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Utility - Electric Power Outlook: A Strong Long-Term Holding

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Domestic focused and regulated utility electric power companies supply basic-necessity electricity and its demand rarely fluctuates during economic cycles. These stocks are favored by investors for their stability and ability to payout regular dividend to their shareholders.

With rising emphasis on emission, these electric utilities are investing in generating plants that produce electricity with low and negligible amounts of emissions, and are focused on improving and upgrading transmission and distribution networks. To upgrade and strengthen the existing infrastructure, electric power companies depend on capital markets.

Though regulated utilities are cash generators, funds generated from internal sources are not sufficient to carry out long-term projects. The rate-sensitive, capital-intensive utility stocks also had to accommodate the Fed’s rate hike. The rise in interest cost will no doubt increase the cost of capital for utilities and might limit their ability to payout dividends and buy back shares.

Despite the above drawbacks, cost control, customer growth and requirement of electricity in all spheres of life are the driving forces behind the success and stable performance of the electric power companies.

Industry Lags in Terms of Shareholder Returns

Looking at shareholder returns over the past year, it appears that the broader economic recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospect. And this is despite the fact that the domestic-focused electric utilities enjoy steady demand and are not too much dependent on the movement in economic trend.

The Zacks Utility Electtic Power Industry, which is a 71-stock group within the broader Zacks Utility Sector, has underperformed the Zacks S&P 500 Composite but the decline was narrower than its own sector over the past year.

While the stocks in this industry have collectively lost 4.4%, while Zacks Utility Sector declined 7.4% but the Zacks S&P 500 Composite rallied 17.7%.

One-Year Price Performance



Utility Electric Power Industry Stocks Trading Cheap


Since electric power companies have a lot of debt on their balance sheets, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio.

This is because the valuation metric considers not just equity but also the level of debt. For capital-intensive coal companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structure and ignores the effect of noncash expenses.

The valuation of the industry still appears cheap, in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 10.35, which is above the median level of 10.23.

The trailing 12-month EV/EBITDA ratio for the Zacks S&P 500 Composite is 11.92 and the median level is 11.50.


 

Since the S&P 500 has the best companies under the universe it is quite natural that its valuation appears pricey compared with the utility electric power industry stocks. It will assure investors that the electric power industry is currently trading at a decent discount to the broader sector. The Zacks Utility Sector’s trailing 12-month EV/EBITDA ratio of 12.01 and the median level of 12.11 for the same period are above the Zacks Coal Industry’s respective ratios.

Weak Earnings Outlook Could Impact Future Performance

Utility Electric Power companies are among the safest investment bets, due to their domestic focus and regulated nature of operations.  However, they still have their share of weaknesses. Stringent emission rules, weather variation and increased debt loads amid rising interest rates are major concerns for such entities.

The Fed has raised interest rates from the near zero level for seven times till June 2018, which is hurting the capital intensive electric power companies. Making things worse, the Fed might hike interest rates two more times in 2018, if economic conditions remain conducive. If the electric power companies fail to pass the higher costs of financing to customers through rate hikes, their profitability will be affected and appeal among income investors will be lost.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The valuation analysis above shows that the Utility Electric Power industry is presently trading cheaper than the broader sector and the Zacks S&P 500 composite.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is its earnings outlook. Empirical research shows that the earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

The current consensus earnings estimate for the Zacks Utility Power stock industry of $2.55 per share implies a 13.6% year-over-year decline.
 

Price and Consensus: Zacks Utility Electric Power industry

Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

Current Year EPS Estimate Revision


 

Zacks Industry Rank Indicates Bright Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Utility – Electric Power industry currently carries a Zacks Industry Rank #84, which places it at the top 33% of more than 255 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Utility Electric Power Stocks Promise Long – Term Growth

Per the U.S. Energy Information Administration (“EIA”) release, price of electricity in the United States was 10.78 cents per Kilowatt-hour (Kwh) at the end of June 2018 compared with 10.87 cents per Kwh at the end of June 2017. There has also been a sharp drop in the top line of utility electric power stocks since the end of first quarter of 2018.

This is primarily because of the ongoing decline in average price of electricity in the United States. Utilities are lowering electric rates for customers to pass on the tax savings generated from the implementation of the Tax Cuts and Jobs Act.
 

 

An important indicator of solid long-term prospect is the improvement in the group’s return on equity (ROE), which is a key metric for evaluating Utility electric power stocks. After touching its lowest point in third-quarter 2017, return on equity for the Utility electric power industry is improving.


To Sum Up

Stock market investing is no doubt a risky venture, and even well-thought out investment strategies at times fail to generate desired returns. Against this backdrop, let us focus on the domestic-focused utilities known for stability and visibility of earnings and cash flow.

The unemployment rate in the United States decreased to 3.9% in July from 4% in June, matching the expectations of the market.  In addition, the United States Building Permits increased 1.5% sequentially in July 2018 to 1,311 thousand. All these factors indicate an increase in demand for residential utility services.

A recent EIA release projects overall electricity consumption in the United States in 2018 to improve year over year, as demand for electricity from residential and transportation rises. This is definitely a positive for the Utility electric power industry.

At present, we have a few top-ranked stocks in our Utility Electric Power industry that have been witnessing positive earnings estimate revisions.

NRG Energy Inc. (NRG - Free Report) , the Zacks Rank #1 (Strong Buy) stock is based on Princeton, NJ. This utility has gained 46.1% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 16.6% upward over the last 60 days. You can see the complete list of today’s Zacks #1 Rank stocks here.


Price and Consensus: NRG

IDACORP, Inc. (IDA - Free Report) the Zacks Rank #2 (Buy) stock is based on Boise, ID. This utility has gained 9.7% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 2.2% upward over the last 60 days.

Price and Consensus: IDA

FirstEnergy Corp. (FE - Free Report) is a Zacks Rank #2 stock based out of Arkon, OH. This utility has gained 17.6% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 2.5% upward over the last 60 days.

Price and Consensus:FE

DTE Energy Company (DTE - Free Report) is a Zacks Rank #2 stock based out of Detroit, MI. This utility has gained 1.3% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 6.8% upward over the last 60 days.

Price and Consensus:DTE



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