As would be expected, the growth of the utility industry is tied
to overall economic conditions. As per the U.S. Energy Information
Administration (EIA), energy consumption in the United States will
increase 0.3% annually from 2010 through 2035. EIA's assumption
takes into consideration modest growth in economic conditions after
the recessionary period of 2008-2009 and increase in the energy
The majority of new power in this period will be generated from
natural gas and renewable sources. Besides the abundance of natural
gas, as many as 30 U.S. states and the District of Columbia have
enforceable renewable portfolio standards or other renewable
generation policies. We expect this count to go up, compelling
producers to generate more green power to meet the renewable
standards fixed by the states.
As per the EIA report, the rise in demand for energy over the 2010
to 2035 period is because of stepped-up demand from commercial,
industrial, transportation and residential sectors. The highest
growth in demand is expected to come from the commercial sector
clocking an expected yearly growth rate of 0.7%, stemming from 1%
annual growth in floor-space over the same period.
Besides growth in demand from the commercial sector, the EIA report
shows that the industrial sector will also recover from the
2008-2009 recession, leading to higher volume of energy
consumption. A large chunk of industrial demand will be
attributable to the increase in production of biofuels, enabling
the companies to meet the renewable fuel standards of the Energy
Independence and Security Act of 2007.
The utility industry attracts the attention of income-oriented
investors due to its steady income generation capacity, as most of
the rates for the power generated are regulated by utility
commissions at the state levels. The wholesale power generation
segment of the industry is effectively deregulated.
On the flip side, ever-increasing and stringent government
regulations as well as demand fluctuation owing to irregular
weather patterns is a permanent feature of the utility industry
A key challenge for most utility operators is to find the optimal
mix of generation from its producing units to meet regulatory
requirements. These operators are also working towards enhancing
their production organically and also through acquisitions.
As per the EIA report global energy use will increase to 770
quadrillion British thermal units (Btu) in 2035 from 505
quadrillion Btu in 2008. The majority of this usage is expected to
come from countries outside the Organization for Economic
Cooperation and Development (non-OECD nations). The non-OECD
nation's energy market has a larger scope for improvement compared
to the mature OECD nations.
The rise in demand for energy is definitely a good sign for the
companies in the utility sector. However, our concern lies in the
cost that needs to be paid for development at such unprecedented
levels, particularly the environmental cost. Will emerging nations
be able to impose strict environmental standards, like the ones
which are prevailing in the U.S. and Europe? The EIA's report does
not look so promising, with an indication of more greenhouse gases
being emitted from the developing nations.
This basic tenet will remain the driving force for the industry.
There will always be demand for power generation, with ebbs and
flows in between.
Each passing day we are increasingly dependent on a number of
electrical gadgets, which means more and more demand for
electricity and utility services.
New avenues are opening up which will enhance the demand for
electricity. We see new growth opportunities in the transportation
segment. Green vehicles have the potential to be a game changer in
the global arena and can help to cut down on emissions drastically.
A number of big automobile companies like
General Motors Company
Toyota Motors Corp.
Honda Motor Co.
) are the front runners in the creation of hybrid (and electric)
vehicles. These vehicles, which run on electricity, will drive
demand in the utility sector.
Utility services have no alternative:
A big positive for the utility operators is that there is hardly
any viable substitute for utility services. We can have different
fuel types like coal, oil, natural gas, nuclear power and renewable
sources to produce electricity, but do not have any alternative to
electricity. Similarly, clean water does not have any substitute.
This is the primary driving factor for the industry.
Previously, conventional fossil fuels were used solely to generate
electricity. Now alternate sources are also utilized for
electricity generation. As per the EIA report, energy generated
from alternate sources will increase at an annual rate of 3% from
2010 through 2035.
Regular dividend payment:
The utility operators generate more or less stable earnings unless
there are severe factors disrupting their operations. These
operators likewise reward their shareholders through the payment of
sustainable dividends. This has been evident during the economic
crisis of 2008-2009 when these operators continued to pay out
dividends without fail.
Currently, among the electric utility companies,
) has the highest dividend yield of 13.0%. Among the natural gas
) has the highest dividend yield of 7.6%, while within the water
Middlesex Water Company
) has the highest dividend yield of 3.9%. All these dividend yield
numbers compare favorably with the industry average of a yield of
In their quest to improve the standard of services, the utility
operators have relentlessly pursued research and development work.
Keeping the rise in demand and efficient use of power in mind, the
operators have brought in new smart meters, new transmission and
distribution lines, and new gas pipelines into operation.
Utility operators are also benefiting from ongoing research work in
the solar photovoltaic (PV) sector. Solar energy is a growing
alternate energy source and the new solar cells having higher
conversion rates allow operators to generate more power with fewer
solar panels. This enables the operators to lower the cost of
Mergers and acquisitions:
Apart from growing organically, the players in the utility industry
are carrying out strategic merger and acquisition deals, which lead
to cost synergies and better utilization of resources.
