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 efficiency level.
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
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
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
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 3.8%.
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
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 producing power.
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
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 tolling agreement.
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
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
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
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
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
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
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
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 strategic partnerships.
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
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
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 generation.
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
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