Rate Hike Apart, What Can Hold Back Utilities?

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Stocks of utility companies are among the safest investment bets in the market, but they have their share of weaknesses. A growing regulatory burden and increased debt loads remain a concern. But an even bigger issue is the interest rate backdrop.

The Fed posture following the December lift-off has not been favorable for rate-sensitive sectors like utilities. While long-term yields have come down notably in recent days as a result of the market's evolving Fed outlook, the long-term monetary policy trajectory is not helpful.

Let's look into the factors which might deter investors from investing in the utility space.

New Regulations

The U.S. Environmental Protection Agency (EPA) has finally come 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 like Peabody Energy ( BTU ), among others, were against this new plan and felt the implementation of this rule will further harm their businesses.

DTE Energy Co. ( DTE ) management believes that nearly $15 billion needs to be invested in the state of Michigan to upgrade energy infrastructure to match the required environmental standards prescribed by the EPA. The company will have to invest in the range of $7 billion to $8 billion to meet the standards of the energy policy.

So, going by the above example, upgrading all the old coal-fired power plants across the country to meet environmental compliance will need huge capital outlays and will put immense stress on the finances of these utilities.

A good many U.S. utility operators prefer to shut down their old coal-fired generation units, rather than inject fresh funds to make them fit for new emission standards. Per a recent release from the U.S. government's Energy Information Administration (EIA), the electricity industry retired nearly 14 gigawatts (GW) of conventional steam coal-fired generating capacity during 2015. The industry plans to further retire 10.7 GW of coal-fired units during 2016 and 2017.

Debt Levels

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 than was the case just a few weeks back, the access to capital markets has been steadily getting restricted lately. 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 the interest rate gradually in 2016. However, market experts believe that the Fed might not increase borrowing costs anytime soon. We believe that a rising interest rate environment could add to the troubles of the 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 to be a safe option. Even though utilities pay regular dividends, 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.

Bottom Line

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 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 more electricity from renewable sources. The EIA expects total renewables used in the electric power sector to increase by 9.5% in 2016.

We recommend investors to stay away from MDU Resources. ( MDU ), Pinnacle West Capital Corporation ( PNW ) and South Jersey Industries, Inc. ( SJI ) as these stocks currently carry a Zacks Rank #4 (Sell). These companies registered an average negative earnings surprise of 15.8%, 25.9% and 71.7%, respectively, over the last four quarters.

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.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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