From Zacks: Utility companies are among the safest investment bets, but they have their share of weaknesses as well. Growing regulatory burden and increased debt loads remain concerns, but an even bigger issue is the interest rate backdrop.
The Fed stance following the Sep 2016 meeting is not favorable for rate-sensitive sectors like utilities. Though the Fed has not increased rates following the hike last December, another raise is expected in the final quarter of 2016 if economic conditions remain favorable.
Let’s look into the factors which might deter investors from investing in the utility space.
The U.S. Environmental Protection Agency (EPA) finally came out with a new plan to curb carbon pollution from domestic power plants. The finalized Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030 from 2005 levels. Coal producers had to undertake the tedious and financially stressful task of reducing their carbon footprint. As a corollary, big names in the coal mining space, like Peabody Energy and Arch Coal, had to file for bankruptcy protection in the face of falling demand.
A good many U.S. utility operators preferred to shut down their old coal-fired generation units, rather than inject fresh funds to make these units fit for new emission standards. Per a recent release from the U.S. government’s Energy Information Administration (EIA), coal’s usage in power generation would fall to 26% of U.S. electricity generation in 2040 from 33% in 2015.
Utilities are capital intensive and need to have a continuous inflow of funds to carry on their organic growth and infrastructure upgrade projects. This is essential in maintaining an uninterrupted supply of basic amenities like electricity, fresh water and gas. Utilities generate funds from operations which are to some extent used to meet their capital requirements. But these funds are mostly used for dividend payouts. They take recourse to external sources of financing to meet their capital requirements.
While interest rates remain low by historical standards and the market’s evolving Fed outlook seems to call for even fewer rate hikes this year, the access to capital markets has steadily been declining. This issue will likely become even more acute as the Fed tightening cycle becomes more visible.
The Federal Reserve finally raised the interest rate in Dec 2015. Fed officials had plans to raise interest rates gradually in 2016 but overall economic conditions were not conducive to a rate hike. Market experts believe that the Fed might increase interest rates once more in the final quarter of 2016.
We believe that a rising interest rate environment could add to the woes of utility operators, as it will increase their cost of capital, restraining their ability to pay consistent dividends. So, while investing in a utility, one must take note of its outstanding debts.
Competition with Bonds
These reliable dividend payers are in competition with bonds as an investment option. The increase in interest rates will definitely make bonds with its yields another attractive investment option for risk-averse investors, driving them away from the utility space.
Safe but Limited Growth Potential
Investment in these highly regulated defensive utilities is considered safe. Even though utilities pay regular dividends and go for buybacks, the scope of capital appreciation is quite limited for investors in this space. Share prices in this sector do not jump the way they do in the technology sector, so the returns are never dramatic.
Utilities to Avoid for the Time Being
We presently recommend investors to stay away from the following utilities as they presently have an unfavorable Zacks Rank. The other metrics also indicate that they are not profitable investment options at present.
Atlantica Yield plc (ABY – Free Report) currently has a Zacks Rank #5 (Strong Sell). The average negative surprise for the last four quarters is 316.13%. The 2016 earnings estimates have gone down by 61.1% in the last 60 days.
ALLETE Inc. (ALE – Free Report) currently has a Zacks Rank #4 (Sell). The average negative surprise for the last four quarters is 7.63%. The 2016 earnings estimates have gone down by 2.5% in the last 60 days.
Southwest Gas Corp. (SWX – Free Report) currently has a Zacks Rank #4. The average negative surprise for the last four quarters is 73.29%. The 2016 earnings estimates have gone down by 0.9% in the last 60 days.
Consolidated Water Co. Ltd.’s (CWCO – Free Report) average negative surprise for the last four quarters is 11.07%. The 2016 earnings estimates have gone down by 7.7% in the last 60 days. The company currently has a Zacks Rank #4. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Despite the drawbacks of the utility industry, it is still undoubtedly one of the most stable industries to invest in. The focus on clean energy is going to be the top-most on the agenda in the coming years. We expect utilities to take advantage of the shale boom in the U.S. and the falling prices to develop more power plants based on natural gas. Combined-cycle natural gas power plants not only help to lower pollution but also result in energy efficiency.
A makeover in the utility space is already underway, with utilities shutting down coal-fired units and focusing more on green energy generation. The crucial question is, will they be able to sustain this momentum following the hike in interest rates?
Despite stringent emission standards, the extension of investment tax credits and production tax credits is a positive for the utilities. We expect regulatory backing to naturally boost production of electricity from renewable sources.
Check our latest “Utility Industry Outlook” for more details on the current conditions prevailing in the market from an earnings perspective, and how the trend is going for this important sector of the economy now.
The SPDR Utilities Select Sector Fund (NYSE:XLU), which lost more than 2% of its value yesterday, was mostly flat in premarket trading Wednesday. Despite a big pullback that began in early July, year-to-date, XLU has still gained 9.27%.
This article is brought to you courtesy of Zacks Research.