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Industry Outlook

Overview

Utility services play a vital role in a nation’s economic progress as cheap and abundant supply of power keeps the wheels of development rolling. With development comes the need for more power, as cities expand, and the use of new gadgets increases. However, everything comes for a price. Greenhouse gas emitted by large utilities cause immense damage to the environment.  

Utilities have been under the scanner for a long time. However, the recent climate action plan from President Obama, followed by the U.S. Environmental Protection Agency's (EPA) proposal for granting permission for setting up new power plants are putting immense pressure on power producing units.

The utility operators are implementing new technologies in generation and distribution of power. The introduction of smart meters will benefit customers while the smart-grid technology is likely to increase efficiency.

However, implementation of these new technologies, over vast service territories, is a long, drawn-out process. In addition, the cost involved in implementing the latest requirement from the environmental agencies could make power plants run on coal more costly than before. This is compelling power generators to install more eco-friendly power units and develop more power from renewable energy sources.

As per a U.S. Energy Information Administration (EIA) report, global energy use will increase to 770 quadrillion Btu in 2035 from 505 quadrillion Btu in 2008. The majority of this usage is expected to come from countries outside the Organization for Economic Cooperation and Development (non-OECD nations). The energy market of non-OECD nations has a larger scope for improvement compared to the more mature OECD nations. The Asian market is expected to take center stage in the global arena over the next four decades, accounting for nearly 50% of global energy consumption by 2050.

In such a scenario, positive steps from the U.S. alone will not be enough to counter the negative impact of global greenhouse gas emissions. The variance in the socio-economic structure of different countries and the quest for cheaper sources of electricity are making the task difficult, if not impossible. In fact, a recent study from International Energy Agency showed that the greenhouse gas emitted from China in 2012 offset the positive impact of lower emission from Europe and the U.S.

What is in the Climate Change Proposal?

The proposal from the EPA aims to strengthen the existing policies on greenhouse gas emissions. Per the proposal, new large natural gas-fired turbines would require to limit carbon emission of 1,000 pounds of CO2 per megawatt-hour, while new small natural gas-fired turbines would need to meet a limit of 1,100 pounds of CO2 per megawatt-hour.

A new coal-based power plant will have to limit carbon emission to 1,100 pounds of CO2 per megawatt-hour. In addition, coal based power generators would have the option to meet a somewhat tighter limit if they opt for an average emission over multiple years.

The new recommendation will make electricity generation from coal units far more costlier than before. Increasing awareness about the pitfalls of coal-based power generation will drive regulators to formulate even more stringent laws on emission from coal-fired generating units.

After this back to back announcement from the President and EPA, most of the U.S. electric utilities that rely heavily on coal for power generation will have to rethink their plant development activities.

Zacks Rank

Within the Zacks Industry classification, Utilities are a stand-alone sector, one of 16 Zacks sectors. The rural wire-line telephone companies are also grouped within the Zacks Utility sector, but the three major industries within this sector include Electric Power, Gas Distribution and Water Supply.

The Utility sector’s defensive attributes reflect the group’s lack of correlation with the broader market/economy. Of course, the sector’s reputation as a dividend payer also adds to its perceived defensiveness.

We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank. http://www.zacks.com/rank/industry.php

The way to look at the complete list of Zacks Industry Rank for the 260+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,’ between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.’

Scanning the industries in the Utility sector, we find none in the top 1/3rd. Gas Distribution and Water Supply both has a Zacks Industry Rank #104, while Electric Power is at Zacks Industry Rank #181.

Besides the Industry Rank, we also have ticker-wise rank allocation for each ticker in our coverage universe. This indicates the movement of the companies over a short timeframe (1 to 3 months).

We cover 77 electric utilities, out of which 11 tickers have a Zacks Rank #2 (Buy), 48 tickers hold a Zacks Rank #3 (Hold) and the remaining 18 tickers either have a Zacks Rank #4 (Sell) or a Zacks Rank #5 (Strong Sell).

