The year 2018 has just started and this is the right time to look into utilities as an investment option. Staying invested in fundamentally strong and domestic-focused utility stocks assure investors a steady performance and regular dividends. These highly regulated capital intensive stocks are subject to heavy regulation, both at the federal and state levels. Utility business is known for stability and visibility of its earnings and cash flow.
Over the last few years, we have noticed that utilities are gradually changing their preference of fuels to produce electricity. In the United States, natural gas currently contributes the largest portion of the fuel mix, removing coal from the top spot.
Utilities, apart from investing in generating plants that produce electricity with low and negligible amounts of emissions, are also focused in improving transmission and distribution networks. Utilities are also investing in power storage facilities and guiding investors for efficient usage of electricity. They are also undertaking plans to shift the transmission lines underground in weather sensitive areas to lower chances of power outages.
Natural gas utilities depend on pipelines to deliver their product to the end users. Water utilities are also required to upgrade and replace old pipelines and water mains. So, to upgrade and strengthen the existing infrastructure, utilities depend on capital markets.
These capital intensive utilities therefore routinely take recourse to capital markets to meet the above requirements. Though regulated utilities are cash generators, the funds generated from internal sources are not sufficient to carry out long-term projects. Utilities have been benefiting from the rock-bottom interest rate environment. However, the Fed raised interest rates four times in the last five quarters (December 2016, March 2017, June 2017 and December 2017), which will certainly hurt utilities.
The rise in interest cost will no doubt increase cost of capital for utilities and might limit their ability to pay dividends and buy back shares. These developments could lower attractiveness of utilities and investors might turn to bonds as an alternative source of investment.
Weather continues to impact the operation of utility services. Hurricanes in Texas and Florida have adversely impacted normal operation of the utilities operating in the region. Even with efficient work of a large team of workers it took weeks to bring back services at normal levels. The results of the utilities were adversely impacted by disruption of normal services.
Per the Bureau of Economic Analysis, GDP rose 3.3% in the third quarter of 2017, up from 3.1% in the second quarter. The improvement in GDP is expected to continue in 2018 as well.
All other industries depend on utilities for the basic requirements of electricity, gas and water. The ongoing growth will result in higher demand from industrial, commercial and residential space for utility services and boost its performance.
Repeal of Clean Power Plan: Impact on Utilities
Historically, electric utilities have heavily relied on coal for a large part of power generation, which has become a big challenge for the group in these times of enhanced environmental awareness. In line with this, in August 2015, President Obama introduced the Clean Power Plan to lower emissions levels from electricity generation by around 32% by 2030 from 2005 levels.
President Trump acted on his pre-election promises and has taken steps toward repealing the Clean Power Plan. Trump believes that such plans will make U.S. manufacturing non-competitive in the global markets. This new development will help in running the coal fired electricity generation units for a longer period than previously expected.
Per a U.S. Energy Information Administration (EIA) release, the overall emission of carbon dioxide declined 1.7% in 2016 and 0.8% in 2017 due to initiatives undertaken by the utilities. According to EIA carbon dioxide emission is likely to rise 1.8% in 2018, due to higher coal usage. However, utilities are overall focusing on sources on fuel that helps to lower emission levels. Utilities like NextEra Energy (NEE) and Dominion Energy Inc. (D), among others, have already invested and plan to spend more to create green energy generation portfolio.
Zacks Industry Rank - Negative
Within the Zacks Sector classification, utilities are a stand-alone sector, one of 16 Zacks sectors. The rural wire-line telephone companies are also grouped within the Zacks Utility sector, but the three major industries within this sector include Electric Power, Gas Distribution and Water Supply.
We rank the 265 sub-industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries in two groups - the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than two to one. To learn more visit: About Zacks Industry Rank .)
All three industries related to the utility sector - Gas Distribution, Electric Power and Water Supply - fall in the second group, having the Zacks Industry Rank of #161, #202 and #212, respectively.
Our present outlook for the utility sector is negative, with all the major industries placed in the second group of the Zacks Industry Rank.
Utility Trading at Mid-Range
The valuation of the sector (Considering Gas Distribution, Water Supply and Electric Power industry) looks attractive at present. The Water Supply industry is currently trading at 19.7x forward 12-month EPS estimates, Gas Distribution industry is trading at 21.6x while Electric Power industry is trading at 12.4x, compared with S&P 500 trading average of 19.8x.
The current 21.6x multiple for Gas Distribution companies compares to the five-year range of 16.6x to 24.6x (median of 20.3x) while 19.7x multiple for Water Utilities compares to five-year multiple ranged from a low of 12.4x to a high of 23.3x (median of 18.6x). The current 12.4x multiple for Electric Utilities compares to a five-year range of 11.5x to 16.4x (median of 13.9x).
The above study shows that the current multiples are within the five-year ranges, but are trading above its median level (except Electric Power) and offers some room for increase from the current levels.
Earnings Review & Outlook
Third-quarter earnings in the utility space were down 3.6% due to a 2.1% drop in revenues. Inconsistent weather and hurricanes impacted their performance.
However, cost control, new electric rates and customer growth will help the utility sector to come up with earnings growth in the fourth-quarter reporting cycle. Fourth-quarter earnings from the utility sector are expected to improve 4.9% on the back of revenue growth of 3.2%.
The domestic defensive Utility sector's earnings in 2018 is expected to improve 4.8%, on the back of revenue growth of 1.5%. Read more on weekly Zacks Earnings Trends .
Utilities Worth Buying
The year 2017 has been profitable for most investors, with major indices gaining year to date. This trend is likely to continue in 2018. The S&P 500 and Nasdaq have rallied 19.8% and 14.4%, respectively, in 2017.
Investors may keep an eye on the couple utilities, which witnessed positive estimate revisions, paid regular dividend and returned higher than the market.
DTE Energy (DTE), a Zacks Rank #2 (Buy) stock, along with its subsidiaries, provides electric and gas to its customers in the United States. You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here.
Shares of the company have gained 11.1% last year, outperforming the Zacks Electric Power industry 's rally of 6.5%. The projected EPS growth rate (three to five years) is 6.00%. The company reported an average positive surprise of 3.8% in the last four quarters.
WEC Energy Group (WEC), a Zacks Rank #2 stock, is engaged in the generation and distribution of electricity in southeastern, east central and northern Wisconsin, as well as in the upper peninsula of Michigan.
Shares of WEC Energy have gained 13.2% last year, outperforming the industry's rally of 6.5%. The projected EPS growth rate (three to five years) is 5.4%. The company reported an average positive surprise of 3.08% in the last four quarters.
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Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free reportWEC Energy Group, Inc. (WEC): Free Stock Analysis ReportNextEra Energy, Inc. (NEE): Free Stock Analysis ReportDTE Energy Company (DTE): Free Stock Analysis ReportDominion Energy Inc. (D): Free Stock Analysis ReportTo read this article on Zacks.com click here.Zacks Investment Research