Utilities have become an integral part of our day to day life. The
importance of electricity, clean water and natural gas has
increased greatly with rapid urbanization and industrialization. We
can hardly imagine a moment without these essential supplies, and
expect uninterrupted supply of these essentials 24x7.
An improving standard of living besides industrial growth in the
United States has led to a higher demand for utility services. This
huge demand has trigged the growth of the utility industry. Since
these vital services are required across the board -- by
residential, commercial and industrial customers alike -- the
government has laid down norms and regulations to keep the prices
of these services under control and at the same ensure that
pollution perpetrated by the utilities is kept in check.
We believe growth of the utility industry will be tied to
overall economic conditions. As per the U.S. Energy Information
Administration (EIA), energy consumption in the United States will
increase 0.3% annually from 2010 through 2035. EIA’s assumption
takes into consideration modest growth in economic conditions after
the recessionary period of 2008-2009 and increase in the energy
efficiency level.
The majority of new power in the aforesaid period will be
generated from natural gas and renewable sources. Besides the
abundance of natural gas, as many as 30 U.S. states and the State
of Columbia have enforceable renewable portfolio standards or other
renewable generation policies. We expect this count to go up,
compelling producers to generate more green power to meet the
renewable standards fixed by the states.
As per the EIA report, the rise in demand for energy over the
2010 to 2035 period is because of stepped-up demand from
commercial, industrial, transportation and residential sectors. The
highest growth in demand is expected to come from the commercial
sector clocking an expected yearly growth rate of 0.7%, stemming
from 1% annual growth in floorspace over the same period.
Besides growth in demand from the commercial sector, the EIA
report shows that the industrial sector will also recover from the
2008-2009 recession, leading to higher volume of energy
consumption. A large chunk of industrial demand will be
attributable to the increase in production of biofuels, enabling
the companies to meet the renewable fuel standards of the Energy
Independence and Security Act of 2007.
The utility industry attracts the attention of income-oriented
investors due to its steady income generation capacity, as most of
the rates for the power generated are regulated by federal
authorities. However, the government has deregulated the wholesale
power markets. Regular dividend payments also make these stocks
attractive to investors.
On the flip side, ever-increasing and stringent government
regulations as well as demand fluctuation owing to irregular
weather patterns is hurting the industry fundamentals.
Global Scenario
As per the EIA report global energy use will increase to 770
quadrillion British thermal units (Btu) in 2035 from 505
quadrillion Btu in 2008. The majority of this usage is expected to
come from countries outside the Organization for Economic
Cooperation and Development (non-OECD nations). The non–OECD
nation’s energy market has a larger scope for improvement compared
to the matured ones in OECD nations.
The rise in demand for energy is definitely a good sign for the
companies in the utility sector. However, our concern lies in the
cost that needs to be paid for development at such unprecedented
levels. Will the non-OECD nations be able to impose strict
environmental standards, like the ones which are prevailing in the
United States? The EIA’s report does not look so promising, with an
indication of more greenhouse gases being emitted from the
developing nations.
OPPORTUNITIES
Unending demand: The demand for utility services is going to
last as long as the existence of the human race on this planet.
This basic tenet will remain the driving force for the industry.
There will always be demand for power generation, with ebbs and
flows in between.
Each passing day we are increasingly dependent on a number of
electrical gadgets, which means more and more demand for
electricity and utility services.
New avenues are opening up which will enhance the demand for
electricity. We see new growth opportunities in the transportation
segment. Green vehicles have the potential to be a game changer in
the global arena and can help to cut down on emissions drastically.
A number of big automobile companies like General Motors
Company (GM), Toyota Motors Corp. (TM)
and Honda Motor Co. (HMC) are the front runners in
the creation of hybrid vehicles. These vehicles, which run on
electricity, will drive demand in the utility sector.
Utility services have no alternative: A big positive
for the utility operators is that there is hardly any viable
substitute for utility services. We can have different fuel types
like coal, oil, natural gas, nuclear power and renewable sources to
produce electricity, but do not have any alternative to
electricity. Similarly, clean water does not have any substitute.
This is the primary driving factor for the industry.
Previously, conventional fossil fuels were used solely to
generate electricity. Now alternate sources are also utilized for
electricity generation. As per the EIA report, energy generated
from alternate sources will increase at an annual rate of 3% from
2010 through 2035.
Regular dividend payment: The utility operators
generate more or less stable earnings unless there are severe
factors disrupting their operations. These operators likewise
reward their shareholders through the payment of sustainable
dividends. This has been evident during the economic crisis of
2008-2009 when these operators continued to pay out dividends
without fail.
Currently, among the electric utility companies,
Atlantic Power Corporation (AT) has the highest
dividend yield of 8.9%. Among the natural gas utilities,
TransAlta Corp. (TAC) has the highest dividend
yield of 6.8%, while within the water utilities Artesian
Resources Corp. (ARTNA) has the highest dividend yield of
3.5%. All these dividend yield numbers compare favorably to the
industry average of a yield of 2.37%.
