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Industry Outlook

Stocks of utility companies enjoy a reputation for safety given the regulated nature of their business that 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. The Dow Jones Utility Average (DJU) is up 16.4% year to date (til Jun 3, 2016) compared with the S&P 500 return of 2.7% over the same time frame.

Though demand for utility services like electricity, gas and water varies with the swings of the economy, the fortunes of these companies don’t fluctuate to the same extent over the economic cycle. After all, these companies providing basic services can never go out of business -- this is their most basic fundamental strength. Their ability to boost shareholders’ value through consistent dividends makes them all the more attractive.

To provide an uninterrupted supply of basic amenities, utilities need to upgrade and strengthen their infrastructure and modernize the generation fleet. The water utilities in particular are positioned for massive growth as billions of dollars in regulated investment are required to upgrade the soiled and old water infrastructure. These modifications enable utilities to meet increasing demand and abide by stringent environmental regulations laid out by state and federal agencies.

The capital intensive utility industry was enjoying the benefit of near zero interest rates and was using the funds to strengthen existing infrastructure and add to their generating assets. However, the increase in the interest rate by the Federal Reserve in Dec 2015 has to some extent raised the cost of capital for the utilities. In addition, investors might show more interest toward bonds than utilities as an alternative source of investment.

The Environmental Challenge

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. Curbing pollution is now an ongoing process and the regulators have fixed standards of emission that need to be achieved within a stipulated timeframe. Utilities are installing smart meters, attaching scrubbers to lower emissions and launching energy efficiency programs to reduce customers’ energy consumption.

Governments across the world are enforcing ever stricter rules and mandates to bring down the industry’s carbon footprint. In Aug 2015, the U.S. Environmental Protection Agency released the final version of the Clean Power Plan. The plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels.

There was however strong opposition to the enforcement of this Clean Power Plan, as a large group felt it was too harsh and will have an adverse impact on other industries like coal apart from utilities. The Supreme Court ruling in Feb 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.

Per a U.S. Energy Information Administration (EIA) report, thanks to the already undertaken pollution control initiatives, emissions of carbon dioxide were reduced by 2.7% in 2015 and are expected to further decline 1.5% in 2016.

Something to Cheer About

Per the U.S. Bureau of Labor Statistics, the unemployment rate in May 2016 was down by nearly 70 basis point year over year to 4.7%. As per U.S. Census Bureau, new single family home sales in Apr 2016 increased 23.8% year over year to 619,000.

Recent projections from the EIA, however, indicate that despite the increase in housing permits, retail sales of electricity to the residential sector are expected to fall by 1.3% year over year during 2016.

However, the EIA forecasts that retail electricity sales to the commercial sector will rise by 0.5% and 1.3% in 2016 and 2017, respectively. In addition, U.S. industrial sector sales are expected to remain flat in 2016 but increase by 1.5% in 2017.

Zacks Industry Rank - Neutral

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 all of the 257 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank.

The way to look at the complete list of Zacks Industry Rank for the 257+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,’ between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.’

After scanning the utility sector, we find that out of the three prominent industries two fall under the second category and one in the last category. Water Supply has a Zacks Industry Rank #96, Electric Power has a Zacks Industry Rank #111 and Gas Distribution has a Zacks Industry Rank #189.

Our present outlook on the utility sector is Neutral with two major industries in this space currently holding a neutral rank while Gas Distribution slipping since the last update.

Earnings Results and Expectations

Here let’s discuss how these safe investment bets have fared in the first quarter of 2016 and how they’re shaping up for the second quarter earnings release.

First-quarter 2016 earnings in the utility space declined by 2.2% compared with a fall of 6.6% for the S&P 500. Revenues in the utility space declined by 1.2%, compared with a fall of 1.1% for the S&P 500.

Large utilities like Edison International (EIX - Free Report) and American Electric Power Co., Inc. (AEP - Free Report) missed earnings estimates in the first quarter, while others like FirstEnergy Inc. (FE - Free Report) and NiSource Inc. (NI - Free Report) surpassed estimates.

However, earnings in the second quarter of 2016 are expected to improve at a clip of 2.2%, contrary to the S&P 500 contraction of 6.1%. The top line of the utility sector is expected to improve by 1.9% in the second quarter of 2016 as against a decline of 0.8% for the S&P 500.

Investors might keep a watch on the following utilities as they have the financial strength to withstand a gradual increase in the interest rate without compromising on dividend payments.

Public Service Enterprise Group Inc. (PEG - Free Report) has a long-term earnings growth projection of 2.62% and a dividend yield of 3.62%. This Zacks Rank #3 (Hold) utility has registered positive earnings surprises in the last four quarters with an average beat of 3.31% and has a current ratio of 1.11.

UGI Corporation (UGI - Free Report) , another Zacks Rank #3 stock, has a long-term earnings growth projection of 6.73% and a dividend yield of 2.07%. The average positive earnings surprise in the last four quarters is 6.91% and the current ratio is 1.16.

ONE Gas, Inc. (OGS - Free Report) also holds a Zacks Rank #3 and has a long-term earnings growth projection of 6.00%. The utility has beaten estimates in three out of the last four quarters with an average beat of 3.11%. The stock has a current ratio of 1.83 and a dividend yield of 2.32%.

For more information about earnings for this sector and others, please read our 'Earnings Trends' report.