock would hit $45.30 for 17.6% upside.
PPL (NYSE:PPL) is also attractive given that it trades at roughly two-thirds of its historical 5-year average PE multiple and 60% of its sector's. In my DCF model on PPL, I assume (1) 4.6% per annum growth over the next six years and (2) 2.5% into perpetuity and (3) consistent operating metrics. The firm trades at 14.6x my free cash flow, which appears expensive. But this expense is largely compensation for expansion into diversified regulatory jurisdictions that have mitigated risk.
Moreover, PPL is the cheapest of the three utilities highlighted in this report while trading below 10x earnings and offering a 5.2% dividend yield. What makes PPL interesting is that its expected growth rate is substantially below the industry's: 2.7% annually for EPS over 5 years. In my view, this expected underperformance is unjustified given how impressive recent results have been. During the last five quarters, management beat expectations by an average of 8.7%. Despite strong momentum, the firm has only appreciated by just 2.9% while Duke gained nearly 25%. Exelon similarly experienced an unjustified return at -10%. While Duke is led by excellent management, Exelon still has greater scale. In light of this backdrop, I recommend utility investors back Exelon and PPL as the market corrects itself.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.