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The Utility sector is mature and fundamentally strong as demand for utility services is generally immune to 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. The very basic nature of these services also results in heavy regulation, both at the federal as well as state levels.

Utility business is known for stability and visibility of its earnings and cash flows.  Stable earnings enable utilities to pay out consistent dividends that add to their attractiveness to income-oriented investors.

Over the last few years, we have noticed that utilities are gradually changing their preference of fuels to produce electricity. In the United States, natural gas currently contributes the largest portion of the fuel mix and has removed coal from the top spot.

Utilities, apart from generating electricity, focus on strengthening transmission and distribution lines. Meanwhile, natural gas utilities depend on pipelines to deliver the product to the end users. Water utilities are also required to upgrade and replace old pipelines and water mains. 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 Fed raised interest rates for three consecutive quarters (December 2016, March 2017 and June 2017), which will certainly hurt utilities.

The rise in interest cost will no doubt increase cost of capital for utilities and might limit their ability to pay dividend and buy back shares. These developments could lower attractiveness of utilities and investors might turn to bonds as an alternative source of investment.

Weather continues to impact the operation of utility services. Hurricane Harvey has left many customers in Texas without power, as major power transmission lines were out of service due to the storm. Restoration services are gradually making things normal but we believe that these outages will hurt the earnings goal of utilities operating in the region. Also, before this catastrophe could be dealt with, Hurricane Irma, a Category Five storm is making its way and could impact regions from Caribbean to Florida.

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 is up 12.6% year to date (as of Sep 5, 2017).

Repeal of Clean Power Plan: Impact on Utilities

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 August 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 February 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 be able to run their units for a longer period than expected earlier.

Zacks Industry Rank - Positive

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 the 265 sub-industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries in two groups — the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than two to one. To learn more visit: About Zacks Industry Rank.)

Note that two of the three industries related to the utility sector — Gas Distribution and Electric Power — fall under the first group, with a Zacks Industry Rank of #72 and #101, respectively, while Water Supply with a Zacks Industry Rank of #208 falls in the second group.

Our present outlook for the utility sector is positive, with two of the major industries placed in the first group of the Zacks Industry Rank.

Utility Valuations Look 'Full'

The valuation of the sector (Considering Gas Distribution, Water Supply and Electric Power industry) looks expensive at present. The Water Supply industry is currently trading at 20.2x forward 12-month EPS estimates, Gas Distribution industry is trading at 24.1x while Electric Power industry is trading at 15.4x compared with S&P 500 trading average of 19.4x.

The current 24.1x multiple for Gas Distribution companies compares to the five-year range of 16.6x to 24.1x (median of 19.9x) while 20.2x multiple for Water Utilities compares to five-year multiple ranged from a low of 12.4x to a high of 23.3x (median of 18.5x). The current 15.4x multiple for Electric Utilities compares to a five-year range of 11.5x to 16.4x (median of 13.9x).

The above study shows that the current multiples are within the five-year ranges, but are clearly toward the high end of those ranges. Since the utilities are trading near high end of historical averages, we can consider these valuation levels as anything but 'full' at this juncture.

Earnings Review & Outlook

Here's how these safe investment bets fared in the second quarter of 2017 and how they're placed ahead of its third-quarter earnings release.

Second-quarter earnings in the utility space increased 7% on the back of 7.7% revenue growth.

Mild weather experienced in the first half in most parts of the United States lowered demand for electricity and did not help the utilities. However, cost control, new electric rates and customer growth helped the utility sector come up with positive earnings growth in the second-quarter reporting cycle.

Earnings for the third quarter are expected to decrease at a clip of 2.5% against an improvement of 4% for the S&P 500. Revenues at the sector are expected to improve 0.7% in the third quarter compared with 4.8% for the S&P 500. Earnings from the utility sector are expected to increase 2.1% on the back of 4.4% improvement in total revenues in 2017. 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 from the Electric Power industry, all of which have positive estimate revisions, paid regular dividend and returned higher than the industry they belong to.

CenterPoint Energy Inc. (CNP - Free Report) has a Zacks Rank #2 (Buy) and a long-term earnings growth projection of 4.3%.

The utility reported positive earnings surprises in three of last four quarters with an average surprise of 10.3%. The stock has a dividend yield of 3.61%. Its 2017 earnings estimates moved up 1.6% in the last 60 days. Shares of CenterPoint have gained 19.9% year to date, outperforming the industry’s 10.2% rally.

Duke Energy Corporation (DUK - Free Report) has a Zacks Rank #2 and a long-term earnings growth projection of 4%. The utility reported positive earnings surprises in two of last four quarters with an average surprise of 1.2%. The stock has a dividend yield of 4.08%. Its 2017 earnings estimates moved up 0.2% in the last 60 days. Shares of Duke Energy have gained 12.6% year to date, outperforming the industry.

Ameren Corporation (AEE - Free Report) has a Zacks Rank #2 and a long-term earnings growth projection of 6.5%. The utility reported positive earnings surprises in two of last four quarters with an average surprise of 2.8%. The stock has a dividend yield of 2.93%. Its 2017 earnings estimates moved up 1.1% in the last 60 days. Shares of Ameren Corporation have gained 13.7% year to date, outperforming the industry.

PPL Corporation (PPL) has a Zacks Rank #2 and a long-term earnings growth projection of 5%. The utility reported positive earnings surprises in three of last four quarters with an average surprise of 6.5%. The stock has a dividend yield of 4.03%. Shares of PPL Corporation have gained 14.7% year to date, outperforming the industry.

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