For Immediate Release
Chicago, IL - October 06, 2015 - Today, Zacks Equity Research discusses the Utilities, part 3, including Peabody Energy ( BTU ), DTE Energy Co. ( DTE ), Great Plains Energy Inc. ( GXP ), Consolidated Water Co. Ltd. ( CWCO ) and South Jersey Industries, Inc. ( SJI ).
Industry: Utilities, part 3
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. Though the Federal Reserve kept rates on hold in its September meeting and the issue has likely been further delayed following the soft September non-farm payroll reading, the overall monetary policy posture continues to be in the direction of tightening.
Higher interest rates mean increased cost of capital, a basic need of these operators given their ongoing investments in clean technology. Just as their low-risk and high-yielding attributes make them a preferred choice during an economic down-cycle, a bullish economic environment makes utilities look a little wan.
Let us look into the factors which might make the investors rethink before investing in the utility space.
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 ruin their business.
Incidentally, emission from old coal-fired electricity generating units is a primary source of greenhouse gases. Electric utilities relying primarily on coal and without adequate retrofit to scale down the carbon footprint will be the worst affected.
The 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.
Coal-fired power plants in excess of 12,000 MW will go offline in the U.S. in 2015 due to the Mercury and Air Toxics Standards (MATS) implemented this April.
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 outlay and put immense stress on the finances of these utilities.
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.
The Federal Reserve in its recent meeting did not alter the interest rates. However, market experts believe that the Fed might increase the borrowing costs maybe by the end of this year given the current pace of U.S. economic recovery.
Higher interest rates and an increase in the debt level - for that matter a steep debt/equity ratio - will impact the credit ratings of these utility operators. If the credit ratings go down, a company will find it difficult to borrow funds from the markets at reasonable rates, leading to a rise in cost of operations.
We believe that a rising interest rate environment could add to the troubles of the utility operators, as raising funds from the market becomes costlier. So, while investing in a utility, one must take a note of its outstanding debts.
The utility service markets are gradually transforming into buyers' markets. Many states allow consumers to migrate from one utility operator to another. Consumers thus have the option of choosing the best and/or the cheapest operator in the region. Higher-cost producers are gradually pushed out of the market unless they can scale down their costs.
Long-term power purchase agreements between operators and customers could also impact profitability. In situations when there is an increase in the cost of generation, the operators still have to abide by the pre-existing agreement and sell power at pre-determined rates, thereby stretching margins.
Competition with Bonds
Additionally, these reliable dividend payers are in competition with bonds as an investment option. The looming threat of an increase in interest rates from the present level will definitely make bonds more attractive than utilities and might drive away investors from the utility space.
Limited Growth Potential
Though the utilities play regular dividends, the scope of capital appreciation is quite limited for the operators in this space. Stock price in this sector does not jump like the ones in the technology sector. So, the returns are never dramatic or over the top.
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 the utilities to take advantage of the shale boom in the U.S. and develop more power plants based on natural gas, which in a way will lower emission.
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 when the interest rates finally go up?
We recommend investors stay away from Great Plains Energy Inc. ( GXP ), Consolidated Water Co. Ltd. ( CWCO ) and South Jersey Industries, Inc. ( SJI ) as these stocks currently have a Zacks Rank #4 (Sell). These companies registered an average negative earnings surprise of 6.5%, 13.2% and 47.5%, 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.