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The Utility sector is mature and fundamentally strong as demand for utility services is generally immune to the vagaries of the economic cycle. It’s because these companies provide basic services like electricity, gas and water, which can never go out of demand. While these businesses are not ‘growthy’ in the traditional sense, but the stability and visibility of their earnings and cash-flows allow them to pay out consistent dividends, which adds to their attractiveness to income-oriented investors.

To maintain an uninterrupted supply of basic amenities, utilities need to upgrade and strengthen their infrastructure and modernize the generation fleet. Water utilities in particular are positioned for massive growth as billions of dollars in regulated investment are required to upgrade soiled and old water infrastructure.

Apart from generating electricity, electric utilities focus on strengthening transmission and distribution lines. Meanwhile, natural gas utilities depend on pipelines to deliver the product to the end users. So to upgrade and strengthen the existing infrastructure, utilities depend on capital markets.

These capital intensive utilities therefore routinely take recourse to capital markets to meet the above requirements. Though regulated utilities are cash generators, the funds generated from internal sources are not sufficient to carry out long-term projects. Utilities have been benefiting from the rock-bottom interest rate environment. However, the Federal Reserve raised interest rates for two consecutive quarters (Dec 2016 and Mar 2017), which will certainly hurt utilities.

The Fed may raise interest rates again in 2017 if the economic factors are conducive. If the cost of capital increases further for utilities, investors might turn to bonds as an alternative source of investment.

However, utility companies enjoy a reputation for safety given the regulated nature of their business, which give their revenues a high level of certainty. They also benefit from the domestic orientation of their business, which shields them from foreign currency translation issues that have been a headwind for many other industries lately. Utilities are also gaining from customer growth, proper cost control and the latest electric rates. The Dow Jones Utility Average (DJU) is up 6.16% year over year (as of May 12, 2017).

President Trump & Clean Power Plan

Historically, electric utilities have heavily relied on coal for a large part of power generation, which has become a big challenge for the group in these times of enhanced environmental awareness. In line with this, in Aug 2015, President Obama introduced the Clean Power Plan to lower emissions levels from electricity generation by around 32% by 2030 from 2005 levels.

To adhere to the Clean Power Plan, some utilities had taken steps to bring down emission levels, which included the shutting down of old coal-based power plants, investing in emission control equipment, and increasing the share of natural gas and alternate energy sources in electricity generation.

There was, however, strong opposition to the enforcement of Clean Power Plan, as a large group felt it was too harsh and will have an adverse impact on industries like coal apart from utilities.

The Supreme Court ruling in Feb 2016 temporarily stayed the implementation of this Clean Power Plan and blocked the efforts of the U.S. administration to lower global warming by regulating emissions from coal-fired power plants.

President Trump acted on his pre-election promises and has taken steps toward repealing the Clean Power Plan. Trump believes that such plans will make U.S. manufacturing non-competitive in the global markets. The move toward repealing the Clean Power Plan will benefit coal-focused electric utilities like American Electric Power Company (AEP - Free Report) .

Even if these amendments take time to be implemented, it will benefit coal-based utilities as they will able to run their units for a longer period than expected earlier.

Zacks Industry Rank – Neutral

Within the Zacks Industry classification, utilities are a standalone 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.

We rank all of the 257 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.

In the complete list of Zacks Industry Ranks for the 257+ industries, the outlook for industries with a Zacks Industry Rank of #88 and lower is 'Positive,’ those between #89 and #176 is 'Neutral' and those with #177 and higher is 'Negative.’

Note that each of the three industries related to the utility sector – Gas Distribution, Water Supply and Electric Power – falls under the second category, with a Zacks Industry Rank of #109, #153 and #166, respectively.

Our present outlook for the utility sector is Neutral, with all the three major industries placed in the middle-third of the Zacks Industry Rank.

Utility Valuations Look ‘Full’

The valuation of the sector (Considering Water Supply, Gas Distribution and Electric Power industry) looks expensive at present. The Water Supply industry is currently trading at 18.9X forward 12-month EPS estimates, while Gas Distribution industry is trading at 21.4X.

The current 21.4X multiple for Gas Utilities compares to the 5-year range of 15.8X to 22.7X (median of 19.3X), while Water Utilities’ 5-year multiple has ranged from a low of 11.6X to a high of 22.1X (median of 19.9X). Electric Utilities are currently trading at 13.3X forward 12-month EPS estimates, related to a 5-year range of 11.5X to 14.8X (median of 13.1X).

What this shows is that while current multiples are within the 5-year ranges, they are clearly towards the high end of those ranges. It is hard to consider these valuation levels as anything but ‘full’, considering the expected onset of the Fed tightening cycle.

Earnings Review & Outlook

Here’s how these safe investment bets fared in the first quarter of 2017 and how they’re placed ahead of their second-quarter earnings release. First-quarter earnings in the utility space increased 4.0% on the back of 8.3% revenue growth.

Moderate winter weather in most parts of the U.S. lowered demand for electricity and did not help the utilities. However, cost control, new electric rates and customer growth helped the utility sector to come up with positive earnings growth in the first-quarter reporting cycle.

Earnings for the second quarter are expected to decrease at a clip of 2.8%, compared with an improvement of 6.1% for the S&P 500. Revenues at the sector are expected to improve 5.5% in the second quarter, higher than expected growth of 4.7% for the S&P 500. For more information on earnings for this sector and others, please read our ‘Earnings Preview' report.

Utilities Worth Buying

Investors may keep an eye on the following utilities, all of which have the financial strength to withstand a gradual increase in interest rates without compromising on dividend payments.

CenterPoint Energy Inc. (CNP - Free Report) has a Zacks Rank #2 (Buy) and a long-term earnings growth projection of 5.00%. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The utility reported a positive earnings surprise of 2.78% in the last quarter. The stock has a current ratio of 1.10 and a dividend yield of 3.92%. Its 2017 earnings estimates moved up 1.6% in the last 90 days.

ONE Gas, Inc. (OGS - Free Report) has a long-term earnings growth projection of 5.53%. The utility surpassed estimates in the last four quarters with an average beat of 13.38%. The stock has a current ratio of 1.56 and a dividend yield of 2.45%. Its 2017 earnings estimates moved up by 0.7% to $2.98 in the last 90 days. ONE Gas currently carries a Zacks Rank #2.

Telephone and Data Systems, Inc. (TDS - Free Report) , sporting a Zacks Rank #1, has a long-term earnings growth projection of 5.0%. It surpassed estimates in two out of the last four quarters, with an average beat of 802.41%. The stock has a current ratio of 2.74 and a dividend yield of 2.28%. Estimates for 2017 improved to earnings of 23 cents from a loss of 2 cents over the last 60 days.

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