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Industry Outlook

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As would be expected, the growth of the utility industry is tied to overall economic conditions. As per the U.S. Energy Information Administration (EIA), energy consumption in the United States will increase 0.3% annually from 2010 through 2035. EIA’s assumption takes into consideration modest growth in economic conditions after the recessionary period of 2008-2009 and increase in the energy efficiency level.

The majority of new power in this period 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.

As per the EIA report, the rise in demand for energy over the 2010 to 2035 period is because of stepped-up demand from commercial, industrial, transportation and residential sectors. The highest growth in demand is expected to come from the commercial sector clocking an expected yearly growth rate of 0.7%, stemming from 1% annual growth in floor-space over the same period.

Besides growth in demand from the commercial sector, the EIA report shows that the industrial sector will also recover from the 2008-2009 recession, leading to higher volume of energy consumption. A large chunk of industrial demand will be attributable to the increase in production of biofuels, enabling the companies to meet the renewable fuel standards of the Energy Independence and Security Act of 2007.

The utility industry attracts the attention of income-oriented investors due to its steady income generation capacity, as most of the rates for the power generated are regulated by utility commissions at the state levels. The wholesale power generation segment of the industry is effectively deregulated.

On the flip side, ever-increasing and stringent government regulations as well as demand fluctuation owing to irregular weather patterns is a permanent feature of the utility industry story.

A key challenge for most utility operators is to find the optimal mix of generation from its producing units to meet regulatory requirements. These operators are also working towards enhancing their production organically and also through acquisitions.

Global Scenario

As per the EIA report global energy use will increase to 770 quadrillion British thermal units (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 non–OECD nation’s energy market has a larger scope for improvement compared to the mature OECD nations.

The rise in demand for energy is definitely a good sign for the companies in the utility sector. However, our concern lies in the cost that needs to be paid for development at such unprecedented levels, particularly the environmental cost. Will emerging nations be able to impose strict environmental standards, like the ones which are prevailing in the U.S. and Europe? The EIA’s report does not look so promising, with an indication of more greenhouse gases being emitted from the developing nations.

OPPORTUNITIES

Unending demand: This basic tenet will remain the driving force for the industry. There will always be demand for power generation, with ebbs and flows in between.

Each passing day we are increasingly dependent on a number of electrical gadgets, which means more and more demand for electricity and utility services.

New avenues are opening up which will enhance the demand for electricity. We see new growth opportunities in the transportation segment. Green vehicles have the potential to be a game changer in the global arena and can help to cut down on emissions drastically.

A number of big automobile companies like General Motors Company (GM), Toyota Motors Corp. (TM) and Honda Motor Co. (HMC) are the front runners in the creation of hybrid (and electric) vehicles. These vehicles, which run on electricity, will drive demand in the utility sector.

Utility services have no alternative: A big positive for the utility operators is that there is hardly any viable substitute for utility services. We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but do not have any alternative to electricity. Similarly, clean water does not have any substitute. This is the primary driving factor for the industry.

Previously, conventional fossil fuels were used solely to generate electricity. Now alternate sources are also utilized for electricity generation. As per the EIA report, energy generated from alternate sources will increase at an annual rate of 3% from 2010 through 2035.

Regular dividend payment: The utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. These operators likewise reward their shareholders through the payment of sustainable dividends. This has been evident during the economic crisis of 2008-2009 when these operators continued to pay out dividends without fail.

Currently, among the electric utility companies, Genon Energy (GEN) has the highest dividend yield of 13.0%. Among the natural gas utilities, TransAlta Corporation (TAC) has the highest dividend yield of 7.6%, while within the water utilities Middlesex Water Company (MSEX) has the highest dividend yield of 3.9%. All these dividend yield numbers compare favorably with the industry average of a yield of 3.8%.

Focused R&D: In their quest to improve the standard of services, the utility operators have relentlessly pursued research and development work. Keeping the rise in demand and efficient use of power in mind, the operators have brought in new smart meters, new transmission and distribution lines, and new gas pipelines into operation.

Utility operators are also benefiting from ongoing research work in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells having higher conversion rates allow operators to generate more power with fewer solar panels. This enables the operators to lower the cost of producing power.

Mergers and acquisitions: Apart from growing organically, the players in the utility industry are carrying out strategic merger and acquisition deals, which lead to cost synergies and better utilization of resources.