We track 25 gas utilities, out of which 7 tickers have a Zacks Rank #2 (Buy), 12 tickers hold a Zacks Rank #3 (Hold) while 6 tickers aren't doing well with a Zacks Rank #4 (Sell) or a Zacks Rank #5 (Strong Sell).

We presently cover 12 water utilities, out of which 1 each have a Zacks Rank #1 (Strong Buy) and Zacks Rank#2 (Buy), 8 tickers carry a Zacks Rank #3 (Hold) and 2 tickers either have a Zacks Rank #4 (Sell) or Zacks Rank #5 (Strong Sell).

We would recommend investors to concentrate on Strong Buy, Buy or Hold Ranked stocks. The reason is simple: the tickers with a Zacks Rank #1 to 3 will have a higher probability to report strong earnings results and outpace market expectation, compared to the tickers in the bottom half having either a Zacks Rank #4 and 5.

Earnings Trends

The utilities on the whole reflected growth of 0.7% year over year in the second quarter of 2013 compared to 3.1% registered by the S&P 500 companies. As per the current standing, the utilities are expected to improve upon their previous quarter's performance. The utilities are expected to register a 2.4% year-over-year increase in the third quarter, outpacing the S&P 500 beat of 0.5% over the same period.

Electric Utilities

The EIA reported that electricity consumption in the U.S. will increase from 3,841 billion kilowatt hours in 2011 to 4,930 billion kilowatt hours in 2040, increasing at an average annual rate of 0.9%. For the fuel type in energy generation, renewables and natural gas will play an increasing role while coal and nuclear power will gradually fall out of favor.

As per EIA, the increasing demand for electricity and retirement of nearly 103 gigawatts (GW) of existing capacity will result in an addition of 340 GW of power production units from 2012 to 2040.

Natural gas-fired plants will provide 63% of the projected capacity, while 31% will come from renewables, 3% from coal and 3% from nuclear. This proves that natural gas will continue to play a vital role in energy solutions in the coming three decades.

The electric utilities expected to play an important role in meeting this increased demand for power are Alliant Energy Corporation (LNT), American Electric Power Inc. (AEP), Duke Energy Corp. (DUK), Entergy Corp. (ETR), NextEra Energy Inc. (NEE - Analyst Report), PPL Corporation (PPL) and Southern Company (SO) among others.

Natural Gas Utilities

Among the utility services, natural gas usage is increasing due to its abundance, cheap price and clean-burning nature. The EIA forecasts the use of natural gas in the U.S. to increase from 24.37 trillion cubic feet in 2011 to 29.54 trillion cubic feet in 2040, increasing at an average annual rate of 0.7%.

New fracking technology has multiplied natural gas production from rock and rock structures previously considered uncommercial.  A study from NaturalGas.org pointed out that the natural gas reserve in the U.S. increased by 39% from 2006 levels, thanks to the implementation of new exploration techniques.

The natural gas utilities are not only expected to benefit from the steady increase in domestic demand but also from exports that are expected to rise significantly. The new techniques used to drill natural gas will enable natural gas operators to export large volumes after meeting domestic demand.

The positive dynamics are going to benefit natural gas utilities like AGL Resources Inc. (GAS - Analyst Report), Atmos Energy Corporation (ATO - Snapshot Report), New Jersey Resources Corp. (NJR), Southwest Gas Corporation (SWX - Snapshot Report), Questar Corp. (STR - Analyst Report), Sempra Energy (SRE - Analyst Report) and  MDU Resources Group Inc. (MDU - Snapshot Report), among others. As per an EIA release, for the week ending Oct 9, 2013, U.S. natural gas hub prices grew moderately over the one-week period. The Henry Hub spot price closed at $3.70 per million British thermal units (MMBtu), on Oct 9, up 9 cents per MMBtu from the beginning of the report week.

The recovery in natural gas prices will benefit the numerous operators in the sector. With more than 71 million domestic natural gas customers, the industry has enough room for nearly 1,200 natural gas utilities presently operating in the country.

