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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 at a price, as green-house gases emitted by large utilities cause immense damage to the environment.

As per a U.S. Energy Information Administration (EIA) report, total energy use in the U.S. will increase to 106.3 quadrillion Btu in 2040 from 95 quadrillion Btu in 2012. Most of this demand is expected to come from the Industrial sector followed by the Commercial sector. While demand for energy from the Industrial sector is expected to increase 25.5% over the aforesaid period, the Commercial sector is improving at a clip of 18.6% year over year.

Even so, the utilities have been under review for a long time. The climate action plan of the U.S. President followed by the U.S. Environmental Protection Agency's (EPA) proposal for tightening the rules to set up new power plants are putting immense pressure on power producing units.

Utilities are now gradually shifting their emphasis towards natural gas and alternate energy sources to produce power. Global concerns about the pitfalls of green-house gas emissions supported by increasingly stringent government regulations have brought alternative energy into the limelight.

In such a scenario, progressive 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, emission from power generators in the developing nations is undermining the positive steps taken in the U.S. and Europe to curb pollution.

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, three prominent industries under this sector are currently ranked in three different categories. Water Supply has a Zacks Industry Rank #40, Gas Distribution has a Zacks Industry Rank #92 while Electric Power is at Zacks Industry Rank #161.

Earnings Trends

The utilities on the whole recorded growth of 4.7% year over year in the third quarter of 2013 as compared to 5.0% registered by the S&P 500. Utilities hardly surpass expectations by a large margin, primarily due to the regulated nature of their operation. For 2014 and 2015, earnings from this sector are expected to increase at rates of 6.5% and 4.8% year over year, lower than the 9.1% and 11.2% growth expected from the S&P 500 in these two years.

Annual net margins of the utilities are expected to increase from 8.9% in 2013 to 9.3% and 9.6% in 2014 and 2015 respectively. However, margins at the S&P 500 are expected to expand at a brisker pace of 9.6% in 2013, 10.4% in 2014 and 11.1% in 2015.

S&P 500 net margins will be primarily driven by the Technology, Finance and Business Services sectors. The defensive nature of the Utility sector is well reflected in its margin expansion forecast. Of the 16 sectors, margin improvement projection for the Utility is ranked at 8th over the 2013-2015 time frame.

For more information about earnings for this sector and others, please read our 'Earnings Trends' report. http://www.zacks.com/commentary/31310/

New Trends

The emergence of Microgrids for power generation could threaten the dominance of the age-old power distribution system in the U.S. Microgrids have evolved from simple power backup systems to small smart grids. The swift and cost effective installation of Micro grids could help distribute electricity among the masses. These rooftop solar systems meet the energy needs of the customers. In addition, the customers are allowed to sell excess power back to the utilities.

A report from American Society of Civil Engineers estimated that utilities need to spend $763 billion by 2040 to properly modernize and harden the existing grids against natural disasters. We believe that rather than going for a very costly maintenance, it will be economical to develop these Microgrids, which could lend support to the existing system.

Electric Utilities

The EIA reported that electricity consumption in the U.S. will increase from 3,826 billion kilowatt hours in 2012 to 4,954 billion kilowatt hours in 2040, implying an average annual rise 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.

The new proposal from the EPA directs a new coal-based power plant to limit carbon emission to 1,100 pounds of CO2 per megawatt-hour. In addition, coal based power generators would have to meet a somewhat tighter limit if they opt for an average emission over multiple years. Going forward, we expect regulations to get more and more stringent for power generation from coal fired units.

In this context, we believe fresh investments in the power sector would go more to the development of natural gas based combined cycle power plants. An EIA report indicates that natural gas will become the largest fuel source for power production in the U.S. by 2040 thereby displacing coal.

EIA report indicates coal-fired power generation to drop from 310 gigawatts (GW) in 2012 to 262 GW in 2040. The decline is a function of greater dependence on natural gas, usage of alternate energy sources and stricter regulations.   The utility operators are implementing new technologies for the generation and distribution of power. The introduction of smart meters will benefit customers while the smart-grid technology is likely to increase efficiency.

The electric utilities which would play an important role in meeting this increased demand for power are American Electric Power Inc. (AEP), Duke Energy Corp. (DUK), Pinnacle West Capital Corporation (PNW - Analyst Report), NextEra Energy Inc. (NEE - Analyst Report), PPL Corporation (PPL - Analyst Report) and Southern Company (SO - Analyst Report) among others.

