Key Takeaways
- While utilities used to be seen as defensive, income-driven plays, investors are now treating them more like growth stocks.
- Enormous demand for artificial intelligence technologies sent utilities soaring, as investors bet that demand for the electricity needed to power AI data centers would follow.
- Demand for electricity for AI data centers isn’t expected to fall any time soon, but Morningstar analysts believe many forecasts are too bullish.
- Utilities stocks in general are overvalued, according to Morningstar.
Do growth stocks now include US utilities? For investors looking for steady cash payouts, utilities have long been a popular but unadventurous choice. These defensive dividend payers have been insulated from the ups and downs of the business cycle. That’s a far cry from buzzy growth stocks, which can soar as investors bet on future earnings gains, and fall just as quickly if those prospects wane. But the artificial intelligence boom is rapidly redefining an industry in which the most exciting developments used to be the occasional rate increase.
As demand for AI technology soars, so too does demand for the infrastructure needed to keep those applications running. That includes data centers and the systems that generate and carry the enormous amounts of electricity needed to power them. That demand is showing no signs of waning as AI giants like Nvidia NVDA, Advanced Micro Devices AMD, and OpenAI announce deal after deal and project after project.
As a result, utilities stocks are soaring as investors bet heavily (maybe too heavily) on future demand and earnings growth. Investors are “essentially saying that utilities are growth stocks now, not yield stocks,” explains Morningstar senior equity analyst Travis Miller. That’s a “huge shift from the entire history of utilities equity investing.”
With this changed investor mindset, the Morningstar US Utilities Index has returned 24% since the start of the year, beating the Morningstar US Market Index‘s 16% return. This year’s gains come on top of a 26% return in 2024, which was the sector’s best annual gain since 2014. In all, utilities are up more than 70% since their low in September 2023, beating every sector except technology and communication services and outperforming the broader market’s 60% return over the same period. Here’s what investors need to know about the changing outlook for utilities.
How Does the AI Boom Affect Utilities?
AI applications like ChatGPT or Microsoft’s MSFT Copilot don’t exist in a vacuum. The infrastructure needed to power these complex programs is housed in massive data centers full of servers, semiconductors chips, and storage systems. Those centers require enormous amounts of electricity to run and keep cool.
That’s where utilities companies come in. Firms like Alliant Energy LNT, Evergy EVRG, and American Electric Power AEP are investing billions and working with regulators to build the infrastructure needed to serve data centers.
In a new industry report, Morningstar analysts say investors expect AI data centers to “usher in a generational revival of US electricity demand growth.” It’s a major change for a once-sleepy industry. Miller says that demand for electricity, along with natural gas and water, has been mostly flat for several decades. With the advent of AI, analysts forecast that electricity demand from US data centers will triple between 2024 and 2030. Today, it constitutes 3% of total US electricity demand.
At the same time, Morningstar analysts expect that the share of data centers dedicated to AI will increase from one-quarter of all data center capacity in the US to two-thirds by 2030. “This produces the sharp increase in electricity demand in our forecast,” they write.
Utilities Investors Bet on Growth
Investors are on the same page. More demand means more earnings growth, which often translates to better stock performance. In the US Utilities Index, the median price/earnings ratio is hovering above 20, higher than the 20-year average for the sector. Miller says a P/E ratio around 16 is more typical.
At the same time, the sector’s dividend yield (the amount a stock pays out in dividends relative to its price) has fallen to historic lows below 3%, according to Morningstar’s analysts. Over decades, dividend yields tend to track the 10-year US Treasury yield, but utilities’ yield is currently trailing the 10-year yield by more than 100 basis points.
The combination of an elevated P/E ratio and a low dividend yield suggests that “investors value utilities’ growth prospects more than their dividends,” Morningstar analysts argue. More evidence of the shift? Historically, utilities tend to outperform as interest rates fall and investors turn away from lower-yielding products to assets that pay higher dividends. Utilities stocks historically underperform when interest rates rise.
But that phenomenon “has not happened” in the years following the Fed’s most recent hiking cycle in 2022, Miller says. Instead, utilities have outperformed and their dividend yields have remained low, even with interest rates elevated. It’s a sign that “the market is pricing in a lot of growth,” Miller explains, and “investors are undervaluing yield.”
Is the Market Too Bullish on Utilities?
Expectations of supercharged growth have pushed utilities higher and added a premium to their prices. Overall, “we think the sector is going to grow more than it has in a generation,” Miller explains. But he and Morningstar’s analyst team say the market’s expectations for growth may be a little too aggressive. They think utilities will grow, but not at the astonishing pace seen in the tech sector.
They point to two important developments that investors may be discounting. First are advances in energy efficiency, which in the coming years could reduce how much electricity is needed to power AI applications, even as usage of those applications continues to grow. Second is a shift in the in the type of actions performed by AI models as they enter a later stage of development. That shift will be from the building and training of AI models, which is extremely energy-intensive, to a process called inference, which requires much less energy. Inference is the process by which an AI model that is already trained makes predictions. Think making a query using ChatGPT, rather than building ChatGPT from scratch.
On top of that, Morningstar’s analysts say regulatory factors could constrain the outlook. “We think the most bullish forecasts don’t consider the challenges that utilities, regulators, and grid operators will face in supplying the energy to support huge new data centers, particularly in areas that have minimal existing infrastructure or that already face reliability risks,” they write. Regulators could also raise customer energy rates more slowly than expected, Miller says, which would put downward pressure on earnings growth.
To be sure, the analysts don’t expect demand for energy use in data centers to fall—in fact, they expect it to accelerate rapidly over the next five years. But after that, the rate of growth could taper off.
Taken all together, Morningstar’s analysts consider utilities to be about 10% overvalued, an estimate that assumes roughly 6% annual earnings growth for the sector over the next few years. The market is pricing in earnings that grow even faster than that, while the sector typically sees earnings growth closer to 3%, Miller says.
In addition, Morningstar analysts stress that not all utilities are equally positioned to take advantage of this secular shift. “With most utilities’ valuations still elevated relative to historical levels and our fair value estimates, we think investors will have to be selective to find utilities that can produce consistent, long-term earnings growth that justifies their premium valuations,” they write. Overall, they say mid-cap utilities in the Midwest have the best chance of realizing the growth expectations priced into the stocks.
