As I mentioned in a column last week, one of my favorite assets for income generation is Master Limited Partnerships (MLPs) in the oil and gas sectors. If you missed the article, you can read it here.
Today, though, I’m going to talk about a slice of the energy sector you should avoid.
Historically, the electric utilities sector has been a great source of income-producing stocks. They’re the ones your grandparents bought and never sold. But as Bob Dylan so aptly put it in his 1964 classic, “The times they are a-changin’.”
Are utility stocks still a good buy? Are the ones you have worth holding?
For the answer, we’ll first look at the overall utility market. I’ll then provide a few examples of the good, the bad… and the ugly.
In 1992, Congress passed the Energy Policy Act. It was sweeping legislation that effectively deregulated the electric utility industry.
The law set an era of industry consolidation in motion. In the decades since, the ranks of publicly traded electrical utilities has shrunk to 50 or so – compared to over 100 before deregulation.
Todd Shipman is a Standard & Poor’s utilities analyst. In a New York Times article, Shipman indicated he feels “that number could be halved to 25 in as little as five years.”
These companies will have market caps approaching those of Apple Inc. (NASDAQ:AAPL) and Exxon Mobil Corporation (NYSE:XOM). Many will have mountains of debt and decreasing cash reserves from which to pay dividends.
What’s going on?
Several factors are working against the sector right now. Even in the face of an improving economy, demand growth for electricity in the U.S. is slowing. It’s hard to imagine, especially in the face of increasing numbers of tablet computers, Internet data centers and electric vehicles. But where demand was once growing by more than 8% per year throughout the nation, it’s now expanding by just 0.7% annually.
An Improving Economy: Bad for Utilities?
In an improving economy, several factors work against utilities.
First, utilities are countercyclical. When GDP growth is decent and jobless claims are falling, utility stocks tend to lag.
Economic data has been improving for two years. Couple that with the Fed’s quantitative easing, and you have a stock market that’s been on fire.
Up until recently, retail investors have been sitting on the sidelines. But they are now putting their cash piles to work. They’re choosing aggressive investments over utilities.
Another problem with utility stocks is they’re currently trading at hefty premiums to the market. Historically, at least in terms of their price/earnings ratios, utility stocks trade at a 25% discount to the market. Right now, though, they’re trading at hefty premiums.
Translation: proceed cautiously when considering a stake in the sector.
The Good, the Bad and the Ugly
The demand slowdown is straining many publicly traded utilities, as their costs rise when load factors drop. In addition, a number of the large utilities have specific issues.
Recent action proves that a combination of increasing demographics and economic strength in a utility’s underlying service area will be its keys to future success.
A big factor for coal-burning utilities is whether upgrading old plants to meet new EPA emissions rules is worth the cost.
Let’s look at a few specific examples and see how they stack up against each other.
NextEra Energy, Inc. (NYSE:NEE) is a Florida-based power producer. Its 42 gigawatts (GWs) of generating capacity is located in 26 states and four Canadian provinces.
Only 2.9% of its total power generation came from coal in 2012. It is the largest wind power producer in the country. NextEra has one of the lowest emissions profiles among all U.S. electric power producers.
In 2012, the company’s revenues amounted to $14.3 billion. It achieved record earnings per share of $4.57 last year. Its total shareholder return over the last 10 years has been 228%. This compares with 170% for the S&P 500 Utilities Index.
Exelon Corporation (NYSE:EXC) is a utility holding company. Of the 34.6 GWs the company produces, 12 GWs come from fossil fuel plants located in nine states and Canada.
While it has sold a number of its old coal-fired plants, those that remain will have to be upgraded to meet the 2015 EPA emissions standards. While the company supports “clean coal” technology research, it’s announced nothing that would indicate its ability to meet the new EPA standards.
At the opposite end of the spectrum from NextEra is The Southern Company (NYSE:SO). It’s the largest electric generator in the U.S., with 42.9 GWs of capacity. Of that, 26 GWs comes from coal-fired plants.
The company must upgrade to meet the new 2015 EPA emissions requirements.
It has other problems as well. Let’s start with its nearly $1 billion construction overage on its “clean coal” Plant Ratcliffe in Mississippi. Nearly $540 million of that will be “absorbed by the company.” This cash would otherwise be available to shareholders in the form of dividends or stock buybacks.
Southern’s other big money sinkhole is the two additional nuclear reactors it’s adding at its Vogtle plant. In February, Southern subsidiary Georgia Power revealed construction costs for the reactors are $737 million over budget.
The worst part? Construction is only halfway done.
Take a look at the chart below, which boils down the total return of the three utilities we cited as examples. It’s interesting to note that investing in the S&P 500 would have given you a 2% higher return over the last year compared to NextEra, the best of the bunch.
The bottom line is not all utilities are created equal and the industry is facing growing headwinds. There are some high-yielding winners in the sector, but you’ll have to do your homework to sort the good from the bad.