In addition, the U.S. Department of Energy (“DOE”) nod for LNG exports will open up new market opportunity for the U.S. gas utilities. In Sep 2013, electric and natural gas supplier Dominion Resources Inc. (D - Snapshot Report) received an approval from the DOE to export 770 million cubic feet of natural gas a day (mmcf/d) for 20 years.

The DOE is being cautious in granting permission for LNG exports. At present 21 applications are pending with the regulator for LNG export permission. Given the huge natural gas reserve in the U.S. and ever increasing global demand for natural gas, the natural gas export permission will help to unlock greater value of this natural resource. This could be a potential game changer for the natural gas sector.

Water Utilities

The major challenge ahead for water utility operators is the aging water and sewer infrastructure. Maintenance and development of facilities play a crucial role and will test the financial capabilities of the water utilities.

A report from Economic Development Research Group Inc. suggests an alarming gap between the water infrastructural requirement and actual investments planned for the coming years. The gap is expected to reach $84 billion in 2020 and widen to $144 billion in 2040. The report also revealed that without proper renewal or replacement, nearly 44% of the existing pipelines will become too poor for operation by 2020.

The utility operators have begun to invest in their ageing infrastructure, but it appears the initiatives are inadequate to bridge the gap. The government should consider taking adequate measures before things blow out of proportion.

Among the water utilities, American States Water Company (AWR - Snapshot Report), Aqua America, Inc. (WTR - Snapshot Report), Connecticut Water Service, Inc. (CTWS - Snapshot Report) and Consolidated Water Co. Ltd. (CWCO - Snapshot Report) registered positive earnings surprises in their latest reported quarters. The performance of these water utilities indicates that these will register sequential growth in the third quarter of 2013 as well.

What Keeps the Utilities Going?

The biggest positive for the utilities is that there is hardly any viable substitute for utility services. This is the most fundamental strength of the industry. Moreover, increasing demand drives this industry forward.

Another inherent advantage of these utilities is their size and the requirement of huge initial capital outlay.  For this reason, we generally do not find many new entrants in the market. Also, stringent government regulations and the hard toil for new entrants to establish a loyal consumer base put existing players in an advantageous position.

Finally, utilities have been known to pay dividends consistently, thereby retaining investor confidence. This was evident during the economic crisis of 2008-2009 when these operators continued to pay out dividends without fail.

In Conclusion

Despite the assured demand for services, the utilities have to constantly meet the high expectations of its wide customer base, adapt to a changing global economic scenario, and upgrade technologies to meet stringent environmental norms.

Utility operations globally depend on weather patterns that determine the extent of demand. Erratic weather patterns thereby impact the profitability of these operators, so much so that their operational goals remain unmet.

Moreover, hurricanes, storms and blizzards disrupt the normal operation of the utility operators. American weather tracking body, National Oceanic and Atmospheric Administration ("NOAA") has projected a very active hurricane season in the second half of 2013, and storms are expected to exceed the seasonal averages.

The majority of new electricity in the next two decades in the U.S. will be generated from natural gas and renewable sources. Besides the abundance of natural gas, as many as 30 U.S. states and the District of Columbia have enforceable renewable portfolio standards or other renewable generation policies. We expect this count to go up, compelling producers to generate more green power to meet the renewable standards fixed by the states.

At the ongoing 22nd World Energy Congress in Daegu, South Korea, the difficulties of providing sustainable energy to a growing global population at a minimal environmental impact were debated. In the same venue, World Energy Council released a note pointing out the challenges resulting from population growth.

To sum up, a more prompt permission for LNG export will increase the profitability of the U.S. natural gas operators. At the same time a concerted effort will have to be made to remove the funding requirement in the water utility sector. Otherwise the aging water infrastructure will lead to more wastage, leading to a hike in cost of operation and a related increase in the price of water supplied.

As for the electric utilities, these are venturing more and more into grid scale solar and wind projects, wrenching the initiative from the pure-play solar companies.

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