We believe that in a mature energy market like the United States,
mergers and acquisitions represent a good way to enhance market
share. It expands market reach through the usage of transmission
and distribution lines, diversifies the generation portfolio of the
company and also lowers operating costs through the usage of common
back office space to control the expanded operations. Mergers and
acquisitions also have risks, but even then these deals are taking
place across the board and the utility sector is no exception.
In one of the mega mergers in this space, North Carolina-based
Duke Energy Corporation
) completed the acquisition of Progress Energy Inc. in July 2012.
The deal was valued at $32 billion including the outstanding debt
of the acquired company. This acquisition created one of the
largest U.S. utilities and increased Duke Energy's capability to
build new power plants to meet future greenhouse-gas emissions
Integrys Energy Group Inc.
) inked an agreement to acquire Fox Energy Company LLC owned by
) and privately held company, Tyr Energy Inc. for $440 million. The
$440 million buyout consists of the purchase of Fox Energy Center,
a 593-megawatt (MW) combined cycle generating unit in Kaukauna, for
$390 million and $50 million for early expiration of the existing
Another utility company,
), had entered into a definitive agreement with
ITC Holdings Corp.
), under which Entergy will divest and then merge its electric
transmission business into ITC. The $1.775 billion divestment deal
is on track with regulatory approvals currently underway.
Existing operators enjoy benefits:
Utility operations need huge initial investments and a large number
of consumers who can help to generate revenues to recover costs.
For these reasons, we generally do not find many new entrants in
the market. Also, government regulations and the hard toil for new
entrants to establish loyal consumer bases put the existing players
in an advantageous position.
Vulnerable to weather changes: Utility operations globally depend
on weather patterns that determine the extent of demand. Moderate
weather conditions drastically lower the demand for utility
services. Erratic weather patterns thereby impact profitability of
these operators such that their operational goals remain unmet.
The hurricane season also affects utility operations. Excessive
rains create floods whereby in some cases operators have to shut
down their generating units. This undermines the profitability of
the utility operators.
The utility service markets are gradually transforming into buyers'
markets. A lot of states allow the consumers to migrate from one
utility operator to the other operating in the region. The
consumers thus have the option of choosing the best and/or the
cheapest operator in the region. Higher-cost producers are
gradually edged out of the market unless they can bring down their
Long-term power purchase agreements between operators and customers
could also impact profitability. In situations when there is an
increase in the cost of generation, the operators still have to
abide by the pre-existing agreement and sell power at
pre-determined rates, thereby stretching margins.
The utility business is a capital-intensive industry and needs huge
capital investments. Particularly when a company goes into
expansion mode, the funds generated internally are insufficient to
fulfill the capital needs. So, the company has to borrow money from
the markets for carrying out the development work.
The increase in the debt level -- for that matter a steep
debt/equity ratio -- impacts the credit rating of these utility
operators. If the credit rating comes down, the company will find
it difficult to borrow funds from the markets at reasonable rates,
and hence the cost of operations of the company will increase.
Government intervention & emission control:
The United States government has come out with stringent laws and
regulations, which are affecting the operations of the utility
operators. To meet the increasing regulatory standards a few of the
utility operators have had to shut down their coal-fired units. In
recent times, to meet the environmental regulations,
American Electric Power
) has decided to retire 4,600 megawatts (MW) of coal-fired
generation from its portfolio.
The operators are gradually idling their old power generation
plants or trying to meet the new regulations by installing
scrubbers and using a better variety of coal. These steps
invariably increase the cost of operating the units.
In the United States, as per the U.S. Environmental Protection
Agency's "Mercury and Air Toxics Standards" (MATS), all coal-fired
units having a generation capacity of more than 25 megawatts ("MW')
will have to abide by the MATS rule beginning 2015. As per this
rule, the coal-fired units have to bring down the greenhouse gas
emissions levels to 90% below their uncontrolled levels.
These units will have to install scrubbers or use carbon injection
controls to bring down emissions levels. Margins would thus be hurt
unless the operators can recover the investments from consumers
through rate hikes.
These stringent measures to control emissions, however, do not seem
to be enough. As per EIA, global carbon dioxide emissions will
increase to 43.2 billion metric tons in 2035 from 30.2 billion
metric tons in 2008.
The development of industries and greater dependence on fossil
fuels to generate power in non-OECD nations will increase the
emissions of greenhouse gases on a global scale. Despite the
increasing focus on renewables, coal still remains the major source
of electricity generation. This is due to coal's wide and cheap
availability on a global scale.
Pending rate case:
Consumers expect to have uninterrupted supply of utility services
at all times. The operators to ensure this supply makes consistent
investments to upgrade their transmission lines, carry out regular
maintenance work and lay down new lines to distribute power.
