BMO Capital Markets initiates coverage of SMID-Cap utilities

Investing.com -- BMO Capital Markets has begun coverage of the small- and mid-cap (SMID-cap) utilities subsector, initiating ratings on five companies. 

The brokerage started coverage on Evergy (NASDAQ:EVRG) and Black Hills (NYSE:BKH) Corporation with an "outperform" rating, while Pinnacle West Capital Corporation (NYSE:PNW), Portland General Electric (NYSE:POR) Company, and NorthWestern Energy received a "market perform" rating. 

BMO Capital Markets also transferred coverage of Alliant Energy (NASDAQ:LNT) Corporation, maintaining its "market perform" rating.

The analysts at BMO Capital Markets stated that despite having similar business models and fundamental drivers to their larger counterparts, SMID-cap utilities are currently "stuck in the SMIDdle." 

The brokerage said that these companies, generally possessing a smaller regulated footprint and fewer regulatory jurisdictions (with Black Hills Corporation being an exception), face potentially more concentrated risks. 

These risks include regulatory, operational, wildfire, and economic factors, which can be amplified during periods of high inflation where affordability becomes a key concern.

According to BMO Capital Markets, the SMID-cap utilities sector typically has fewer options to counteract operational challenges. 

This can make them more vulnerable to headwinds related to climate or interest rates, potentially leading to greater volatility in their year-over-year financial results.

BMO Capital Markets anticipates that the SMID-cap utilities cohort will experience slightly lower earnings per share growth compared to larger utilities. 

This is attributed to a combination of factors such as modestly slower rate base growth on average, increased financing-related costs, longer regulatory lags, and in some cases, a history of less stable regulatory environments. 

These factors, along with a historically less consistent record of meeting financial forecasts, have resulted in a more erratic EPS growth pattern, causing the subsector to generally trade at a discount to large-cap utilities, according to the BMO Capital Markets analysis.

In the current macroeconomic climate, BMO Capital Markets suggests that sustained pressure from inflation and interest rates is likely to have a greater financial impact on SMID-cap companies compared to larger ones. 

Coupled with their lower liquidity, this may make them less appealing to investors primarily seeking safety. 

With the utility sector often viewed as a safe haven, BMO Capital Markets expects investors to continue prioritizing safety and liquidity, potentially putting valuation considerations on the back burner, which would not favor SMID-cap utilities in the near term on a relative basis.

However, BMO Capital Markets pointed out a significant divergence within the SMID-cap group, noting considerable valuation disparities in certain companies that exhibit characteristics expected to drive relative performance. 

The brokerage believes these dislocations present attractive investment opportunities and the potential for above-average returns, particularly where the appealing attributes seen in large-cap peers are not fully recognized in select SMID-cap utilities.

BMO Capital Markets sees an improving trajectory for the subsector, supported by appropriately adjusted long-term forecasts and more appealing relative valuations. 

This could provide management teams with a foundation to build more consistent track records of achieving their financial targets. 

When combined with improved regulatory frameworks and economic development, which can boost growth prospects and potentially create a more stable and predictable EPS growth profile, BMO Capital Markets anticipates an opportunity for the valuation gap between select SMID-cap and large-cap utilities to narrow over time.