Demand for utility services like electricity, gas and water varies marginally with the swings of the economy. This is because the fortunes of these companies do not fluctuate extensively over the economic cycle. After all, these companies that provide basic services can never go out of business -- this is their most basic fundamental strength. Their ability to boost shareholders’ value through consistent dividends and share buybacks makes them all the more attractive.
Stocks of utility companies enjoy a reputation for safety given the regulated nature of their business, which 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 (till Sep 30, 2016) compared with the S&P 500 return of 7.7% over the same time frame.
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 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.
These capital intensive utilities therefore routinely take recourse to capital markets to meet the above requirements. Though regulated utilities are cash generators, the funds generated from internal sources are less than sufficient to carry out long-term projects. Given their business model, the prevailing low interest rate scenario is helping them to get the much-needed funds on favorable conditions.
However, the increase in the interest rate by the Federal Reserve in Dec 2015 has to some extent raised the cost of capital for utilities. The Fed might again increase interest rate once before 2016 ends if economic factors are conducive to a hike. If the cost of capital increases for utilities, investors might turn to bonds as an alternative source of investment.
The Environmental Challenge
Historically, 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 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 even 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 the 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.
Some of the utilities had on their own taken steps to curb emission levels, by shutting down old coal-based power plants, investing in emission control methods, and adding natural gas and alternate energy sources for electricity generation. As a result of these initiatives, per a U.S. Energy Information Administration (EIA) report, the coal share of total electricity generation should fall from 33% in 2015 to 26% in 2040.
Positive Factors to Boost Demand
Per the U.S. Bureau of Labor Statistics, the unemployment rate in Aug 2016 was 4.9%. The level of employment has remained unchanged in the last two months. As per the U.S. Census Bureau, new single family home sales increased 20.6% year over year in Aug 2016 to 505,000.
Recent EIA projections, however, indicate that despite the increase in housing permits, retail sales of electricity to the residential sector are expected to fall by 0.6% year over year during 2016.
However, the EIA forecast that retail electricity sales to the commercial sector will rise by 5.8% in 2016. In addition, U.S. industrial sector sales are expected to increase by 19.4% in 2016.
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.’
We find that out of the three prominent industries, one falls under the first category and two fall under the second category. Gas Distribution has a Zacks Industry Rank #83, Electric Power has a Zacks Industry Rank #152 and Water Supply has a Zacks Industry Rank #166.
Our present outlook on the utility sector is Neutral, with two major industries in this space currently holding a neutral rank. Gas Distribution has moved up to the Positive category since the last update.
Here’s how these safe investment bets fared in the second quarter of 2016 and how they’re shaping up for the third quarter earnings release. Second-quarter earnings in the utility space increased by 8.3% compared with a fall of 1.5% for the S&P 500.
Earnings for the third quarter are expected to improve at a clip of 4.4%, contrary to the S&P 500 contraction of 2.8%. The top line of the utility sector is expected to improve by 1.3% in the third quarter against growth of 1.0% for the S&P 500. For more information on earnings for this sector and others, please read our 'Earnings Preview' report.
Utilities Worth Adding
Investors might keep a watch on the following utilities that have the financial strength to withstand a gradual increase in the interest rate without compromising on dividend payments.
Spark Energy (SPKE - Snapshot Report) has a current ratio of 1.66 anda dividend yield of 4.98%. This utility registered positive earnings surprises in the three out of last four quarters, with an average beat of 48.24%. Its 2016 earnings estimates moved up 12.2% in the last 60 days. Spark Energy currently sports a Zacks Rank #1 (Strong Buy).
ONE Gas, Inc. (OGS - Snapshot Report) has a long-term earnings growth projection of 5.95%. The utility surpassed estimates in the last four quarters, with an average beat of 7.80%. The stock has a current ratio of 1.75 and a dividend yield of 2.26%. Its 2016 earnings estimates moved up by 0.8% in the last 60 days. ONE Gas currently holds a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
DTE Energy Co. (DTE - Analyst Report) holds a Zacks Rank #2 and has a long-term earnings growth projection of 5.80%. The utility exceeded estimates in the last four quarters, with an average beat of 6.94%. The stock has a current ratio of 1.2 and a dividend yield of 3.29%. Its 2016 earnings estimates moved up by 2.6% in the last 60 days.
Southern Company (SO - Analyst Report) holds a Zacks Rank #2 and has a long-term earnings growth projection of 3.93%. The utility surpassed estimates in the last four quarters, with an average beat of 5.58%. The stock has a current ratio of 1.78 and a dividend yield of 4.37%.
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