The regulated utilities recover these costs through rate increases
in its service territories. The pending rate cases and at times
partial allowance of the rate hike requested make it difficult for
the operators to sustain ongoing development and maintenance work.
Pending rate cases continue to mount, as very recently Duke Energy
filed for an annual base revenue increase of 12% or approximately
$387 million with North Carolinas Utilities Commission ("NCUC").
The rate case was filed to recover higher operating expenses and
cost to build low emission generation units.
Earnings Roundup and Zacks Rank
The companies in the utility sector are yet to come out with their
earnings results. We expect the softness in the utility sector will
continue in this quarter as well.
The earnings results of the utility companies were mixed in the
previous quarter, with one or two companies surpassing our
expectation convincingly. Overall, earnings in the previous quarter
were better than what was registered in the first quarter of the
year. The average magnitude of earnings surprises was hovering
around a penny to seven cents.
We presently have a long-term Neutral recommendation (six months
plus) on the majority of the stocks under coverage in the utility
sector. The stalemate is largely due to lackluster results seen in
the first half of 2012, in conjunction with an absence of a
game-changing catalyst on the horizon.
Zacks Ranks indicate the movement of the stocks over the short time
(1 to 3 months). Over the short term we have a few names with a
Zacks #2 Rank (short-term Buy rating). These include
Pinnacle West Capital Corporation
Integrys Energy Group, Inc.
PNM Resources, Inc.
The AES Corporation
Public Service Enterprise Group Inc.
The majority of stocks we cover in the utility industry, such as
Duke Energy Corporation
Dominion Resources Inc.
Pepco Holdings, Inc.
NextEra Energy Inc.
Wisconsin Energy Corporation
OGE Energy Corp.
CMS Energy Corporation
Pike Electric Corporation
), presently retain a Zacks #3 Rank (short-term Hold rating).
However, we presently have a few Zacks #4 Ranked stocks (short-term
Sell rating) in
First Energy Corp.
Xcel Energy Inc.
Hawaiian Electric Industries, Inc.
CenterPoint Energy, Inc.
The utilities nevertheless have to constantly meet the high
expectations of its wide customer base, adapt to a changing global
economic scenario, and upgrade technologies to meet stringent
environmental norms. This can only be achieved by entering into
It is also important to keep in mind that expansion of the customer
base of the utility operators does not necessarily mean growth in
usage. At times, despite an increase in customers, we can see a
decline in usage due to sluggish economic recovery and energy
efficiency initiatives. Nevertheless, we believe a revival in the
economy would raise both the customer base and usage.
We are also seeing a substantial increase in the use of natural gas
for power generation due to its clean burning nature and abundance
in the United States. The relatively lower prices of natural gas
also make it popular among industrial users. This has helped in
augmenting growth for natural gas utilities and gas pipeline
The hot summer weather aided the utility industries across the
board resulting in a rise in demand for electricity. Coal recovered
some lost ground as a source of fuel during this peak demand
scenario. As per an EIA report, in August 2012, coal produced 39%
of U.S. electricity, up from a low of 32% in April 2012.
Our Zacks Rank and Recommendation is a reliable indicator of the
likely movements of these utility stocks. Investors who are willing
to invest in utility companies can look into some of the following
points: 1) debt levels and cash flow generation capabilities, which
indicate the prospects or need for funding of expansion projects,
2) pipeline projects and the fuel type of generation units, which
indicate its ability to grow and at the same time conform to
renewable energy policies, and 3) regulated and unregulated mix of
the generation portfolio, which gives a fair idea about revenue
To round up, the utility stocks will hardly come out with eye
catching numbers but the earnings of these companies are generally
stable due to the regulatory nature of operations. Thus, investors
can expect a modest return on their investment.
AMER ELEC PWR (AEP): Free Stock Analysis Report
AES CORP (AES): Free Stock Analysis Report
DOMINION RES VA (D): Free Stock Analysis Report
DUKE ENERGY CP (DUK): Free Stock Analysis
ENTERGY CORP (ETR): Free Stock Analysis Report
EXELON CORP (EXC): Free Stock Analysis Report
NEXTERA ENERGY (NEE): Free Stock Analysis
NISOURCE INC (NI): Free Stock Analysis Report
NORTHEAST UTIL (NU): Free Stock Analysis Report
PUBLIC SV ENTRP (PEG): Free Stock Analysis
PNM RESOURCES (PNM): Free Stock Analysis Report
PINNACLE WEST (PNW): Free Stock Analysis Report
PEPCO HLDGS (POM): Free Stock Analysis Report
PPL CORP (PPL): Free Stock Analysis Report
SCANA CORP (SCG): Free Stock Analysis Report
SOUTHN COMPANY (SO): Free Stock Analysis Report
INTEGRYS ENERGY (TEG): Free Stock Analysis
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