Duke Energy Upgraded, American Electric Power Downgraded: What You Need to Know

Goldman Sachs is "cautious" on all utilities, but still likes a couple of 'em.

Rich Smith
Rich Smith
Jun 26, 2017 at 12:32PM
Energy, Materials, and Utilities

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Over the past year, shares of Duke Energy (NYSE:DUK), American Electric Power (NYSE:AEP), and PPL Corp (NYSE:PPL) have all underperformed the S&P 500 badly, yielding low- to mid-single-digit gains while the rest of the market roared ahead more than 20%. At this point, optimists might be thinking that utility stocks are bound to bounce back -- but not Goldman Sachs.

Goldman Sachs thinks they've already bounced back a lot from previous lows, and are in fact now guilty of "stretched valuation[s]" despite lagging the rest of the market. Here are three things you need to know about that.

Scissors cutting cash

Goldman Sachs took its scissors to utilities sector stocks this morning. Image source: Getty Images.

1. Downgrading AEP

Let's start with both the worst news of the day, and the big picture that frames it. Shares of American Electric Power briefly fell this morning following a downgrade to neutral at Goldman Sachs. As StreetInsider.com (requires subscription) explains, Goldman downgraded the entire "US Utilities Sector" today, arguing that the P/E multiples of most U.S. utility stocks have reached "peak levels" relative to the S&P 500.

Although AEP (along with Duke and PPL) shares have underperformed the S&P 500 over the past year, you see, since the beginning of this year, they've made up a lot of that lost ground. Goldman attributes the rebound in part to overoptimistic expectations for fiscal 2019 earnings -- estimates Goldman doesn't think will necessarily be met. Accordingly, Goldman has cut its rating on the entire sector from neutral to "cautious," lowered its estimates for AEP's 2018 and 2019 earnings by a couple of cents, and dropped its AEP rating to neutral.

2. Upgrading (yes, you read that right) Duke Energy

And yet, not all utility stocks are created (or valued) equal. As reported on TheFly.com (may require subscription) today, Goldman Sachs actually finds Duke's valuation relative to other utilities "compelling." Among other things that Goldman likes about Duke are the company's "stable regulatory infrastructure business" and its achievements in "cost management."

Indeed, data from S&P Global Market Intelligence show that Duke has grown its gross profit margin steadily each year for the past five years, and its operating profit margin for the past two (going on three). Expecting further progress to come, Goldman is upping its earnings estimates for Duke by a total of $0.11 per share over the course of the next three years, and upgrading its rating on Duke stock to buy.

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3. PPL wins an upgrade, too

Despite the gloomy forecast for the utilities sector as a whole, PPL Corp is another stock Goldman sees as having a silver lining. Raising its earnings estimates by about $0.07 per share over the next three years, Goldman is also removing its sell rating from the stock and upgrading to neutral.

Among the factors Goldman likes here are PPL's exposure to the U.K. market, from whence 29% of the company's annual revenue comes. Goldman is pleasantly surprised with the strength of the British pound, which implies that PPL's profits earned in the U.K. will yield more dollar-denominated profit once converted back into greenbacks.

What it means to investors

How should investors react to Goldman's new ratings? That may depend a lot on how much you like dividends -- because valued on earnings alone, it's hard to find much to like about any of these stocks.

At a price-to-earnings ratio of 50.6, AEP stock looks pricey in the extreme given that analysts who follow the stock see earnings growing at only 4% annually over the next five years. Duke's both better and worse, with a more reasonable (but still not cheap) 27.7 P/E but a projected growth rate of less than 4%, while PPL seems the cheapest of a very expensive bunch -- 14.8 P/E ratio, 5% growth rate.

Income investors will obviously prefer (as Goldman does) Duke and PPL stock with their respective 4% and 4.1% dividend yields. And yes, admittedly, those are a whole lot more generous than the 3.3% yield at AEP -- but I still think dividend investors can do better than the two stocks Goldman grudgingly picks as least worst in an awfully overvalued sector.

Here are a few ideas that may work out better for you.