Back to top

Image: Bigstock

Factors That Might Impact Utilities' Stability

Read MoreHide Full Article

Utility companies are among the safest investment bets, but they have their share of weaknesses as well. Regulatory burdens and increased debt loads remain concerns. But while the new administration is expected to lower the industry’s regulatory burden, an even bigger issue is the interest rate backdrop.

In Dec 2016, the Fed increased interest rates, a move that indicates deteriorating prospects for capital-intensive utilities. A rise in interest rates hurts rate-sensitive sectors like utilities. Making things worse, the Fed is expected to raise interest rates as many as three times this year if the economic conditions remain conducive.

Let’s look into the factors which might deter investors from investing in the utility space.

New Regulations

The new administration plans to completely overhaul U.S. Environmental Protection Agency (EPA) stipulations that we put in place by the previous administration. But before new legislation can be put in place, the law of the land will remain the Clean Power Plan which calls for CO2 reduction of 28% by 2025 and 32% by 2030 from 2005 levels. Coal producers had to undertake the tedious and financially stressful task of reducing their carbon footprint.

A good many U.S. utility operators preferred to shut down their old coal-fired generation units, rather than inject fresh funds to make these units fit for new emission standards. Per a recent release from the U.S. government’s Energy Information Administration (EIA), coal’s usage in power generation would fall to 26% of U.S. electricity generation in 2040 from 33% in 2015.

Debt Levels

Utilities are capital intensive and need to have a continuous inflow of funds to carry on their organic growth and infrastructure upgrade projects. This is essential in maintaining an uninterrupted supply of basic amenities like electricity, fresh water and gas. Utilities generate funds from operations which are to some extent used to meet their capital requirements. But these funds are mostly used for dividend payouts. They take recourse to external sources of financing to meet their capital requirements.

The Federal Reserve finally raised the interest rate in Dec 2016. Going forward, Fed officials hint at further interest rate hikes in 2017, provided that the overall economic conditions are conducive for such a move.

We believe that a rising interest rate environment could add to the woes of utility operators, as it will increase their cost of capital, restraining their ability to pay consistent dividends. We suggest investors to take note of outstanding debts and current ratio, both of which indicate the company’s ability to meet its debt obligations while investing in a utility.

Competition with Bonds

These reliable dividend payers are in competition with bonds as an investment option. The increase in interest rates will definitely make bonds with its yields another attractive investment option for risk-averse investors, driving them away from the utility space.

The Fed’s plans to increase the interest rate thrice in 2017, assuming favorable economic conditions, will hurt utilities and make bonds a more attractive option for investors.

Safe but Limited Growth Potential

Investment in these highly regulated defensive utilities is considered safe. Even though utilities pay regular dividends and go for buybacks, the scope of capital appreciation is quite limited for investors in this space. Share prices in this sector do not jump the way they do in the technology sector, so the returns are never dramatic.

Utilities to Avoid for the Time Being

We presently recommend investors to stay away from the following utilities as they presently have an unfavorable Zacks Rank. The other metrics also indicate that they are not profitable investment options at present.

TerraForm Power Inc. currently has a Zacks Rank #5 (Strong Sell). Its Zacks Consensus Estimate for 2017 has deteriorated to a loss from of 41 cents from earnings of 13 cents in the last 60 days.

Brookfield Infrastructure Partners LP (BIP - Free Report) currently has a Zacks Rank #4 (Sell). Its Zacks Consensus Estimate for 2017 has declined 4.3% in the last 60 days to $3.13.

New Jersey Resources Corp. (NJR - Free Report) holds a Zacks Rank #4 as well. Its average negative surprise for the last four quarters is 5.96%. The Zacks Consensus Estimate for 2017 has decreased by a penny in last 60 days.

Global Water Resources Inc.’s (GWRS - Free Report) average negative surprise for the last four quarters is 22.22%. The Zacks Consensus Estimate for 2017 has declined by a penny in the last 60 days. The company currently has a Zacks Rank #4.You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Bottom Line

Despite the drawbacks of the utility industry, it is still undoubtedly one of the most stable industries to invest in. The focus on clean energy is going to be the top-most on the agenda in the coming years. We expect utilities to take advantage of the shale boom in the U.S. and the falling prices to develop more power plants based on natural gas. Combined-cycle natural gas power plants not only help to lower pollution but also result in energy efficiency.

A makeover in the utility space is already underway, with utilities shutting down coal-fired units and focusing more on green energy generation. The crucial question is, will they be able to sustain this momentum following the hike in interest rates?

We expect President Trump’s view on climate change and plans to abandon the Paris agreement to be support fossil fuel-based companies and help them survive the ongoing challenges.

 

The Best Place to Start Your Stock Search

To help you find the most promising stocks in this industry, you are invited to download the full list of 220 Zacks Rank #1 "Strong Buy" stocks – absolutely free of charge. Since 1988, Zacks Rank #1 stocks have nearly tripled the market, with average gains of +26% per year. Plus, you can access the list of portfolio-killing Zacks Rank #5 "Strong Sells" and other private research. See these stocks free >>