Focused R&D: In their quest to improve the standard
of services, the utility operators have relentlessly pursued
research and development work. Keeping the rise in demand and
efficient use of power in mind, the operators have brought in new
smart meters, new transmission and distribution lines, and new gas
pipelines into operation.
Utility operators are also benefiting from ongoing research work
in the solar photovoltaic (PV) sector. Solar energy is a growing
alternate energy source and the new solar cells having higher
conversion rates allow operators to generate more power with fewer
solar panels. This enables the operators to lower the cost of
producing power.
Mergers and acquisitions: Apart from growing
organically, the players in the utility industry are carrying out
strategic merger and acquisition deals, which lead to cost
synergies and better utilization of resources.
We believe that in a mature energy market like the United
States, mergers and acquisitions represent a sure way to enhance
market share. This activity expands market reach through the usage
of transmission and distribution lines, diversifies the generation
portfolio of the company and also lowers operating costs through
the usage of common back office space to control the expanded
operations.
In one of the mega-mergers in this space, North Carolina-based
Duke Energy Corporation (DUK) has decided to buy
Progress Energy Inc. (PGN). This $16.1 billion
transaction is expected to be consummated by July 2012. It would
create the largest U.S. utility and increase Duke Energy’s
capability to build new power plants to meet future greenhouse-gas
emissions limits.
Earlier, FirstEnergy (FE) acquired Allegheny
Energy, creating a large utility company with a significant portion
of non-regulated generating assets.
Another utility company, Entergy Corporation
(ETR), had entered into a definitive agreement with ITC Holdings
Corp., under which Entergy will divest and then merge its electric
transmission business into ITC.
Recently, Footprint Power LLC, a New Jersey-based power company,
acquired Salem Harbor Power Station from Dominion Resource
Inc. (D). Footprint will convert this coal- and oil-based
power plant to a natural gas unit with new production starting from
2016. We consider this acquisition to be a smart move that would
lower pollution in the region.
WEAKNESSES
Vulnerable to weather changes: Utility operations
globally depend on weather patterns that determine the extent of
demand. Moderate weather conditions like a warmer winter or a
cooler summer drastically lower the demand for utility services.
Erratic weather patterns thereby impact profitability of these
operators such that their operational goals remain unmet.
The hurricane season also affects utility operations. Though the
utility operators prepare themselves for the disruptions caused by
hurricanes, most of the time nature has its way, uprooting
transmission and distribution lines. Excessive rains create
flood-like situations whereby in some cases the operators have to
shut down their generating units. This undermines the profitability
of the utility operators.
Buyers’ market: The utility service markets are
gradually transforming into buyers’ markets. A lot of states allow
the consumers to migrate from one utility operator to the other
operating in the region. The consumers thus have the option of
choosing the best and/or the cheapest operator in the region.
Higher-cost producers are gradually edged out of the market unless
they can bring 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.
Capital intensive: The utility business is a
capital-intensive industry and needs huge capital investments.
Particularly when a company goes into expansion mode, the funds
generated internally are insufficient to fulfill the capital needs.
So, the company has to borrow money from the markets for carrying
out the development work.
The increase in the debt level -- for that matter a steep
debt/equity ratio -- impacts the credit rating of these utility
operators. If the credit rating comes down, the company will find
it difficult to borrow funds from the markets at reasonable rates,
and hence the cost of operations of the company will increase.
Government intervention & emission control: The United
States government has come out with stringent laws and regulations,
which are affecting the operations of the utility operators. To
meet the increasing regulatory standards a few of the utility
operators have had to shut down their coal-fired units. In recent
times, to meet the environmental regulations, American
Electric Power (AEP) has decided to retire 4,600 megawatts
(MW) of coal-fired generation from its portfolio.
The operators are gradually idling their old power generation
plants or trying to meet the new regulations by installing
scrubbers and using a better variety of coal. These steps
invariably increase the cost of operating the units.
In the United States, as per the U.S. Environmental Protection
Agency’s “Mercury and Air Toxics Standards” (MATS), all coal-fired
units having a generation capacity of more than 25 megawatts (“MW’)
will have to abide by the MATS rule beginning 2015. As per this
rule, the coal-fired units have to bring down the greenhouse gas
emissions levels to 90% below their uncontrolled levels.
These units will have to install scrubbers or use carbon
injection controls to bring down emissions levels. Margins would
thus be hurt unless the operators can recover the investments from
consumers through rate hikes.
These stringent measures to control emissions, however, do not
seem to be enough. As per EIA, global carbon dioxide emissions will
increase to 43.2 billion metric tons in 2035 from 30.2 billion
metric tons in 2008.
The development of industries and greater dependence on fossil
fuels to generate power in non-OECD nations will increase the
emissions of greenhouse gases on a global scale. Despite the
increasing focus on renewables, coal still remains the major source
of electricity generation. This is due to coal’s wide and cheap
availability on a global scale.
