Unplugged & Up In Smoke

This has been an exceptionally warm winter. One of the biggest casualties of that has been the Electric Utility industry. Evidence of this comes from the Industrial Production report that came out last week. While overall industrial production rose 0.4%, that was due to a 0.9% rise in factory output, and a 0.3% rise in mine output. Utility output tumbled an eye-opening 2.7%. It was also down for the fourth month in a row. For all of 2011, utility output was down 6.6%.

Utility power plants do not come cheap. Electric Utilities have a lot of money invested in them, and are inherently very operationally leveraged. If anything, the capacity utilization numbers from the same report were even more shocking. Utility utilization tumbled to 76.8% of capacity, down from 79.0% in November and 79.6% in October. A year ago, power plants were running at 83.7% of capacity. The long term (since the late 1960’s) average is 86.6% of capacity.

OK, there is a bit of a headwind, since we have added 1.8% to capacity over the last year, probably from renewable sources like wind farms. Still, we are now at a record low, substantially below the 79.2% that was the bottom in 2009. Expensive idle plants are not conducive to strong earnings.

As is often the case, when a primary industry catches a cold, its suppliers get pneumonia. The biggest supplier to the electric utility industry is the Coal industry. This industry faces an additional challenge in that the chief substitute for coal in electricity generation is natural gas, and we are facing a massive glut of it which has sent the price of natural gas tumbling. That is going to put downward pressure on coal prices.

The coal companies have been doing a good job of exporting of late, but there are indications that it to is beginning to slow. The Baltic Dry index, which measures the day rates to charter the bulk freighters that carry commodities like coal, has absolutely collapsed.

Zacks Industry Classifications

The Zacks industry classifications are very fine, with 258 different industries tracked. It is not particularly noteworthy if a single small industry shows up doing well, a single firm with good news can propel a one or two firm industry to the top (or bottom) of the charts.

It is interesting when you see a cluster of similar industries at the top of the list. The same holds true for the bottom of the list. The definition of size that matters here is not the total sales or market capitalization but the number of companies in the “industry.” 

Electric Utilities Not Sparking, Coal Not Heating

The Electric Utility industry is, however, a very large one, with 80 different firms in it, although not all of them are domestic. The ones based in Europe have their own issues. The Coal industry is not quite as large, with 20 firms in it, but it is still well above average in size.

The Electric Utility industry was in 217th place of the 258 ranked industries, an improvement of five spots from last week as its average Zacks Rank fell to 3.31 from 3.34. Still, for such a large industry (by number of firms) that is an exceptionally weak showing.

The Coal industry is faring even worse in 248^th place, a deterioration of 11 spots as its average Zacks Rank rose to 3.70 from 3.50. That is weak, regardless of the size of the industry.

If the Zacks Ranks were distributed randomly, one would expect that only 5% of the members of these “industries” would earn the dreaded Zacks #5 Rank (Strong Sell). Instead, of the 20 coal firms, four (20.0%) have earned that dubious distinction. If it were random, only 15% would hold Zacks #4 Ranks (Sell) but actually four (20%) hold it. For the Electric Utilities, seven (8.8%) hold Zacks #5 Ranks, and 21 (26.3%) have Zacks #4 Ranks.

There are a wide variety of market capitalizations to choose from, although in general, the bigger firms are in the Utility area, and the Coal industry has more small caps. Some of the biggest electric firms are from overseas. The foreign ones might be a bit tougher to short than a domestic firm of the same size.

Small firms can be tough to short and generally do not have options available. If you have one of these firms in your portfolio, strongly consider selling it; if not, just avoid them all until their Zacks Ranks improve.

The valuations are for the most part reasonable, and while I don’t show the FY2 over FY1 growth on the tables, you can get a good idea of it by looking at how much lower the P/E for next year is relative to the P/E for this year.

Utilities are, of course, famous refuges for those who seek income. However, these days there are plenty of non-electric utilities that pay attractive dividends. The coal companies either don’t pay dividends at all or have low yields.

Number 5 Ranked Firms

Number 4 Ranked Stocks

In evaluating the Zacks Industry Ranks, you want to see two things: a good overall score (low, meaning more Zacks #1 and #2 Ranked stocks than #4 or #5 Ranked stocks) and some improvement the relative position from the prior week. It is also helpful to understand exactly what the Zacks Industry Rank is.

The Zacks Industry Rank is the un-weighted average of the individual Zacks ranks of the firms in that industry. It does not matter if the stock is the 800 lb gorilla that dominates the industry or some very small niche player in the industry -- they have the same influence on the industry rank.

Also, that means that the bigger the industry in terms of number of firms, the less influence any given company has on the industry rank. It also implies that small industries, with just two or three firms, should be the ones found at either the top or the bottom of the list. After all, if there are only two firms in the industry, it is relatively easy to get a Zacks rank of 2.00 (i.e. one with a Zacks Rank of #1 and the other with a #3). Right now, that industry rank would be tied for 6th place among the 255 industries tracked.

The same obviously goes for the bottom of the list as well. If there are 50 firms in the industry, and it ends up at one of the extremes, that means there has to be something pretty significant going on. Thus, I do not always focus on the very highest rated industries, but on the highest rated ones in which there are a large number of firms.

Click here for the Zacks Industry Rank List: http://www.zacks.com/zrank/zrank_inds.php

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