Three Concerns Facing Utilities

3/27/2017


The S&P 1500 Utility Sector Index has returned 6% including dividends since Election Day on Nov. 8, ahead of the broad index's 5% total return. Utilities have outperformed despite three challenges, outlined below.

New power sources

The sector is undergoing a structural change, as alternative-energy sources gain popularity. Last year, net U.S. electrical capacity rose by the most since 2011, driven by growth in natural gas, wind, and solar. However, coal capacity continued the sharp decline it's experienced in recent years, primarily due to the retirement of smaller, older, and inefficient plants. Coal accounted for just 30% of U.S. electricity generation last year, down from 49% in 2006. Natural gas and renewable sources, including wind and solar, have become more popular.

Nuclear energy has consistently supplied 19% to 20% of U.S. electricity over the past decade. Yet five U.S. nuclear plants have closed in the past four years, and four more are scheduled to shut down by 2025. Altogether, the closures would reduce the number of nuclear plants to 61.

Nuclear plants face political pressure and competition from cheaper forms of electricity. PG&E ($67; PCG) plans to shutter its nuclear plant in California, which will be replaced with clean energy. The utility is testing a system to store electricity generated from solar panels. Solar farms in California create so much daylight power that they frequently push the state's spot wholesale prices to zero, reported The Wall Street Journal. Additionally, the surge in fracking has created a glut of natural gas, reducing wholesale power prices 45% over the past decade.

Entergy ($77; ETR) was the second-largest U.S. generator of nuclear power a decade ago, when it owned nine nuclear plants. Even in 2016, nuclear power remained an important energy source for Entergy, accounting for one-third of total capacity for its utility (83% of 2016 revenue) and wholesale (17%) units.

But Entergy plans to scale back exposure to nuclear energy, specifically to its wholesale business, over the next five years because of low energy prices for natural gas and higher operating costs. It shuttered one nuclear plant in 2014, plans to close three more by 2021, and agreed in August to sell a fifth plant to Exelon ($36; EXC) for $110 million.

These strategic moves will increase Entergy's focus on its utility business, which provides electricity and natural gas to 2.9 million customers in five southern states. Seeking to reduce emissions, management plans to build three new facilities that will replace older, less-efficient power plants. Entergy is a member of our Top 15 Utilities portfolio. Exelon is rated B (average) on our Monitored List.

Rising interest rates

The Federal Reserve increased the federal funds rate by 0.25% on March 15, its second such bump since December. Reassured by the economy's recent strength, the Fed told investors it plans two more rate hikes this year.

The low-rate environment has been a boon for utilities. Their fat dividends attracted income investors frustrated by unusually low bond yields. Low rates also decreased borrowing costs for utilities to invest in new equipment and technology. In their rush to issue bonds at favorable terms, S&P 1500 utilities boosted total debt by an average of 10% last year, more than any of the index's other 10 sectors. Utilities averaged 8% higher capital spending in 2016, behind only telecommunications companies. U.S. utilities were also awarded a record number of patents in 2016.

Higher interest rates threaten to reverse these trends. Additionally, S&P 1500 utilities tend to underperform other stocks during periods of rising rates.

Scana ($68; SCG), an electric utility based in South Carolina, boosted capital spending 37% last year to a record $1.58 billion. Management expects capital expenditures to peak at $2.07 billion in 2017 before declining in 2018 and 2019. The higher spending comes at a time Scana is building a new nuclear power plant in South Carolina. However, one of its contractors, Westinghouse Electric, faces financial pressures, forcing Scana to draw up contingency plans in case Westinghouse defaults or halts work on the plant.

Scana has tapped the historically cheap bond market to help fund the project. Total debt increased 14% to $7.43 billion in 2016, versus cash of just $208 million. Scana expects to issue an additional $960 million of debt in 2017. But the capital investments have not crowded out dividend growth. Last month management announced a 7% hike to its quarterly dividend to $0.6125 per share, payable April 1. Scana also increased its targeted dividend payout ratio to a range of 55% to 65% of earnings. The stock, yielding 3.6%, is a component of our Top 15 Utilities portfolio.

High valuations, muted growth

Utilities look pricey compared to historical norms, as shown in the nearby table. At 20.5 times trailing earnings, the average S&P 1500 utility stock has been more expensive on just 12 month-ends over the past 10 years. It trades 18% above its 10-year average of 17.3. The sector's average trailing P/E ratio crept up to 22.9 in June 2016, its highest month-end total since at least December 1994.


