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Industry Outlook

The global market is far from being stable, thanks to possibilities of a Fed rate hike, uncertainties surrounding the Presidential Election in the U.S., the volatility in oil prices and sluggish growth in China. To counter the overall uncertainty, an investor should opt for defensive plays like utilities that known for their stability even amid global turmoil.

The utility sector is at a crucial juncture after the release of new emission standards by the U.S. Environmental Protection Agency (EPA) last August. The finalized version of the Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels. An EPA report also indicates that nearly $600 billion will be required to be invested in the water sector over the next two decades to get uninterrupted water and wastewater services of high quality.

Larger utilities with more financial strength and better access to capital are favorably placed to achieve regulatory compliance. This is also likely to trigger more consolidation in the utility landscape, be it the water or the electric utilities. For the electric utilities, the focus is definitely on generating electricity from natural gas and renewable sources. As a result, we expect to see higher solar installations across the U.S. as solar power currently contributes only 1% of total electricity produced in U.S.

The combination of steady electricity price gains and stable-to-improving demand will drive the utility sector. A decline in the unemployment rate, increase in hourly earnings of average workers and higher demand for utility services are acting as tailwinds for the utilities.

Rising up to the environmental challenge, utility companies are steadily improving their operations by investing in more environment-friendly power generation facilities. A recent release from the U.S. government’s Energy Information Administration (EIA) projects other renewables used in the electric power sector to increase from 2.6 quadrillion Btu per year in 2015 to 8.8 quadrillion Btu per year in 2040, reflecting growth of 5%.

The report also forecasts hydropower generation in the electric power sector to increase from 2.3 quadrillion Btu per year in 2015 to 2.8 quadrillion Btu per year in 2040, reflecting growth of 0.8%.

Moreover, the report indicates U.S. coal based generation to drop from 17.2 quadrillion Btu per year in 2015 to 13.1 quadrillion Btu per year in 2040, reflecting a decline of 1.1%.

We believe a constructive utility rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will enable the utilities to efficiently serve a larger customer base.

In the segment below, we discuss the basic strengths of the utility sector.

Regular Dividend & Share Buybacks

Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008–2009 when utilities continued to pay dividends without fail.

We have a long list of companies that are sharing profits consistently with their shareholders. Notable among them are CenterPoint Energy (CNP - Free Report) , and Duke Energy (DUK - Free Report) , which have raised dividend rates annually for more than 10 years now.

In Jan 2016, CenterPoint Energy increased its quarterly dividend by 4% to 25.75 cents, In Jul 2016, Duke Energy increased its quarterly dividend by 3.6% to 85.5 cents.

Stable & Growing Demand

The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for its services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.

Due to the planned reduction in coal-powered units, the EIA forecasts total U.S. electricity generation in 2016 to average 11.2 terawatt hours per day, marginally below 2015 generation. The EIA expects total electricity generation to grow by 1.6% in 2017.

Focused on R&D & Extension of ITC/PTC

In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, and transmission and distribution lines, into operation without compromising on energy efficiency.

Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.

In addition, the utility friendly move of the U.S. administration through the extension of the validity period of Solar Energy Investment Tax Credit (ITC) and Wind Energy Production Tax Credit (PTC) will help the utilities. We will see more utility scale solar and wind projects coming up, which will boost green power generation.

Mergers and Acquisitions

Utility sector operators don’t shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.

We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and lowers operating costs through the usage of common back office space.

In May 2016, Great Plains Energy Inc. (GXP - Free Report) announced that it has entered into an agreement to acquire Westar Energy Inc. (WR - Free Report) .The merger, reportedly valued at $12.2 billion, includes about $8.6 billion in total stock and cash consideration, and $3.6 billion of Westar Energy’s debt. Recently, shareholders of the both companies approved the merger.

We are also likely to see major acquisition activities in the water utility space. During the first half of 2016, American Water Works Company (AWK - Free Report) closed 10 acquisitions, adding 7,556 customers to its customer base. The 13 pending acquisitions will add 47,845 customers to its existing base.

Another player in the water utility space, Aqua America Inc. (WTR - Free Report) , completed several acquisitions in its service territories, adding 5,396 customers (as of Aug 2, 2016). Thanks to strategic acquisitions and organic growth, the company expects to expand its customer base by 1.5% to 2% in 2016. Aqua America currently carries a Zacks Rank #3 (Hold).You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

To Sum Up

We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water and wastewater services do not have any viable substitute. This is perhaps the most vital driving factor for the industry.

Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features.

Without a doubt, the likely interest rate hike before 2016 end will further increase the borrowing cost for the utilities. With all eyes set on the next move, the Fed Chair might increase rates if she finds overall economic factors strong enough for the next liftoff. While Fed officials are seriously considering a hike before the end of 2016, still low interest rates will definitely benefit utilities.

Volatility in the markets has also driven investors to seek protection in the utility space. These regular dividend payers are often regarded as a “bond substitute” and consistent performing utilities continue to be safe investment options for jittery investors.

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