Though utility companies are among the safest investment bets, they have their share of weaknesses. Regulatory burdens, weather variation and increased debt loads are major concerns. While the Trump administration is expected to lower the industry's regulatory burden, an even bigger issue is the interest rate backdrop.
Let's look into the factors which might deter investors from investing in the utility space.
Debt Levels & Rising Rates
Utilities are capital intensive and need to have a continuous inflow of funds to maintain organic growth and infrastructure upgrade projects. This is essential for 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.
We believe that a rising interest rate environment could add to the woes of utility operators, as it will increase cost of capital, restraining their ability to pay consistent dividends. We suggest that investors take note of outstanding debts and current ratio, both of which indicate the company's ability to meet its debt obligations.
Weather a Headwind
Weather plays a vital role in driving demand for utility services. A normal winter and summer season assure higher demand for utility services. However, a milder winter and a cooler summer results in lower demand for utility services.
The credit rating firm, Moody's has estimated that hurricanes Harvey and Irma will lead to around $150-$200 billion loss in the United States and additional $20-$30 billion economic expenses owing to disruption of services.
NextEra Energy Inc. (NEE), a Zacks Rank #2 (Buy) stock, and Duke Energy Corp. (DUK) have made substantial investments in Florida in the last few years to strengthen their power delivery systems. You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here.
However, the hurricanes caused damages to the solar panels installed in the state. Repairing and restoration of the solar panels will result in additional expenditures for the companies that already have made substantial investment in solar power generation.
Competition with Bonds
These reliable dividend payers are in competition with bonds as an investment option. The ongoing 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.
The Fed raised interest rates in four of the last five quarters (December 2016, March 2017, June 2017 and December 2017), which is a drag for rate-sensitive sectors like Utilities. Making things worse, the Fed might hike interest rates thrice in 2018, if economic conditions remain conducive.
The increasing interest rates will raise the cost of capital for the utilities and might adversely impact its ability to carry on with dividend payment and share buybacks, making the high interest-bearing bonds a more alluring option for investors.
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 with an unfavorable Zacks Rank. The other metrics also indicate that these utilities are not profitable investment options now.
Black Hills Corporation (BKH) currently has a Zacks Rank #4 (Sell). It saw an average negative surprise of 6.18% in the last four quarters. The Zacks Consensus Estimate for 2017 and 2018 earnings per share declined 4.0% and 5.9%, respectively, in the last 90 days. Black Hills Corporation has lost 3.1% last year versus 6.5% rally of the Zacks Electric Power industry it belong to.
Connecticut Water Service Inc. (CTWS) saw an average negative surprise of 14.27% in the last four quarters. The Zacks Consensus Estimate for 2017 and 2018 earnings per share declined 3.6% and 3.5%, respectively in the last 60 days. The company currently has a Zacks Rank #4. Connecticut Water Service stock has gained 2.8% last year, much lower than Zacks Water Supply industry's gain of 22.9%.
At the end of the day, we believe that rise in interest costs will continue to hurt utilities. However, these fundamentally strong utilities are here to stay forever as we are yet to come out with any alternatives to their services.
The changes in the U.S. administration might result in intensity of regulation, which has some positive impact on their performance due to increasing operation costs. The utilities are gradually converting their operation from non-regulated to regulated nature, which will again provide stability to earnings.
A makeover in the utility space is already underway, but the decision to repeal the Clean Power Plan will help the utilities continue with the coal-fired units for longer than previously expected.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.