Report on Utilities Industry in America

Description of Industry

The utilities sector is comprised of gas and power stocks with the utility companies consisting of electric, gas, water, and other integrated provider companies. These companies are responsible for providing their utilities to residential, commercial, industrial, as well as agricultural markets.

The current Utilities Sector SPDR Fund group allocation is currently lead by electric (96. 30%), water (2. 27%), gas (1. 27%), and sovereign (. 14%), with its top asset allocation in equity ay 99. 84%. The sector is very capital-intensive which means there needs to be a continuous inflow of funds for upgrades and growth, especially with increasing laws and regulations. Most of the funding for capital requirements comes from external sources of financing which means that companies are very market condition reliant. If interest rates increase, they will be paying more money on their debt; increased debt levels can cause lower credit ratings which in turn, will make it difficult to borrow at good rates and essentially increase the cost of operations.

Some states will allow consumers to have the ability to choose their utility operators, who will obviously choose the lowest costing option. This will eliminate high-cost produces unless they are able to find a way to cut their costs.

Overall, utility stocks are attractive as they generally pay reliable dividends similar to bonds. The 2008 crisis saw an increase in conservative investors buying stocks versus bonds due to the low interest rates, however once interest rates began increasing, bonds became more attractive once again. As of January 2018, the XLU paid a dividend of 3. 5% which was notable larger than the S&P 500 yield and 10-Year Treasury note.

According to S&P 500 Utility Index, as of 10/9/2018, the total market capitalization for utilities was $717. 805 billion. The Free Float Market consisted of 667. 802B and the average market capital was 23. 936B. The price/earnings per share were 17. 37 and the dividend yield was 3. 39. Annual revenue saw $845. 3B from 68, 457 different businesses and utility companies employed roughly 950, 000 people. The forecasted growth for these areas for 2018-2023 all ranged from 1. 6% to 2. 9%.

Overall Market Opportunity

There are many positive outlooks surrounding the utilities sector that mainly revolve around the electrical and gas aspect of things. Non-hydro renewables, declining power prices, and distributed energy resources are the main focus points pertaining to overall market opportunity.

Non-hydro renewables, primarily coming from wind and solar energy have doubled from 5% in 2007 to 10%. Paired with this is close to 50 gigawatts of coal-fired generation being shut down. Natural gas is also on the rise, surpassing coal steadily on an annual basis for the first time since 2016; this can be traced to the low price of natural gas.

Wholesale power prices have been steadily declining to roughly 50% on average since 2014. This has helped offset the cost of utility capital-expenditures on upgrades and growth of the grid. Not only has it helped companies with their expenditures, it has made increased customer bills less noticeable. Looking towards the future, companies are looking to continue to focus on lower-cost resources such as wind, solar, and natural gas.

Distributed energy resources such as energy storage, microgrids, energy efficiency, electric vehicles, and smart appliances could have the most prominent impact around opportunity of the utilities sector. With increasing technology and reliability of, consumers will be more inclined to switch to environmentally friendly products to save money and reduce their carbon footprint.

Like stated earlier, the utilities sector is greatly subjected to interest rate risk which can hurt companies credit ratings resulting in a higher cost of capital.

Another risk of the sector revolves around the Environmental Protection Agency (EPA) and their regulations to reduce companies carbon footprint by 30%. To adjust to these regulations and continue operation, companies are required to spend an extensive amount of capital on upgrades. The area hurt most by this is the electrical utilities that rely mostly on coal with substandard reconstruction.

Natural disasters could be another big risk pertaining to the utilities industry and rising prices in power. Forest fires, like the seemingly annual occurrence, especially in California are causing billions of dollars in not only maintenance, but also retrofitting to protect the grids to be accident-proof. These costs are generally passed down to the consumer. Hurricanes are also a major worry that can devastate areas to power outages for extended periods of time. Puerto Rico is a prime example as they had to essentially start from scratch in reconstructing their power source, costing $100’s of billions.

Lastly, cyber security might be one of the biggest concerns when it comes to risks. A massive cyber-attack could cut off power to hospitals, banks, factories, and other crucial assets to the U. S. economy. Cybersecurity framework is starting to grow, but is nowhere near where it needs to be in today’s day and age.

Analysis of the Leaders and Laggards

Currently, year-to-date returns as scattered among the 10 largest by market capitalization stocks in the Utility Sector. The leaders are Exelon Corporation and NextEra Energy, with returns of 14. 62% and 13. 53% respectively. Exelon Corporation has grown its earnings at 19. 23% year over year, and has long-term earnings growth pegged at 5. 7%. Exelon has also begun lowering its operating expenses with a target of 1. 9% between 2018-2021. Exelon is reducing its overall debt in excess of $4 billion over the next four years. NextEra Energy has seen positive results this year due in part to steady growth from its two subsidiaries, Florida Power and Light and NextEra Energy Resources. NextEra’s management team has reiterated solid long-term expectations of 6-8% annual EPS growth through 2021. This ranks among the best growth rates in the Utilities Sector. NextEra has also continued to be a leader in the use of renewable energy. Currently, it owns 16% of installed wind capacity and 11% of all solar capacity.

The laggards among the sector are Dominion Energy and The Southern Company, with returns of -6. 19% and -4. 53% respectively. Dominion’s stock has floundered due to two reasons primarily. First, uncertainties associated with its ongoing merger with Scana Corp (SCG) has caused many investors to think twice. In early January, Dominion Energy offered to buy Scana for $7. 9 billion in stock. The deal would help bail Scana out of a failed nuclear project with the state of South Carolina. However, South Carolina wants Scana (and now by default Dominion) to pay the full price for the failed project. Due to this Dominion may walk away from the deal. Second, in March regulators ruled that MLPs could no longer collect an allowance for income taxes along with their cost of service fees on some pipelines. Dominion Energy has an MLP called Dominion Energy Midstream Partners. The new rule could reduce how much Dominion Energy Midstream Partners could earn on some of the pipelines purchased from its parent company, Dominion Energy. As a result, Dominion Energy might not be able to use its MLP as a financing vehicle in the future. Southern Company’s decline is somewhat surprising due to their projected sales growth of 15. 76% next year. However, Southern has a high Debt/Equity ratio and very low profit margins. Combine this with rising interest rates, then it is understandable why the market dislikes Southern stock.

Thoughts on Valuation: Should we Invest Today?

There are several disadvantages associated with investing in the utility sector. Due to their bond like nature, when interest rates are rising utility stocks tend to lose some of their value. This is due to when interest rates rise it increases the borrowing costs for utility companies. Typically, utility companies have high levels of debt due to major capital expenditures. Stocks may also decrease to where investors will actually suffer the loss. Utility stocks are not insured by the Federal Deposit Insurance Corporation or protected by the government, this is another crucial downside to the purchase of utility stock; if a utility company is said to go bankrupt, there is no insurance or protection in any form for the investor which increases the risk even more. Although dividend yields on utility stocks may currently be high, this does not mean that they will decrease or completely be eliminated. However, even though most stocks were below the S&P 500, there were a number of utility stocks that were above it and withstood the recession. If we can locate a utility stock with below average debt-to-equity ratio and strong growth potential then we believe that there may be some utility stocks worth investing in.