Can Utilities Power Up Again?

12/26/2016


For utility stocks, 2016 has been a tale of two halves. The S&P 1500 Utility Sector Index jumped off to a great start, returning 24% including dividends through June, second-highest among the index's 11 sectors. Since June, utilities have lost 5%, worse than any other sector.

For the year, the utilities sector has delivered a total return of 17%, good for sixth place. Our Top 15 Utilities portfolio has managed a total return of 31% this year, as shown below.

Top 15 continues to outperform
Our Top 15 Utilities portfolio is on pace to surpass its benchmark, the S&P 1500 Utilities Sector Index, for the eighth calendar year in the past decade.
Year
Top 15
Utilities
(%)
S&P 1500
Utilities
(%)
Cumulative return *
221.4
105.5
Annualized return *
12.4
7.5
2016 *
30.6
17.4
2015
0.2
(4.5)
2014
27.1
27.4
2013
25.5
14.7
2012
10.3
1.7
2011
20.9
19.4
2010
7.9
7.1
2009
20.3
12.8
2008
(20.5)
(26.7)
2007
11.9
16.6
*Through Dec. 20.

Rich valuations and the anticipation of higher interest rates may have contributed to the sector's second-half power outage.

On Dec. 14, the Federal Reserve increased the federal funds rate for just the second time since the 2008 financial meltdown and said it now expects three additional rate hikes in 2017, up from its prior forecast of two hikes. As we noted in the Feb. 22 issue, stocks with higher dividend yields tend to lag in periods of rising rates.

Also worrisome for the sector are current valuations. As a group, utility stocks look extremely expensive compared to historical norms. Stocks in the S&P 1500 utility sector average trailing P/E ratios of 21, a 25% premium to their 20-year average of 17, as shown below. In the past 20 years, the average S&P 1500 utility stock been pricier in only three months.

Similarly, utilities look expensive on a stock-by-stock basis, as shown below. Just 11 of the 70 utility stocks we monitor have a trailing P/E ratio below their five-year average. Meanwhile, 43 stocks trade more than 10% above their five-year average P/E.

Still, diversification benefits and income-generation potential make utilities an important component of many investment portfolios. Some decent values can be found in the diversified and electric industries. The largest utilities based on market valuation also appear reasonably priced, though investors may need to settle for paltry operating growth.

Better growth prospects exist among natural-gas and water industries, both projected to boost per-share profits by double-digits in fiscal 2017. See the table below for detailed breakdowns for the utility sector by industry and market value.

We are making one change to our Top 15 Utilities portfolio this week, detailed below. We also review three additional utilities, which rank alongside EQT Midstream Partners ($74; EQM) as our favorite stocks in the portfolio for 2017.

Scana ($74; SCG) replaces Otter Tail ($41; OTTR) in our Top 15 Utilities portfolio. Scana supplies electricity and natural gas in North Carolina, South Carolina, and
Georgia.

We downgraded Scana in the Oct. 10 issue due to its high valuation and slowing operating growth. Both factors have improved in the past few months. Its Value score has risen to 57 from 44 at the time of the downgrade. Expectations for Scana remain fairly modest, with per-share profits projected to climb 2% in 2017 on 3% higher revenue. But analyst estimates are rising, reflected by its Earnings Estimates score of 78. Scana yields 3.1%.


Otter Tail's stock has surged 25% since we added it to the Top 15 Utilities portfolio in June. Otter Tail continues to offer better growth prospects than most electric utilities, with its earnings per share projected to climb 8% in 2017. But that growth already appears to be reflected in its share price. The stock trades at 24 times estimate 2017 earnings, well above its industry average of 18. Otter Tail should be sold.


CONE Midstream Partners ($23; CNNX) is a master limited partnership (MLP) that operates natural gas pipelines and production facilities in the Marcellus Shale basin, located in Pennsylvania and West Virginia. CONE uses long-term, fixed-fee agreements to help minimize the effect of fluctuating commodity prices on its cash flow. That strategy is paying off, as management has raised its cash distribution 4% in each of the past five quarters, pushing its yield to 4.5%.

The stock earns an Overall rank of 99 and scores above 60 for all six Quadrix categories. CONE trades at just 13 times estimated 2017 profits of $1.77 per share, which implies 15% growth. CONE earns a Best Buy rating in Upside, our sister newsletter.


UGI ($45; UGI) shares have generated a total return of 37% in 2016. Yet its Quadrix Value rank has risen to 67 from 60 at the end of 2015, largely due to per-share profits surging 48% for 12-months ended September. UGI's growth prospects remain attractive, with the consensus targeting 16% higher earnings per share in 2017. The stock trades at 19 times estimated 2017 profits, versus an average P/E ratio of 21 for the natural gas stocks we monitor.

UGI operates gas and electric utilities, along with its propane-distribution business. The stock yields 2.1%, trailing its industry average of 4.1%. But UGI has grown its dividend at an annualized rate of 8% over the past three years, double its industry average.


Vectren ($52; VVC) operates natural gas (30% of revenue for nine months ended September) and electric (26%) utilities, in addition to its energy and infrastructure-services businesses (43%). Revenue slipped 4% in the first nine months of the year. But lower costs, especially for natural gas, helped Vectren increase earnings per share 7%.

