by Charles Fishman, CFA | Morningstar Research Services LLC | 09-12-17

Dominion Resources recently changed its name to Dominion Energy, but in our opinion, the market doesn't appreciate the conservative strategy pivot relying on wide-moat infrastructure investments, which has also transpired. The company exited oil and gas exploration and production in 2010 and is now less dependent on merchant generation, two businesses where earning a moat is difficult.

Dominion's wide-moat growth projects -- notably the Cove Point Liquefied Natural Gas facility and the Atlantic Coast Pipeline -- illustrate the new conservative strategy and should be in commercial operation later this year and late 2019, respectively. We expect wide-moat businesses to generate roughly half of Dominion's operating earnings by 2021 and we believe these businesses will earn a material spread over our estimate of the company's cost of capital through the next decade.

We think some are valuing wide-moat Dominion like a narrow-moat company. Our $85 fair value estimate is 9% above the current stock price and 7% above the median consensus price target. The market also underappreciates what we believe are near-certain 10% annual dividend increases and moatworthy growth opportunities driving high-single-digit EPS growth. We think the dividend yield and earnings growth have the potential to deliver low double-digit total annual returns for conservative investors for the foreseeable future.

Utilities' Valuations Reach Another Peak, but Yield Paradox Persists

by Travis Miller | Morningstar Research Services LLC | 09-14-17

U.S. utilities' valuations reached a 14-month high this week when the median price/fair value ratio hit 1.17 for the 40 U.S. utilities in Morningstar's coverage.

This is the highest median P/FV ratio for U.S. utilities since the all-time peak of 1.21 in July 2016. Other valuation metrics such as price/earnings (22) and price/book (2.1) for U.S. utilities also hit 2017 highs this week and are approaching peak levels from mid-2016. Morningstar's U.S. Utilities Sector Total Return Index also hit an all-time high, up 15% year to date including dividends. This outpaces the S&P 500 (up 13%) and all sectors except healthcare and technology year to date.

Even though utilities' valuations appear exceedingly rich on an absolute basis, the sector's yield paradox--as we call it--continues to give bullish signs. Impressive dividend growth has kept the sector's average yield near 3.5% even with the runup in utilities' stock prices. This is a historically attractive yield premium to market interest rates. During the past 30 years, utilities' average dividend yields have been in line with 10-year U.S. Treasury yields, which held near 2.1% this week. If this historical relationship holds, utilities could have another leg of upside. Alternatively, the sector shouldn't suffer much on an absolute basis if interest rates rise.

We are reaffirming our fair value estimates and moat and moat trend ratings for all the U.S. utilities we cover. Our top picks are utilities like Dominion Energy and Duke Energy, which have transparent, high-quality growth investment opportunities but trade at average sector multiples. They also include utilities facing risks that the market is overly discounting. These include Scana and Southern, which are facing new nuclear project cost overruns, and FirstEnergy, whose nonregulated FirstEnergy Solutions subsidiary faces bankruptcy.

Many Positive Trends within the Banking Industry, but Compelling Valuations Are Tough to Find
by Eric Compton | Morningstar Research Services LLC | 09-14-17

Many of the U.S. banks we cover presented at the Barclays Global Financial Services Conference over the past three days, giving updated takes on guidance and views on the industry and the U.S. economy. Overall, not much changed, with only slight adjustments to guidance levels. Despite many positive industry trends, we don't see many compelling valuations within the U.S. banking sector. Best idea Wells Fargo is the main standout, trading at a 23% discount to our fair value estimate, while many of our regionals, despite our assumption that a tax cut will take place, still trade at or even above our fair value estimates.

Several key themes emerged during the conference, including the consistency of low deposit betas, continued efforts to improve operating efficiency, increasing capital returns to shareholders, and marginally slower loan growth for the third quarter. The universal U.S. banks also mentioned a likely reduction in third-quarter trading revenue. We believe investors should not overreact to these short declines in loan growth or trading revenue. As for trading, volatility may have remained low over the summer, but we don't expect markets to remain calm forever. At the same time, a tight rein on expenses across the industry in recent years should pay off once volatility returns. For loan growth, once uncertainty abates surrounding key proposals in Washington, such as those related to tax reform, we believe commercial investment and mergers and acquisitions should pick up more.

Many of the banks were confident that low deposit betas would continue to hold, and even with slower loan growth, margins should remain steady to up. We believe that low betas cannot stay forever. Eventually competition will have to pick up. As a result, we forecast that betas will begin increasing in 2018, and net interest margin expansion will begin to slow somewhat, but will still occur amid slow but steady rate increases over the next several years.

While some of the banks will be affected by the destruction from the hurricanes in the Southeast, there was not much specific guidance around the effects of these storms, although all affected banks commented that any costs should be manageable, and many losses will be covered by insurance.

Many of the banks remarked that they will also continue closing branches and investing in digital initiatives, leaving room for banks to keep improving operating efficiency over the medium term. We project nearly all banks under our coverage improving their cost/income ratios over the next several years as this trend plays out.

Finally, the push towards lower common equity Tier 1 ratios also remains a key theme, as banks attempt to more efficiently use their capital, improve returns on tangible equity, and return excess capital to shareholders following excellent CCAR results. As an example, we expect undervalued Citigroup to return 10% of its current market capitalization to shareholders in the form of dividends and repurchases over the next 12 months, with dividends likely to account for a larger share of that total over time. This more efficient capital base will be another key item helping U.S. banks to improve returns on equity over the medium term.