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Can Utilities Return Value on Investments Amid Rising Rates?

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Utility companies are among the safest investment bets, yet they have their share of weaknesses. Regulatory burdens, weather variation and increased debt loads amid rising interest rates are the major concerns. While the Trump administration is expected to lower the industry’s regulatory burden, an even bigger issue is the interest rate backdrop.

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. So, the debt levels of this industry are generally higher compared with the other industries. Low rates have helped the utilities to invest in infrastructure and upgrades cost-effectively.

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.

The rise in Fed interest rates six times since December 2015 it going to hurt utilities. 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.

In addition to higher interest rates having a direct negative impact through increased financing burden, utility stocks and other high-yielding equities tend to struggle in a rising interest rate environment since the relative attractiveness of their high yields gets diminished by fixed income instruments.

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 hurricane season, which officially spans from Jun 1 to Nov 30, poses the toughest challenges for the utility operators in the United States. We have seen the devastation caused by Hurricanes Harvey and Irma last year that exceeded billions of dollars.

Utilities like Duke Energy Corporation (DUK - Free Report) and NextEra Energy Inc. (NEE - Free Report) , both Zacks Rank #3 (Hold) stocks, have made substantial investments in Florida in the last few years to strengthen their power delivery systems. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

However, despite making substantial investment in strengthening infrastructure, we have seen that it is really difficult to ascertain in advance the disruption and damage from these storms.

Safe but Limited Growth Potential

Investment in these highly regulated defensive utilities is considered safe. Even though utilities pay regular dividends and make share 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. The utility sector has returned 2.3% in the past five years compared with the S&P 500’s gain of 70.3%.

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.

Fed’s interest rates hikes are a drag for rate-sensitive sectors like utilities. Making things worse, the Fed might hike interest rates two more times in 2018, if economic conditions remain conducive.

Utilities to Avoid for the Time Being

We presently recommend investors to stay away from the following utilities with an unfavorable Zacks Rank. The other metrics also indicate that these utilities are not profitable investment options now.

Spark Energy Inc. (SPKE - Free Report) currently has a Zacks Rank #5 (Strong Sell). It saw an average negative surprise of 139.18% in the last four quarters. The Zacks Consensus Estimate 2018 earnings per share declined by 27.6%, in the past 60 days. In last one-year Spark Energy’s share have lost 29.5%.

Middlesex Water Co. (MSEX - Free Report) delivered an average negative surprise of 14.14% in the last four quarters. The Zacks Consensus Estimate for 2018 earnings per share declined by 8.8%, in the past 60 days. The company currently has a Zacks Rank #4 (Sell). Middlesex Water’s shares have lost 3.4% in the last six months.

Bottom Line

At the end of the day, we believe that rise in interest costs will continue to hurt utilities. However, these fundamentally strong utilities are here to stay forever as we have yet to come up with any alternatives to their services.

Changes in the U.S. administration might result in intensity of regulations, which has some positive impact on their performance due to increasing operation costs. Utilities are gradually converting their operation from non-regulated to regulated nature, which will again provide stability to earnings. In addition, the latest tax reforms have helped all the utilities across the United States, and the benefits of the same are being passed on to customers.

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