We believe that in a mature energy market like the United States, mergers and acquisitions represent a good way to enhance market share. It expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio of the company and also lowers operating costs through the usage of common back office space to control the expanded operations. Mergers and acquisitions also have risks, but even then these deals are taking place across the board and the utility sector is no exception.

In one of the mega mergers in this space, North Carolina-based Duke Energy Corporation (DUK - Analyst Report) completed the acquisition of Progress Energy Inc. in July 2012. The deal was valued at $32 billion including the outstanding debt of the acquired company. This acquisition created one of the largest U.S. utilities and increased Duke Energy’s capability to build new power plants to meet future greenhouse-gas emissions limits.

Integrys Energy Group Inc. (TEG) inked an agreement to acquire Fox Energy Company LLC owned by General Electric (GE) and privately held company, Tyr Energy Inc. for $440 million. The $440 million buyout consists of the purchase of Fox Energy Center, a 593-megawatt (MW) combined cycle generating unit in Kaukauna, for $390 million and $50 million for early expiration of the existing tolling agreement.

Another utility company, Entergy Corporation (ETR), had entered into a definitive agreement with ITC Holdings Corp. (ITC), under which Entergy will divest and then merge its electric transmission business into ITC. The $1.775 billion divestment deal is on track with regulatory approvals currently underway.

Existing operators enjoy benefits: Utility operations need huge initial investments and a large number of consumers who can help to generate revenues to recover costs. For these reasons, we generally do not find many new entrants in the market. Also, government regulations and the hard toil for new entrants to establish loyal consumer bases put the existing players in an advantageous position.

WEAKNESSES

Vulnerable to weather changes: Utility operations globally depend on weather patterns that determine the extent of demand. Moderate weather conditions drastically lower the demand for utility services. Erratic weather patterns thereby impact profitability of these operators such that their operational goals remain unmet.

The hurricane season also affects utility operations. Excessive rains create floods whereby in some cases operators have to shut down their generating units. This undermines the profitability of the utility operators.

Buyers’ market: The utility service markets are gradually transforming into buyers’ markets. A lot of states allow the consumers to migrate from one utility operator to the other operating in the region. The consumers thus have the option of choosing the best and/or the cheapest operator in the region. Higher-cost producers are gradually edged out of the market unless they can bring down their costs.

Long-term power purchase agreements between operators and customers could also impact profitability. In situations when there is an increase in the cost of generation, the operators still have to abide by the pre-existing agreement and sell power at pre-determined rates, thereby stretching margins.

Capital intensive: The utility business is a capital-intensive industry and needs huge capital investments. Particularly when a company goes into expansion mode, the funds generated internally are insufficient to fulfill the capital needs. So, the company has to borrow money from the markets for carrying out the development work.

The increase in the debt level -- for that matter a steep debt/equity ratio -- impacts the credit rating of these utility operators. If the credit rating comes down, the company will find it difficult to borrow funds from the markets at reasonable rates, and hence the cost of operations of the company will increase.

Government intervention & emission control: The United States government has come out with stringent laws and regulations, which are affecting the operations of the utility operators. To meet the increasing regulatory standards a few of the utility operators have had to shut down their coal-fired units. In recent times, to meet the environmental regulations, American Electric Power (AEP) has decided to retire 4,600 megawatts (MW) of coal-fired generation from its portfolio.

The operators are gradually idling their old power generation plants or trying to meet the new regulations by installing scrubbers and using a better variety of coal. These steps invariably increase the cost of operating the units.

In the United States, as per the U.S. Environmental Protection Agency’s “Mercury and Air Toxics Standards” (MATS), all coal-fired units having a generation capacity of more than 25 megawatts (“MW’) will have to abide by the MATS rule beginning 2015. As per this rule, the coal-fired units have to bring down the greenhouse gas emissions levels to 90% below their uncontrolled levels.

These units will have to install scrubbers or use carbon injection controls to bring down emissions levels. Margins would thus be hurt unless the operators can recover the investments from consumers through rate hikes.

These stringent measures to control emissions, however, do not seem to be enough. As per EIA, global carbon dioxide emissions will increase to 43.2 billion metric tons in 2035 from 30.2 billion metric tons in 2008.

The development of industries and greater dependence on fossil fuels to generate power in non-OECD nations will increase the emissions of greenhouse gases on a global scale. Despite the increasing focus on renewables, coal still remains the major source of electricity generation. This is due to coal’s wide and cheap availability on a global scale.

