The U.S. market is showing signs of regained optimism and strength, thanks to the new administration, with the Dow Jones Industrial Average crossing the 20,000 mark for the first time in history, which even the Federal Reserve's interest rate hike failed to mar.
Trump's Presidency is expected to benefit defensive and domestic-oriented utilities immensely, even though conventional wisdom runs counter to this view in light of historical underperformance of high- dividend stocks in rising interest rate backdrop. During his election campaign, Trump had vowed to lower the regulatory pressure on domestic manufacturers and suggested increased investment in energy infrastructure. If the new administration indeed starts working on these lines, the entire utility sector is bound to get a boost.
Utilities are at a crucial juncture also because of the Aug 2015 release of new emission standards by the Environmental Protection Agency (EPA). The final version of the Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from the 2005 levels. Another EPA report indicated the possibility of a need to invest nearly $600 billion in the water sector over the next two decades to ensure high-quality uninterrupted water and wastewater services.
Larger utilities with higher financial strength and better access to capital are favorably placed to achieve regulatory compliance. This is also likely to trigger consolidation in the utility landscape. To curb emission, coal-fired utilities were gradually taking the back seat, as natural gas and renewable energy gained traction.
However, President Trump's view of climate change being "a Chinese Hoax" aimed to make U.S. manufacturing "non-competitive" will definitely keep fossil fuel-based electricity generation afloat longer than expected.
Having said that, we believe there needs to be a balance between emissions control and clean energy generation. A constructive utility rate environment, increase in electricity production from natural gas and renewables, and supporting coal-powered projects by infrastructure investments will enable utilities to efficiently serve a larger customer base.
In the segment below, we discuss the basic strengths of the utility sector.
Regular Dividend & Share Buybacks
Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008-2009 when utilities continued to pay dividends without fail.
We have a long list of companies that are sharing profits consistently with their shareholders. Notable among them are CenterPoint Energy (CNP) and Duke Energy (DUK), which have raised dividend rates annually for more than 10 years now.
In Jan 2017, CenterPoint Energy, which sports a Zacks Rank #1 (Strong Buy), increased its quarterly dividend by 4% to 26.75 cents. You can see the complete list of today's Zacks #1 Rank stocks here.
In Jul 2016, Duke Energy increased its quarterly dividend by 3.6% to 85.5 cents.
Stable & Growing Demand
The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for its services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.
Given the ongoing increase in demand for the electricity, the EIA forecasts U.S. net electricity generation to increase from 4,100 billion kilowatt-hours (BkWh) to 5,362 BkWh in 2050. Utilities will thus undoubtedly benefit from the rise in demand and production.
Focused on R&D & Extension of ITC/PTC
In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, and transmission and distribution lines, into operation without compromising on energy efficiency.
Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.
In addition, the utility friendly move of the U.S. administration through the extension of the validity period of Solar Energy Investment Tax Credit (ITC) and Wind Energy Production Tax Credit (PTC) will help the utilities. We will see more utility scale solar and wind projects coming up, which will boost green power generation.
Mergers and Acquisitions
Utility sector operators don't shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.
We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and lowers operating costs through the usage of common back office space.
In Jan 2017, Duke Energy's unit Duke Energy Renewables acquired three solar power projects from SunPower Corp. (SPWR) totaling 55 megawatts (MW). These acquisitions diversified Duke Energy's generation portfolio and expanded its solar operation in California.
We are also noticing major acquisitions in the water utility space. During the first nine of 2016, American Water Works Company (AWK), a Zacks Rank #3 (Hold) company, added 10,700 customers to its customer base through buyouts. In Dec, 2016, the company had completed the takeover of wastewater system from the Scranton Sewer Authority (SSA) for $195 million. The transaction added nearly 31,000 customers to American Water Work's existing base of 15 million customers across 47 states in the U.S. as well as in Ontario, Canada.
Another major player in the water utility space, Aqua America Inc . (WTR) successfully completed 19 acquisitions in 2016, which added nearly 25,000 customers to its existing base. In 2015, the company had added 17,747 customers primarily through prudent buyouts. Aqua America currently carries a Zacks Rank #3.
To Sum Up
Stable operations, highly visible revenues and cash flows, combined with the sector's income/yield attributes are some of its key defining features. In addition, expectations of reduced stringency of emission regulations under the Trump administration will act as a tailwind for the utility sector.
We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water and wastewater services do not have any viable substitute. This is perhaps the most vital driving factor for the industry.
Even though the last interest rate hike increased the cost of operation for utilities, these fundamentally strong companies should be able withstand the challenges and continue to deliver stable performances. This is evident from the increase recorded by the Dow Jones Utility Average (DJU) since the election results.
The defensive nature and stable performance demonstrated by the utility sector has driven investors to look for a safe haven in this space. Regular dividend payers are often regarded as a "bond substitute" and consistent performing utilities continue to be safe investment options for jittery investors.
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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.