Pending rate case: Consumers expect to have
uninterrupted supply of utility services at all times. The
operators to ensure this supply makes consistent investments to
upgrade their transmission lines, carry out regular maintenance
work and lay down new lines to distribute power.
The regulated utilities recover these costs through rate
increases in its service territories. The pending rate cases and at
times partial allowance of the rate hike requested make it
difficult for the operators to sustain ongoing development and
maintenance work.
Earnings Roundup and Zacks Rank
Most of the companies in the utility industry reported soft
earnings results last quarter. The majority of stocks we cover in
this industry failed to meet the Street’s expectations, affected as
they were by a mild winter, which substantially lowered the demand
for utility services.
A few of the utility companies surpassed our expectations. Yet,
we felt the magnitude of earnings surprises was not all that
flattering, hovering around a penny to five cents.
We presently have a long-term Neutral recommendation (six months
plus) on the majority of the stocks we cover under the utility
sector. The stalemate is largely due to lackluster results seen in
the first quarter of 2012, in conjunction with an absence of a
game-changing catalyst on the horizon.
Zacks Ranks indicate the movement of the stocks over the short time
(1 to 3 months).
Over the short term we have a few names with a Zacks #2 Rank
(short-term Buy rating). These include Duke Energy Corporation,
Dominion Resources Inc., NiSource Inc. (NI),
Pinnacle West Capital Corporation (PNW),
Dynegy Inc. (DYN), Wisconsin Energy
Corporation (WEC), OGE Energy Corp. (OGE)
and Calpine Corporation (CPN).
The majority of stocks we cover in the utility industry, such as
Southern Company (SO), Integrys Energy
Group, Inc. (TEG), Pepco Holdings, Inc.
(POM), NextEra Energy Inc. (NEE), Exelon
Corporation (EXC), Progress Energy Inc., The AES
Corporation (AES), PPL Corporation (PPL),
Public Service Enterprise Group Inc. (PEG),
Northeast Utilities (NU), Entergy Corporation,
TECO Energy Inc. (TE), Edison
International (EIX) and Pike Electric
Corporation (PIKE), presently retain a Zacks #3 Rank (
short-term Hold rating).
However, we presently have a few Zacks #4 Ranked stocks
(short-term Sell rating) in American Electric Power, CMS
Energy Corp. (CMS) and Portland General Electric
Company (POR).
In Conclusion
The companies in this sector do not necessarily come out with
extraordinary numbers or surpass the market expectation by a wide
margin. But earnings performances from these companies are
generally stable.
The utilities have to constantly meet the high expectations of
its wide customer base, adapt to a changing global economic
scenario, and upgrade technologies to meet stringent environmental
norms. This can only be achieved by entering into strategic
partnerships.
It is also important to keep in mind that expansion of the
customer base of the utility operators does not necessarily mean
growth in usage. At times, despite an increase in customers, we can
see a decline in usage due to sluggish economic recovery and energy
efficiency initiatives. Nevertheless, we believe a revival in the
economy would surely raise both the customer base and usage.
We are also seeing a substantial increase in the use of natural
gas for power generation due to its clean burning nature and
abundance in the United States. The relatively lower prices of
natural gas also make it popular among industrial users. This has
helped in augmenting growth for natural gas utilities and gas
pipeline operators.
To round up, our Zacks Rank and Recommendation is a reliable
indicator of the likely movements of these utility stocks.
Investors who are willing to invest in utility companies can look
into some of the following points: 1) debt levels and cash flow
generation capabilities, which indicate the prospects or need for
funding of expansion projects, 2) pipeline projects and the fuel
type of generation units, which indicate its ability to grow and at
the same time conform to renewable energy policies, and 3)
regulated and unregulated mix of the generation portfolio, which
gives a fair idea about revenue generation.
AMER ELEC PWR (AEP): Free Stock Analysis Report
ARTESIAN RES (ARTNA): Free Stock Analysis Report
ATLANTIC PWR CP (AT): Free Stock Analysis Report
CALPINE CORP (CPN): Free Stock Analysis Report
DOMINION RES VA (D): Free Stock Analysis Report
DUKE ENERGY CP (DUK): Free Stock Analysis Report
DYNEGY INC (DYN): Free Stock Analysis Report
ENTERGY CORP (ETR): Free Stock Analysis Report
FIRSTENERGY CP (FE): Free Stock Analysis Report
NISOURCE INC (NI): Free Stock Analysis Report
OGE ENERGY CORP (OGE): Free Stock Analysis Report
PROGRESS ENERGY (PGN): Free Stock Analysis Report
PINNACLE WEST (PNW): Free Stock Analysis Report
SOUTHN COMPANY (SO): Free Stock Analysis Report
TRANSALTA CORP (TAC): Free Stock Analysis Report
INTEGRYS ENERGY (TEG): Free Stock Analysis Report
WISC ENERGY CP (WEC): Free Stock Analysis Report
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