Utility valuations reach rarefied air

Valuations for utility stocks have come down since June but remain above historical norms. The average stock in the S&P 1500 utility sector has a trailing P/E ratio of 20.5, above its 10-year average of 17.3. Utility valuations based on estimated profits for the current fiscal year are also unusually high, as shown below.

Current
10-Year
Average
Premium
To 10-Yr.
Average
(%)
Months
Higher In
Past 10 Yrs.
(Out Of 120)
Trailing P/E ratio
S&P 1500 utilities average
20.5
17.3
18
12
S&P 1500 Index average
22.5
20.9
8
35
P/E ratio based on current fiscal year estimate
S&P 1500 utilities average
20.0
16.4
22
2
S&P 1500 Index average
21.5
19.2
12
12

Utility stocks also appear unusually expensive relative to estimated profits for the current fiscal year. Utilities are projected to average 4% growth for earnings per share over the next 12 months. Analyst estimates are notoriously optimistic. But if the sector meets the current consensus estimates, its growth would fall roughly in line with its 10-year average. In short, investors are paying a premium for average growth.

Total U.S. power generation has essentially held flat over the past decade, meaning utilities must rely on some combination of lower operating costs and price hikes to support profit growth. Looking further out, a push toward energy efficiency may curb future demand.

UGI ($50; UGI) features a diversified business model, operating as a retail propane marketer in both the U.S. and Europe and a natural-gas and electric utility — in addition to midstream operations. The company's per-share profits surged 47% in the 12 months ended December, despite 8% lower sales. Encouragingly, sales rose 5% in the December quarter and are projected to grow at least that much in both the March and June quarters.

UGI earns a Quadrix Value score of 70 and Overall rank of 81, both higher than any other gas-utility stock in the S&P 1500 Index. The stock's trailing P/E ratio of 21 exceeds its five-year median of 18 but lags its industry median of 25. UGI is projected to grow per-share profits 4% over the next 12 months, in line with peers. But at 20 times estimated year-ahead earnings, UGI shares trade 8% below their industry median. UGI is a member of our Top 15 Utilities portfolio.

TOP 15 UTILITIES
We are making four rank changes to our Top 15 Utilities portfolio this week. New stocks Edison International and Eversource Energy are replacing Allete and CONE Midstream Partners.
5-Year
Annual.
Dividend
Growth
(%)
Total Return
---- P/E Ratio ----
Quadrix Scores
Company (Price; Ticker)
Indicated
Dividend
($)
Yield
(%)
Payout
Ratio
YTD
(%)
12
Months
(%)
Trailing
Based On
Est. 12-
Month EPS
Value
Overall
Industry
Atmos Energy ($80; ATO)
1.80
2.3
6
51
8
14
22
22
40
53
Gas
Edison International ($80; EIX)
2.17
2.7
12
55
11
16
20
19
53
83
Electric
Entergy ($77; ETR)
3.48
4.5
1
49
5
3
11
16
79
55
Electric
EQT Midstream ($77; EQM)
3.40
4.4
25
62
1
7
14
15
79
88
Oil & gas storage
Eversource Energy ($60; ES)
1.90
3.2
7
64
9
7
20
19
63
72
Electric
Great Plains Energy ($29; GXP)
1.10
3.8
6
59
7
(4)
16
17
76
81
Electric
Portland General ($45; POR)
1.28
2.9
4
59
4
18
21
20
60
38
Electric
Public Service Enterpr. ($45; PEG)
1.72
3.8
4
59
4
2
16
15
64
47
Diversified
Scana ($68; SCG)
2.45
3.6
4
59
(7)
3
16
15
69
74
Diversified
SJW ($47; SJW)
0.87
1.8
4
38
(16)
36
20
22
47
60
Water
Star Gas Partners ($9; SGU)
0.41
4.5
7
61
(15)
20
14
10
81
62
Gas
UGI ($50; UGI)
0.95
1.9
8
41
8
28
21
20
70
81
Gas
Unitil ($44; UTL)
1.44
3.2
1
74
(1)
11
23
21
56
57
Diversified
Vectren ($58; VVC)
1.68
2.9
4
66
12
21
23
22
53
61
Diversified
WGL Holdings ($83; WGL)
2.04
2.5
5
61
9
22
25
24
38
53
Gas
Top 15 Utilities average
3.2
7
57
3
14
19
19
62
64
S&P 1500 utilities avg.
3.1
6
62
6
14
20
20
57
56
Note: Quadrix scores are percentile ranks, with 100 the best.Ā 

 


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