Though utility companies are among the safest investment bets, they have their share of weaknesses. Regulatory burdens and increased debt loads are major concerns. While the Trump administration is expected to lower the industry’s regulatory burden, an even bigger issue is the interest rate backdrop.
The Federal Reserve raised interest rates for two consecutive quarters (Dec 2016 and Mar 2017) which is a drag for rate-sensitive sectors like utilities. Making things worse, the Fed is expected to lift interest rates two more times this year if economic conditions remain conducive.
Let’s look into the factors which might deter investors from investing in the utility space.
Debt Levels & Rising Rates
Utilities are capital intensive and need to have a continuous inflow of funds to maintain organic growth and infrastructure upgrade projects. This is essential in maintaining an uninterrupted supply of basic amenities like electricity, fresh water and gas.
Utilities generate funds from operations which are to some extent used to meet their capital requirements. But these funds are mostly used for dividend payouts. They take recourse to external sources of financing to meet their capital requirements.
We believe that a rising interest rate environment could add to the woes of utility operators, as it will increase their cost of capital, restraining their ability to pay consistent dividends. We suggest investors take note of outstanding debts and current ratio, both of which indicate the company’s ability to meet its debt obligations while investing in a utility.
Weather a Headwind
Weather plays a vital role in driving demand for utility services. A normal winter and summer season assures higher demand for utility services. However, a milder winter and a cooler summer affect lesser demand for utilities.
A mild winter during the first quarter impacted demand for utilities services and hurt earnings of utilities operating on the East Coast and Midwest.
Competition with Bonds
These reliable dividend payers are in competition with bonds as an investment option. The ongoing increase in interest rates will definitely make bonds with its yields another attractive investment option for risk-averse investors, driving them away from the utility space.
The Fed’s plans to increase the interest rate twice in 2017, assuming favorable economic conditions, will hurt utilities and make bonds a more alluring option for investors.
Safe but Limited Growth Potential
Investment in these highly regulated defensive utilities is considered safe. Even though utilities pay regular dividends and go for buybacks, the scope of capital appreciation is quite limited for investors in this space. Share prices in this sector do not jump the way they do in the technology sector, so the returns are never dramatic.
Utilities to Avoid for the Time Being
We presently recommend investors stay away from the following utilities as they presently have an unfavorable Zacks Rank. The other metrics also indicate that they are not profitable investment options at present.
Connecticut Water Service, Inc. currently has a Zacks Rank #4 (Sell). Its average negative surprise for the last four quarters is 10.19%. Its Zacks Consensus Estimate for 2017 earnings per share decreased 2.7% in last days 90 days to $2.19.
Spark Energy Inc. (SPKE - Free Report) currently has a Zacks Rank #4. Its average negative surprise for the last four quarters is 38.79%. The Zacks Consensus Estimate for 2017 earnings per share declined 6.4% in the last 90 days to $2.62.
Southwest Gas Corporation (SWX - Free Report) holds a Zacks Rank #4 as well. Its average negative surprise for the last four quarters is 26.0%. The Zacks Consensus Estimate for 2017 earnings per share has decreased 2.0% over the last 90 days to $3.40.
Global Water Resources Inc.’s (GWRS - Free Report) average negative surprise for the last four quarters is 75.0%. The Zacks Consensus Estimate for 2017 earnings per share has decreased 15.4% over the last 90 days to 11 cents. The company currently has a Zacks Rank #4.
Despite the drawbacks of the utility industry, it is still undoubtedly one of the most stable industries to invest in. The focus on clean energy is going to be the top-most on the agenda in the coming years. We expect utilities to take advantage of the shale boom in the U.S. and the falling prices to develop more power plants based on natural gas. Combined-cycle natural gas power plants not only help to lower pollution but also result in energy efficiency.
We expect President Trump’s view on climate change and plans to abandon the Paris agreement to be support fossil fuel-based companies and help them survive the ongoing challenges. A makeover in the utility space is already underway, but the decision to repeal the Clean Power Plan will help the utilities to continue with the coal-fired units for longer than previously expected. The crucial question is, will the ongoing hike in interest rate offset the benefits of a favorable decision of the new administration?
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
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