Utilities stocks have lagged much of the ASX market in 2023’s first half, but with electricity prices jumping across the country in the second half of the year, some stocks are set to benefit despite near-term headwinds, according to Morningstar’s latest Outlook Report.

While Morningstar’s Australia Utilities index is currently hovering around the broader Australia indexes’ year-to-date total return, the recent drawdown of ASX utility shares has been much more dramatic.

energy index

The market skepticism has in part been attributed to stubborn inflation figures in the first half of the year and their expected knock-on impact to the industry. At the start of this month residential electricity prices across much of the country jumped as much as 20% in some states in a move flagged by the Australian Energy Regulator back in May.

AER Chair Clare Savage put part of the increase down to rising inflation and the resulting operational cost increases.

While headwinds have weighed on the industry in recent months, the average utility share in Morningstar’s coverage universe remains trading at a slight premium to our fair value.

When split between New Zealand and Australian domiciled companies, the average Australian utility company represented a slight discount to Morningstar’s assessed fair value, with New Zealand utilities typically screening as more overvalued.

Looking ahead, Morningstar analyst Adrian Atkins says wholesale electricity prices now appear to be stabilizing at relatively high levels.

electricity prices

“We expect a strong earnings recovery in fiscal 2024 as retail electricity prices increase 20% or more in most states to pass through high wholesale prices, with a lag,” he says.

According to Atkins, high fuel costs, the closure of ageing coal power stations and delays and cost blowouts for new generation supply are expected to act as positive tailwinds for the industry over the medium term.

With that in mind, Morningstar has highlighted three picks in the utilities sector in its latest quarterly outlook report – which is available in full to Investor subscribers.

All the stocks listed below have been granted a narrow-moat rating from Morningstar, which denotes a company that holds competitive advantages over its peers expected to last for the next 10 years. The below stocks also carry a three- or four-star rating from Morningstar, meaning they are considered “fairly-valued” or “undervalued”, respectively.

Manawa Energy (MNW-NZ)

  • Star rating: ★★★★
  • Fair Value: $6.30
  • Uncertainty: Medium
  • Economic moat: Narrow

New Zealand listed Manawa, formerly Trustpower, is a renewable energy producer, which owns a fleet of small hydroelectric generators.

The company has tracked a rocky year-to-date in terms of market performance but has recently recovered much of its early-year losses. The shares are down just 0.2% since the start of January.

According to Atkins, the narrow-moat company’s strong balance sheet means its well-positioned to grow via the development of wind and solar farms. He adds that the company is well-positioned to capitalize on elevated inflation.

“It sells most power to Mercury NZ under long-term CPI-linked contracts, with earnings to benefit from elevated inflation. We also expect earnings to benefit from diverting more sales to tight wholesale markets as contracted volumes progressively reduce in the medium term,” he says.

Shares in Manawa last traded at a 20% discount to Morningstar’s assessed fair value of NZ$6.30 apiece.

AGL Energy (AGL)

  • Star rating: ★★★★
  • Fair Value: $12.80
  • Uncertainty: High
  • Economic moat: Narrow

Up almost 40% year-to-date, Morningstar senior equity analyst Adrian Atkins says the recovery is underway for narrow-moat AGL Energy.

"The rebound in electricity prices in the past two years should underpin a strong earnings recovery in fiscal 2024," he adds.

"As one of Australia's largest generators and retailers of electricity, we see substantial long-term value in the business."

Further, Atkins notes that the well-publicized battle with activists and new directors has now dissipated, and lenders have shown their support by refinancing $1.6 billion of debt after AGL committed to exiting coal by the mid-2030s.

Shares in AGL Energy last traded at a 15% discount to Morningstar's fair value estimate.

APA Group (APA)

  • Star rating: ★★★
  • Fair Value: $10.20
  • Uncertainty: Medium
  • Economic moat: Narrow

Despite trading close to its fair value estimate, Atkins characterizes APA Group is a “good-quality infrastructure stock” offering investors an attractive yield.

The company, which owns a large-scale network of gas transmission and distribution infrastructure assets across Australia, typically achieves higher returns than its peers, which Atkins puts down to a lower regulatory burden.

“APA Group should benefit from the transition to renewable energy. We expect ongoing investment in wind and solar farms while its core gas transmission networks benefit from growing gas use to backup intermittent renewable power supply," he says. 

"APA is also set to help remote mines in Western Australia replace diesel generators with a mix of solar panels, batteries, and gas turbines. This should reduce the mines' carbon emissions and operating costs.”

While Atkins notes that higher interest rates are a key earnings headwind for highly geared firms like APA Group, Morningstar’s still expects APA’s distributions to grow thanks to CPI-linked revenue, completion of developments, and extensive interest rate hedging.

Shares in APA Group are trading in three-star, “fairly valued” against a Morningstar estimate of $10.20.