More Worries for Utilities in 2017?

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Maybe we are finally seeing that utilities cannot rise endlessly without a concern about proper P/E ratios and rising interest rates. In the daily upgrades and downgrades, there are often many sector calls seen from some of the large brokerage firm research departments. On Tuesday, BofA Merrill Lynch downgraded several key electric utility stocks. There were seven downgrades in total but four were sent down to what other firms would call “sell” ratings.

In this Merrill Lynch downgrade, the firm is cautious on slower growing utilities or utilities that have recently deployed leverage to boost returns and/or growth. They are also no longer favorable on the deregulated generation segment now that reduced environmental restrictions could exacerbate the current power oversupply cycle. Another risk is that proposed corporate tax changes could lower NOL values.

Merrill Lynch’s research team also fears that 2017 could effectively be a repeat of 2015. A combined view from the firm was as follows:

In 2015, the market first began to anticipate a potential Fed rate increase. Given it would be the first Fed rate raise since the Greenspan era, it was unclear if the Fed’s action would start a bounce in the yield curve. At a given Treasury yield, utilities began to trade at lower PE multiples.

Our essential argument is that there is a risk of a repeat of 2015 due to the shift toward fiscal spending. Not only might interest rates continue to climb, but utilities’ valuations relative to those rates could also fall.

 

Here are the four new Underperform ratings from the Merrill Lynch call:

AES Corporation (NYSE: AES) was cut to Underperform from Neutral and the price objective was cut to $11.00 from $12.50. Merrill lynch noted that AES has roughly 25% of its pre-tax contributions in foreign currencies and many of its U.S. dollar contracts have foreign counter-parties whose credit risk could increase with a strengthening dollar. AES shares were last seen down 1.5% at $11.38 on Tuesday.

Duke Energy Corp. (NYSE: DUK) was downgraded to Underperform and the price target was cut to $69.00 from $78.00. The Merrill Lynch view on Duke is that utility valuations are expensive in light of the rising interest rate outlook. They decreased their peer multiple used to value Duke shares from 16.0x to 13.5x. Duke Energy shares were last seen down 0.6% at $73.95 on Tuesday.

Entergy Corp. (NYSE: ETR) was downgraded to Underperform from Neutral and the price objective was cut to $64 from $76 in the call. This downgrade on Entergy was based on a discounted group price multiple and nuclear cost recovery regulatory overhang. Its valuation also no longer includes a discount for consolidated tax adjustments given changes to the Louisiana regulatory commission. Entergy shares were actually up 0.5% at $68.80 after the call.

Portland General Electric (NYSE: POR) was downgraded to Underperform from Neutral based on Merrill Lynch’s group average 13.5x price multiple and its view that small/mid-cap premiums will decrease in a rising rate environment. Portland General Electric’s price objective was cut to $39 from $45 in the call. Shares of Portland General Electric were last seen down 0.3% at $42.11 in mid-Tuesday trading.