The first four months of 2018 have been eventful, with a Fed rate hike, U.S.-China tariff war threats and tensions in Syria wiping out yearly gains from all the major indexes. The S&P 500 index is off its highs for the year and currently remains barely in positive territory, while the Technology-heavy Nasdaq composite is up +2.1% in the year-to-date period.
Stock market investing is no doubt a risky venture, and even well-thought out investment strategies at times fail to generate desired returns. Against this backdrop, let us focus on the domestic-focused, capital-intensive utility stocks that assure investors steady performance and regular dividend yields. Utility stocks are subject to heavy regulation, both at the federal and state levels. Utilities are known for stability and visibility of earnings and cash flow.
Utilities, aside from investing in generating plants that produce electricity with low and negligible amounts of emissions, are also focused in improving and upgrading transmission and distribution networks. They are also investing in power storage facilities and guiding investors for efficient usage of electricity. We expect more battery storage units to be installed across the U.S. due to increasing production of electricity from renewable sources and support to the power grid.
Utilities are also undertaking long-term plans to shift transmission lines underground in weather-sensitive areas to lower chances of power outages. The introduction of smart meters are helping users make efficient use of electricity.
Natural gas utilities depend on pipelines to deliver their product to end users. Water utilities are also required to upgrade and replace old pipelines and water mains. The utilities are using the latest technology to upgrade and maintain their existing infrastructure to increase reliability of their services. Xcel Energy Inc. (XEL) received approval from Federal Aviation Administration (FAA) to use drones beyond their operators' vision to survey transmission lines and perform other operations that require consistent monitoring.
So, to upgrade and strengthen the existing infrastructure, utilities depend on capital markets. Though regulated utilities are cash generators, the funds generated from internal sources are not sufficient to carry out long-term projects. The rate-sensitive, capital-intensive utility stocks also had to accommodate the Fed rate hike.
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 the attractiveness of utilities, and investors might turn to bonds as an alternative source of investment.
However, utilities across the United States have gained from the implementation of the Tax Cuts and Jobs Act from January 2018. Utility operators decided to pass on the benefits to their customers, and the majority of them have enjoyed a decline in monthly bills.
The unemployment rate in the United States was static at a historical low of 4.1% for the last six months. In addition, the United States Building Permits increased 4.4% in March 2018 to 1,379 thousand. The new permits had exceeded the U.S. building permit average of 1355.99 thousand from 1960 to 2018. All these factors indicate an increase in demand for residential utility services.
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.
In August 2015, President Obama introduced the Clean Power Plan to lower carbon dioxide (CO2) emissions levels from electricity generation by around 32% by 2030 from the 2005 levels. President Trump 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.
The U.S. Energy Information Administration ("EIA") estimates that U.S. energy-related CO2 emissions declined by 861 million metric tons or nearly 14% from 2005 to 2017. EIA now projects that carbon dioxide emissions will rise 1.8% from 5,143 million metric tons in 2017 to 5,237 million metric tons in 2018, primarily due to an increase in coal usage in power plants. In 2019, energy-related CO2 emissions will be about 13% lower than 2005 levels.
However, utilities are focusing overall on sources of fuel that help to lower emission levels. Large solar power plants and extensive development of wind farms are indicating a shift in preferences relating to fuel sources among utilities. We notice that utility operators like NextEra Energy (NEE) and Duke Energy (DUK) have already invested and plan to spend more on creating green energy generation portfolio.
Zacks Industry Rank - Positive
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 .)
Two out of three industries related to the utility sector - Gas Distribution, Electric Power and Water Supply - fall into the first group, having the Zacks Industry Rank of #81, #110 and #232, respectively.
Our present outlook for the utility sector is positive, with two major industries placed in the first group of the Zacks Industry Rank.
Utilities 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 19.4X forward 12-month EPS estimates, the Gas Distribution industry is trading at 20.7X while the Electric Power industry is trading at 13.4X compared with the S&P 500 trading average of 17.5X.
The current 20.7x multiple for Gas Distribution companies compares to the five-year range of 17.2X to 24.6X (median of 20.5X) while the 19.4X multiple for Water Utilities compares to the five-year multiple range from a low of 12.4X to a high of 23.3X (median of 18.7X). The current 13.4X multiple for Electric Utilities compares to a five-year range of 11.4X to 16.2X (median of 13.5X).
The above study shows that the current multiples are within the five-year ranges, but trading above their historic median level (except Electric Power), offering some room for an increase from the current levels.
Earnings Review & Outlook
First-quarter earnings in the utility space (till Apr 25, 2018) were up 7.7%. Utilities gained from favorable weather in the first quarter, while tax reforms and ongoing infrastructure spending helped the utilities.
We expect cost control, new electric rates and customer growth will help the utility sector to come up with earnings growth in the first-quarter reporting cycle. First-quarter earnings from the utility sector are expected to improve 12.5% on the back of revenue growth of 0.4%.
Utilities Worth Buying
The first quarter is expected to be the sector's best in the last seven years. Last year was profitable for investors, and we expect the major indices to maintain the momentum in 2018.
Investors may keep an eye on utilities that witnessed positive estimate revisions, paid regular dividend and returned higher than the market.
IDACORP Inc. (IDA), a Zacks Rank #2 (Buy) stock, along with its subsidiaries, provides electricity 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 11.6% in the past year, outperforming the Zacks Electric Power industry 's return of 0.04%. The projected EPS growth rate (three to five years) is 3.87%. The company delivered an average positive surprise of 9.09% in the past 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 7.1% in the past year, outperforming the industry. The projected EPS growth rate (three to five years) is 4.2%. The company delivered an average positive surprise of 4.98% in the past four quarters.