Regulated utilities received a lot of generalist analyst calls to outperform near the end of the third quarter. Credit Suisse’s Dan Eggers revisited what makes the bullish case for regulated utilities in a new report. What is interesting here is that some investors will interpret this as how to view issues in utilities stocks for 2015 and perhaps beyond.

Eggers said that it is hard to make a strong case for regulated utilities at this point because the attractive relative valuation arguments that Credit Suisse has made over the past couple months have happened. The stocks no longer offer the same cheapness against the S&P 500, having shifted from a 5% to 7% discount to a minor premium. Credit Suisse’s preferred exposures remain CMS Energy Corp. (NYSE: CMS), Dominion Resources Inc. (NYSE: D) and PG&E Corp. (NYSE: PCG). This group of stocks is not expensive, compared to the S&P 500 or to bonds, but the seeming expensiveness of equities and bonds gives some pause to Credit Suisse.

• CMS Energy is rated Outperform at Credit Suisse with a $32.00 price target. That is $1 less than the current share price, and CMS yields 3.3%.
• Dominion Resources is rated as Outperform with a $78 price target at Credit Suisse. That is versus close to $74 currently and to a 52-week range of $63.00 to $74.59. Dominion yields 3.2%.
• PG&E has an Outperform rating and $53 price target from Credit Suisse. Its 52-week range is $39.42 to $51.46 and it has a 3.6% dividend yield.

So far in the fall, and for 2014, utility stock performance has been great, but regulated utilities are not the stars that some investors think they might be as they lag behind integrated utilities. Regulated utilities are still in a hole from the second half of 2013, when the relative price-earnings (P/E) ratio went from a 23% premium to a 5% discount, to a now market multiple, since April 2013.

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Eggers further detailed in his report:

Absolute P/Es are pressing the highs of the past 10 years but this is also true of the S&P 500 with relative P/Es currently inline on 2014 and a premium on the rapidly approaching 2015 as a base year; we find complaints about Utility P/Es are generally raised in a vacuum independent of the market valuation.

Dividend yield-bond yield relationships get less conversation as a pressing worry; we see the relationship as a little cheap to recent history but not finding the floors we saw earlier in the fall.

Annual rate of return outlook is dependent upon target multiples with our base 15.5x P/E dropping total return prospects to 4-7% annually; if market P/Es hold the group still offers 8-11% annually.

The EEI conference for 2014 is on the horizon and should offer a good opportunity to refresh on a range of company specific issues going into year-end. This will also act as a useful barometer to gauge broader industry-related issues by surveying management teams at the same point in time.

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Eggers sees a growth outlook for earnings as:

Most companies are targeting 4-6% EPS growth, although our discussions with investors often include their concerns about the durability of these growth rates considering slower underlying demand growth and MATS related environmental capex coming to an end, creating a gap before spending to address EPA’s expected CO2 rules later in the decade. We remain in the camp that Utilities have considerable need to sustain capex with focus shifting to T&D work to support reliability, replace aging infrastructure, and because the dip in generation spending opens a window to deploy capex to the network that is generally less of a priority. We would focus our discussions with managements on where they see spending headed and what are the rate impacts of more T&D spend since these projects often provide efficiency / operating cost savings that lessen the bill impact.

An important element of industry success in a slower load growth world has been the success in managing cost inflation. The benefits from this are seen in earnings and in return on equity.

The report said this regarding pension cost:

We have seen early indications that pension expenses are likely higher in 2015 than 2014 due to a combination of a lower discount rate based on where interest rates are today (bad for obligations) and proposed changes to mortality tables that extend the long-term obligations as retirees live longer. What do companies see as the 2015+ earnings exposure as well as additional pension funding obligations with these updates. How much of the higher pension obligation will flow to the bottom line versus being captured in specific utility clause mechanisms?

Lastly, utilities have benefited from lower than statutory tax rates, particularly in 2014 due to repair deductions. Credit Suisse has an Outperform rating for Exelon Corp. (NYSE: EXC) with a $40 price target. That compares to a $37.60 price and a 52-week range of $26.45 to $37.90. Exelon yields about 3.3%. Eggers sees five cents of risk in earnings per share for 2015 for Exelon.

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