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Factors That Make Utility Stocks a Safe Investment Choice

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The utility sector is currently undergoing a transition as the primary fuel source, coal, is being replaced by natural gas, and we could notice increased usage of clean energy to produce electricity. Stringent emissions regulations enacted by President Obama also prompted utilities to take steps to lower emission levels.

President Trump’s repeal of these stipulations on economic growth grounds are expected to give a new lease of life to utilities that produce a major part of their electricity from coal. Coal still accounts for nearly 30% of the electricity produced in the United States.

However, even without the Clean Power Plan, some large utilities like NextEra Energy (NEE - Free Report) and Duke Energy Corporation (DUK - Free Report) have taken the initiative to produce more electricity from natural gas and alternative sources.

We believe there needs to be a balance between emission control and clean energy generation. A constructive utility rate environment, increase in electricity production from natural gas and renewables, and supporting clean coal-powered projects will enable utilities to efficiently serve a larger customer base.

In the segment below, we discuss the basic strengths of the utility sector.

Stable Demand & Rising Prices

A major positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for its services. The endless need for electricity and utility services is a prime driver. This lends revenues and cash flow a high level of stability and visibility.

In a recent release, the U.S. Energy Information Administration predicted that the annual average U.S. residential electricity price will increase 3.4% in 2017 and 3.2% in 2018, which will surely benefit the utilities. Electricity prices are also projected to increase in commercial and industrial sector. The increase in prices will, no doubt, boost earnings of the utilities.

Regular Dividend & Share Buybacks

Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability. These operators, in turn, reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008-2009 when utilities continued to pay dividends uninterruptedly.

We have a long list of companies that are sharing profits consistently with their shareholders. Notable among them are CenterPoint Energy (CNP) and Duke Energy, which have raised dividend rates annually for more than 10 years now.

CenterPoint Energy, currently a Zacks Rank #2 (Buy) stock, has a quarterly dividend rate of 26.75 cents and a dividend yield of 3.61%. You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here.

In the second quarter, Duke Energy’s board of directors approved a 4.1% increase in the quarterly dividend rate. The current quarterly dividend rate is 89 cents, with a dividend yield of 4.08%.

Focus on R&D & Extension of ITC/PTC

In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have introduced new smart meters and strengthened their transmission and distribution lines, which helped in the efficient usage of energy.

Utility operators are also benefiting from the ongoing research in the solar photovoltaic sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.

In addition, the utility friendly moves of the U.S. administration through the extension of the validity period of Solar Energy Investment Tax Credit (ITC) and Wind Energy Production Tax Credit (PTC) will help the companies. We will see more utility scale solar and wind projects coming up, which will boost green power generation.

Mergers and Acquisitions

Utility sector operators don’t shy away from merger and acquisition (M&A) activities to supplement organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.

We believe that in a mature energy market like the United States, M&As represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and lowers operating costs through the usage of common back office space.

We are noticing major acquisitions in the water utility space. American Water Works Company (AWK - Free Report) closed several acquisitions in the first half of 2017, adding nearly 22,000 customers through acquisition and organic growth. The pending acquisition when closed could increase the company’s customer base by 34,000 in 2017.

Another major player in the water utility space, Aqua America Inc. (WTR - Free Report) , successfully completed a few acquisitions as of Aug 2, 2017 adding 1,002 customers. Its pending acquisition, when closed over the course of the year, will add another 11,087 customers to its existing base.

To Sum Up

Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features. In addition, relaxed emission regulations under the Trump administration should act as a tailwind for the utility sector.

We notice a transition in the utility sector with more focus on clean energy generation, but we do not have any alternative to electricity. Similarly, clean water and wastewater services do not have any viable substitute. This is most important driving factor for the utilities.

There has been increasing focus on electricity storage facilities that will provide more support to the grid during peak demand period. The utilities are also regularly investing to strengthen their infrastructure to serve customers more efficiently.

The defensive nature and stable performance demonstrated by the utility sector has driven investors to look for a safe haven in this space. In the last six months, the Utility sector has returned 6.4% to investors compared with 4.9% gain of the S&P 500. So staying invested in these regular dividend payers often regarded as a “bond substitute” will be a safe option for jittery investors.

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