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Rising Interest Rates Make Life Tough for Utilities

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Though utility companies are among the safest investment bets, they have their share of weaknesses. Regulatory burdens, weather variation 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 Fed raised interest rates for three consecutive quarters (December 2016, March 2017 and June 2017), which is a drag for rate-sensitive sectors like Utilities. Making things worse, the Fed might hike interest rates again in December, 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 for 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 cost of capital, restraining their ability to pay consistent dividends. We suggest that investors take note of outstanding debts and current ratio, both of which indicate the company’s ability to meet its debt obligations.

Weather a Headwind

Weather plays a vital role in driving demand for utility services. A normal winter and summer season assure higher demand for utility services. However, a milder winter and a cooler summer results in lower demand for utility services.

The Electric Reliability Council of Texas (ERCOT) in its recent release announced that since Hurricane Harvey hit the land, demand for electricity in Texas dropped to 20,000 megawatts (MW) per day, down from typical August demand of 44,000 MW, primarily due to structural damage and cooler temperature in the affected region.

We believe that the drop in demand, power outages and structural damage will impact the third-quarter earnings goal of American Electric Power (AEP - Free Report) , CenterPoint Energy Inc. (CNP - Free Report) and Entergy Corporation (ETR - Free Report) , having operations in the region.

Hurricane Irma, a Category Five storm currently progressing toward Florida, could cause vast damage to utility infrastructure.

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 has increased the interest rate three times in the last three quarters, which will raise the cost of capital for the utilities and might adversely impact its ability to carry on with dividend payment and share buyback, making the high interest-bearing 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 to stay away from the following utilities having an unfavorable Zacks Rank. The other metrics also indicate that these utilities are not profitable investment options now.

Westar Energy currently has a Zacks Rank #4 (Sell). It saw an average negative surprise of 7.75% for the last four quarters. The Zacks Consensus Estimate for 2017 earnings per share declined 0.4% in the last 90 days to $2.50. Westar has lost 9.3% year to date versus 10.2% rally of the Zacks Electric Power industry it belongs to.

Global Water Resources Inc. (GWRS - Free Report) saw an average negative surprise of 50% for the last four quarters. The Zacks Consensus Estimate for 2017 earnings per share has decreased 36.4% over the last 90 days to 7 cents. The company currently has a Zacks Rank #4. Global Water Resources stock has gained 3.4% year to date, much lower than Zacks Water Supply industry’s gain of 10.3%.

Bottom Line

We believe that focus on clean energy is going to be at the top of the utility companies agenda in the coming years. We expect utilities to take advantage of the shale boom in the United States and falling prices to develop power plants based on natural gas and renewable source of energy. 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 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?

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