The utilities are in the process of releasing their fourth quarter earnings results. Among the current releases, American Electric Power and PPL Corporation surpassed earnings expectation by 7.1% and 17.6% respectively, while Exelon Corporation (EXC) and Dominion Resources Inc. (D) missed expectation by a respective 5.7% and 9.1%.

Among the 76 electric utilities in our coverage, 2 stocks sports a Zacks Rank#1 (Strong Buy), 11 stocks have a Zacks Rank #2 (Buy), 48 stocks hold a Zacks Rank #3 (Hold) and the remaining 15 stocks have either a Zacks Rank #4 (Sell) or a Zacks Rank #5 (Strong Sell).     

Natural Gas Utilities

The country has huge volumes of natural gas reserves and the 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% in? 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. We noticed positive movements in the U.S. Industrial and Commercial sectors, which could drive demand for natural gas.

Given the abundance of natural gas in the U.S. , after much consideration, the U.S. Department of Energy (DOE) has granted permission to export liquefied natural gas (LNG). To date, the DOE has granted export licenses for LNG from four terminals, while there are 21 pending applications awaiting approval. In Sep 2013, electric and natural gas supplier Dominion Resources Inc. received an approval from the DOE to export 770 million cubic feet of natural gas a day (mmcf/d) for 20 years.

We believe the decision will allow U.S. nat gas producers to channelize their production volumes (after meeting domestic demand) to feed the ever increasing appetite for power in the global market.

LNG export could turn out to be a potential game changer for the natural gas sector. Multi-fuel producer CONSOL Energy Inc. (CNX) has shifted its focus to concentrate more on natural gas and has thus divested a few of its coal assets. After increasing natural gas production, this company might also explore the possibility of LNG export.

The EIA forecasts the use of natural gas in the U.S. to increase from 25.6 trillion cubic feet (Tcf) in 20112 to 31.6 trillion cubic feet in 2040.

The positive dynamics are going to benefit natural gas utilities like AGL Resources Inc. (GAS - Analyst Report), Atmos Energy Corporation (ATO), National Fuel Gas Company (NFG - Snapshot Report), 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.

Over the long run the spot prices for natural gas are expected to increase further from the present level of $4.80 per million British thermal units (MMBtu) on Feb 7. The increasing demand from the Industrial sector, for electric power generation and export obligation could push prices to $7.65/MMBtu in 2040 as per EIA.

With more than 71 million domestic natural gas customers, the natural gas market has enough room for the nearly 1,200 natural gas utilities presently operating in the country.

We track 22 gas utilities, of which 4 stocks have a Zacks Rank #2 (Buy), 16 stocks hold a Zacks Rank #3 (Hold) while 2 stocks aren't doing well at all with a Zacks Rank #4 (Sell).

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.

A prominent water utility, American Water Works Company, Inc. (AWK) has lately resorted to the inorganic route to expand its footprint. We view this as a smart move as larger companies will likely have better provisions to address the infrastructure needs of the industry.

Among the water utilities, American States Water Company (AWR), Connecticut Water Service, Inc. (CTWS) and Consolidated Water Co. Ltd. (CWCO) registered positive earnings surprises in their latest reported quarters. The water utilities are yet to release fourth quarter earnings results. The recent performance of these water utilities indicates that these will register sequential growth in the fourth quarter of 2013 as well.

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

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. In fact, new technology to produce power at a cheaper rate and emerging alternative resources for the generation of green power are likely to drive the industry going forward.

Recently, defense major Lockheed Martin Corp. (LMT - Analyst Report) along with Victorian Wave Partners Ltd decided to use ocean wave technology developed by Ocean Power Technologies Inc. to develop the largest wave energy project. The move skyrocketed the trading price of Ocean Power Technologies.

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.

Population increase and the prevailing economic conditions are two important factors which impact the demand for utility services. The revised projection from the U.S. Census Bureau, indicates that population growth in the U.S. will be lower by 0.2 percentage points from the previous projection in 2040. The downward revision could result in lower demand for utility services than previously expected.

Moreover, 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.

To sum up, LNG exports 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, we would expect more investment in natural gas and alternate energy projects, wrenching the initiative from the pure-play coal based electricity companies.

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