The stock has been one of the better performing utility stocks in the past month, delivering a total return of 10%. That gain may be due to Vectren's nonregulated business, which includes the construction and repair of underground pipelines. Low oil prices led to project delays in the past year. But oil prices could stabilize if members of the Organization of the Petroleum Exporting Countries proceed with planned production cuts, helping to boost demand for new pipelines.

UTILITY SECTOR SNAPSHOT
All pockets of our Utility Update have averaged robust total returns in 2016, regardless of industry or market size. Natural-gas stocks have posted the strongest profit growth over the last year and are expected to deliver the best growth next year, though the industry looks expensive. Electric utilities and large-caps sport the most attractive valuations. All numbers are averages for the 70 stocks in our Utility Update.
Stock-
Market
Value
($Bil.)
3-Year
Annual.
Dividend
Growth
(%)
12-Month
---- Change ----
Est. EPS
Change,
Fiscal
2017
(%)
--- P/E Ratio ---
----------- Quadrix Scores -----------
Div.
Yield
(%)
Earnings
Per Share
(%)
Sales
(%)
Trailing
Based
On Est.
EPS For
Fiscal
2017
YTD
Total
Return
(%)
Momen-
tum
Value
Earns.
Ests.
Overall
Breakdown by industry (number of stocks)
Diversified (17)
14.6
3.4
6
(1)
(3)
6
20
18
29
52
63
65
57
Electric (26)
15.6
3.4
5
2
(3)
4
19
18
20
49
64
53
52
Hybrid (2)
8.7
3.5
11
9
(12)
3
27
26
96
61
45
43
43
Independent (3)
3.6
0.5
(6)
(10)
(3)
(13)
19
21
11
55
58
48
50
Natural gas (14)
3.7
4.1
4
14
(16)
11
23
21
26
51
59
49
50
Water (8)
3.1
2.1
5
4
5
11
27
26
40
57
32
60
49
Breakdown by market value (number of stocks)
Less than $3
billion (21)
1.7
3.2
4
3
(4)
8
24
23
32
50
48
56
50
$3 billion to
$10 billion (25)
5.3
2.9
6
7
(8)
8
21
19
26
53
60
51
52
Above $10
billion (24)
24.6
3.6
5
2
(3)
1
19
18
24
48
68
54
54
Utility Update
average (70)
10.8
3.2
5
4
(5)
6
21
20
27
51
59
54
52
Note: Quadrix scores are percentile ranks, with 100 the best.

 

TOP 15 UTILITIES
Stock-
Market
Value
($Mil.)
3-Year
Ann.
Div.
Growth
(%)
12-Month
-- Change --
Est. EPS
Change,
Fiscal
2017
(%)
------ P/E Ratio ------
----- Quadrix Scores -----
Company (Price; Ticker)
Div.
Yield
(%)
EPS
(%)
Sales
(%)
Trailing
5-Yr.
Avg.
Based
On Est.
EPS For
Fiscal
2017
YTD
Total
Return
(%)
Overall
12-Factor
Sector
Reranked
Overall
Industry
Allete ($64; ALE)
3,147
3.3
3
(11)
(1)
12
21
18
18
30
45
91
37
Electric
Atmos Energy
($74; ATO)
7,775
2.4
6
9
(19)
5
22
19
21
21
57
49
34
Gas
Avista ($40; AVA)
2,552
3.5
4
14
(5)
3
19
18
19
16
56
88
51
Divers.
CONE Midstream
($23; CNNX)
1,361
4.5
NA
63
28
14
15
NA
13
154
99
24
99
Services
Entergy ($73; ETR)
13,121
4.8
1
61
(10)
(31)
9
12
16
12
57
73
85
Electric
EQT Midstream
($74; EQM)
5,970
4.4
26
13
18
3
13
20
14
2
96
55
100
Services
Portland General
($44; POR)
3,886
2.9
4
2
0
10
21
17
19
23
48
90
32
Electric
Public Service Ent.
($44; PEG)
22,144
3.8
4
(22)
(14)
1
15
13
15
17
68
75
96
Divers.
Scana ($74; SCG)
10,607
3.1
4
3
(11)
3
19
16
17
27
66
75
82
Divers.
SJW ($56; SJW)
1,147
1.5
3
89
21
11
23
20
32
92
85
85
97
Water
Star Gas ($11; SGU)
607
3.9
7
1
(33)
15
14
14
12
50
77
100
100
Gas
UGI ($45; UGI)
7,858
2.1
8
48
(15)
16
22
18
19
37
61
85
75
Gas
Unitil ($45; UTL)
627
3.2
1
(2)
(14)
6
24
20
22
29
67
97
93
Divers.
Vectren ($52; VVC)
4,343
3.2
4
15
(6)
6
21
20
20
28
56
84
56
Divers.
WGL Holdings
($78; WGL)
3,982
2.5
5
32
(12)
3
24
21
23
27
68
99
91
Gas
Portfolio average
5,942
3.3
6
21
(4)
5
20
18
19
38
67
78
75
NA Not available

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