Pending rate case: Consumers expect to have uninterrupted supply of utility services at all times. The operators to ensure this supply makes consistent investments to upgrade their transmission lines, carry out regular maintenance work and lay down new lines to distribute power.

The regulated utilities recover these costs through rate increases in its service territories. The pending rate cases and at times partial allowance of the rate hike requested make it difficult for the operators to sustain ongoing development and maintenance work.

Pending rate cases continue to mount, as very recently Duke Energy filed for an annual base revenue increase of 12% or approximately $387 million with North Carolinas Utilities Commission ("NCUC"). The rate case was filed to recover higher operating expenses and cost to build low emission generation units.

Earnings Roundup and Zacks Rank

The companies in the utility sector are yet to come out with their earnings results. We expect the softness in the utility sector will continue in this quarter as well.

The earnings results of the utility companies were mixed in the previous quarter, with one or two companies surpassing our expectation convincingly. Overall, earnings in the previous quarter were better than what was registered in the first quarter of the year. The average magnitude of earnings surprises was hovering around a penny to seven cents.

We presently have a long-term Neutral recommendation (six months plus) on the majority of the stocks under coverage in the utility sector. The stalemate is largely due to lackluster results seen in the first half of 2012, in conjunction with an absence of a game-changing catalyst on the horizon.

Zacks Ranks indicate the movement of the stocks over the short time (1 to 3 months). Over the short term we have a few names with a Zacks #2 Rank (short-term Buy rating). These include Pinnacle West Capital Corporation (PNW), Integrys Energy Group, Inc. (TEG), Scana Corp. (SCG), PNM Resources, Inc. (PNM - Snapshot Report), The AES Corporation (AES - Analyst Report), PPL Corporation (PPL - Analyst Report), Public Service Enterprise Group Inc. (PEG - Analyst Report) and  Northeast Utilities (NU - Analyst Report).

The majority of stocks we cover in the utility industry, such as NiSource Inc. (NI - Analyst Report), Duke Energy Corporation (DUK - Analyst Report), Dominion Resources Inc. (D - Snapshot Report), Southern Company (SO - Analyst Report), Pepco Holdings, Inc. (POM - Analyst Report), NextEra Energy Inc. (NEE - Analyst Report), Exelon Corporation (EXC - Analyst Report), Wisconsin Energy Corporation (WEC), OGE Energy Corp. (OGE), Edison International (EIX), CMS Energy Corporation (CMS), Calpine Corporation (CPN) and Pike Electric Corporation (PIKE), presently retain a Zacks #3 Rank (short-term Hold rating).

However, we presently have a few Zacks #4 Ranked stocks (short-term Sell rating) in First Energy Corp. (FE), Xcel Energy Inc. (XEL), Hawaiian Electric Industries, Inc. (HE) and CenterPoint Energy, Inc. (CNP).

In Conclusion

The utilities nevertheless 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. This can only be achieved by entering into strategic partnerships.

It is also important to keep in mind that expansion of the customer base of the utility operators does not necessarily mean growth in usage. At times, despite an increase in customers, we can see a decline in usage due to sluggish economic recovery and energy efficiency initiatives. Nevertheless, we believe a revival in the economy would raise both the customer base and usage.

We are also seeing a substantial increase in the use of natural gas for power generation due to its clean burning nature and abundance in the United States. The relatively lower prices of natural gas also make it popular among industrial users. This has helped in augmenting growth for natural gas utilities and gas pipeline operators.

The hot summer weather aided the utility industries across the board resulting in a rise in demand for electricity. Coal recovered some lost ground as a source of fuel during this peak demand scenario. As per an EIA report, in August 2012, coal produced 39% of U.S. electricity, up from a low of 32% in April 2012.

Our Zacks Rank and Recommendation is a reliable indicator of the likely movements of these utility stocks. Investors who are willing to invest in utility companies can look into some of the following points: 1) debt levels and cash flow generation capabilities, which indicate the prospects or need for funding of expansion projects, 2) pipeline projects and the fuel type of generation units, which indicate its ability to grow and at the same time conform to renewable energy policies, and 3) regulated and unregulated mix of the generation portfolio, which gives a fair idea about revenue generation.

To round up, the utility stocks will hardly come out with eye catching numbers but the earnings of these companies are generally stable due to the regulatory nature of operations. Thus, investors can expect a modest return on their investment.

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