Utility Stocks Make Secure Bets On Multiple Factors

Donald Trump’s presidency is expected to benefit defensive and domestic-oriented utilities immensely, even though conventional wisdom runs counter to this view in light of historical underperformance of high-dividend stocks in a rising interest-rate backdrop.

During his election campaign, Trump had vowed to lower the regulatory pressure on domestic manufacturers and suggested increased investment in energy infrastructure. The new administration has started to work on these lines, with Trump signing an executive order to repeal the Clean Power plan.

This is based on Trump’s view of climate change being “a Chinese Hoax” aimed at making U.S. manufacturing “non-competitive.” This should keep fossil fuel-based electricity generation afloat longer than expected.

The abolishment of the Clean Power Plan will give a new lease of life to utilities that produce a major part of their electricity from coal. Coal still accounts for nearly 30% of the electricity produced in the U.S.

However, even without the Clean Power Plan, some large utilities like NextEra Energy (NYSE:NEE) (NEE) and Duke Energy Corporation (NYSE:DUK) (DUK) have taken the initiative to produce more electricity from natural gas and alternate sources.

We believe there needs to be a balance between emission control and clean energy generation. A constructive utility rate environment, increase in electricity production from natural gas and renewables, and supporting coal-powered projects by infrastructure investments will enable 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. 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 uninterruptedly.

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

CenterPoint Energy, currently a Zacks Rank #2 (Buy) stock, has a quarterly dividend rate of 26.75 cents and a dividend yield of 3.92%. You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here.

Duke Energy’s current quarterly dividend rate is 85.5 cents, with a dividend yield of 4.10%.

Stable Demand & Rising Prices

A major 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 lends revenues and cash flow a high level of stability and visibility.

In a recent release, the U.S. Energy Information Administration (EIA) predicted that the annual average U.S. residential electricity price will increase 2.4% in 2017 and 2.3% in 2018, which will surely benefit the utilities.

Focus 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 introduced new smart meters and strengthened their transmission and distribution lines, which helped in the efficient usage of energy.

Utility operators are also benefiting from the 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 Merger and Acquisition (M&A) activities to supplement 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., M&As 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.

We are noticing major acquisitions in the water utility space. American Water Works Company (AWK) closed several acquisitions in the first quarter of 2017, largest among them being that of Shorelands Water Company, which added 11,000 customers to the company’s existing customer base. The pending acquisition when closed could increase the company’s customer base by 33,000 in 2017.

Another major player in the water utility space, Aqua America Inc. (WTR), successfully completed a few acquisitions in the first of 2017. Its pending acquisition, when closed over the course of the year, will add another 8,600 customers to its existing base.

To Sum Up

Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features. In addition, relaxed emission regulations under the Trump administration will act as a tailwind for the utility sector.

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.

Though the back-to-back interest rate hikes (Dec 2016 and Mar 2017) will increase the cost of operation for utilities, these fundamentally strong companies should be able withstand the challenges and continue to deliver stable performances. The defensive nature and stable performance demonstrated by the utility sector has driven investors to look for a safe haven in this space. 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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