Utility Industry Stock Outlook - Feb 2013

Zacks

Overview

The rise in population has led to an increasing demand for essential utility supplies. Here utility companies step in with their ability to generate essential supplies in large volumes and cater steadily to the needs of their customers. The utility companies generally are comprised of electric, gas, water and integrated service providers.

The increasing demand for utility services, particularly for electricity, leads to the installation of large generation units. The power generators, in the wake of more stringent environmental regulations and restrictions, are gradually shifting their focus to renewable sources and natural gas to produce power. This is a welcome sign for the industry and a positive step towards reducing the emission of greenhouse gases.

The utility operators are thus in the process of implementing new technology in generation and distribution of power. The introduction of smart meters will benefit customers while the smart-grid technology is likely to increase efficiency of the utility operators. However, the implementation of these new technologies, over vast service territories, is a long, drawn-out process.

The utility sector is highly regulated as the essential supplies cater to basic human needs, and the government tries to ensure the prices of these supplies -- water, electricity, etc. -- stay within reasonable limits. The utilities, on the other hand, try to increase prices through the filing of rate cases. The investments and costs incurred for the modernization and maintenance of reliable services are recovered through these rate cases.

Global Scenario

As per the most recent U.S. Energy Information Administration (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 nations’ energy market has a larger scope for improvement compared to the more mature OECD nations.

The projected increase in the global demand for power will also necessitate massive investment in the utilities over the next couple of decades. Government policies will play a pivotal role regarding speedy approvals to set up plants, government subsidies for renewable projects and grants to promote expensive new technology. However, the sluggish economy in the U.S., tight credit markets and the ongoing debt uncertainty in Europe continue to cast shadows.

There is also a high cost for the rise in demand for electricity in the developing countries. Will emerging nations be able to impose strict environmental standards, like the ones prevailing in the U.S. and Europe? The EIA’s report does not look promising, with an indication of more greenhouse gases being emitted from developing nations.

Utility Drivers

The demand for utility services is primarily driven by the state of the economy, modernization & urbanization, expansion of infrastructure and weather.

Economy: The state of the economy is the primary driver of the utilities. A steady and improving economy acts as a tailwind for the utility sector. At present, the steep public debt in the U.S. is putting downward pressure on government spending and the economy at large. This affects the demand for utility services from the industrial and commercial sectors.

Housing: Improvement in the economy lowers unemployment rates and as a consequence increases the demand for housing. An improving housing sector outlook will also drive demand for utility services.

Population: Population has a direct link with the demand for utility services. Higher density and increase in population drive the requirement for essential services.

Weather: Weather plays a crucial role for utilities. A normal weather pattern throughout the year ensures steady demand for utility services. However, extreme conditions tend to reinvigorate demand.

Earnings and Zacks Rank

Within the Zacks Industry 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. The Utility sector’s defensive attributes reflect the group’s lack of correlation with the broader market/economy. Of course, the sector’s reputation as a dividend payer also adds to its perceived defensiveness.

We rank all of the more than 250 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank http://www.zacks.com/rank/industry.php

The way to look at the complete list of Zacks Industry Rank for the 250+ companies is that the outlook for the top one-third of the list (Zacks Industry Rank of #85 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #170 and higher) is negative.

All three industries in the Utility sector are currently ranked in the middle 1/3rd, with Gas Distribution at Zacks Industry Rank #95, Electric Power at Zacks Industry Rank of #103 and Water Supply at Zacks Industry Rank #170. The exact location of the three mining industries on the Zacks Industry Rank aside, one could safely say that the near-term outlook for the group is leaning towards a Neutral outlook.

Zacks Rank indicates the movement of the stocks over the short term (1 to 3 months). The rank along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Method) helps in predicting the probability of earnings surprises.

The names with a Zacks Rank #1 (Strong Buy) include Alliant Energy Corporation (LNT), Ameren Corporation (AEE), Aqua America, Inc., Otter Tail Corporation (OTTR) and TransAlta Corporation, among others. Except Alliant all the other companies surpassed the respective Zacks Consensus Estimates in the last reported quarter.

A few of the Zacks Rank #2 (Buy) stocks which surpassed the Zacks Consensus Estimates in the last reported quarter were ALLETE, Inc. (ALE), DTE Energy Company (DTE), Sempra Energy (SRE), The Laclede Group Inc. (LG) and IDACORP Inc. (IDA).

However, most of the stocks we cover in the utility industry have a Zacks Rank #3 (Hold). A good many of these stocks, such as, Integrys Energy Group, Inc. (TEG), Entergy Corporation, NextEra Energy, Inc., MGE Energy, Inc. (MGEE), CenterPoint Energy, Inc. (CNP) and American States Water Company, succeeded to beat the Zacks Consensus Estimates in the last reported quarter.

We presently have a few stocks having Zacks Rank #4 (Sell) and Zacks Rank #5 (Strong Sell). AGL Resources Inc. (GAS) and TransCanada Corporation (TRP) have a Zacks Rank #5, with both missing the Zacks Consensus Estimates in the last reported quarter.

Different Types of Utilities

We have various types of utilities. The most important among these are electric, natural gas and water utilities.

Zacks provides an Industry Rank for the different industries under our coverage universe presently numbering 259. Electric utilities currently have a Zacks Industry Rank #76, while the Natural Gas utilities have a Zacks Industry Rank of #158.

Electric Utilities

EIA reports that electricity consumption in the U.S. will increase from 3,841 billion kilowatt hours in 2011 to 4,930 billion kilowatt hours in 2040, an average annual rate of 0.9%. For the fuel type in energy generation, renewables and natural gas will play an increasing role while coal and nuclear power will gradually fall out of favor.

The electric utilities which are expected to play an important role in meeting this increased demand for power are American Electric Power Inc. (AEP), Duke Energy Corp. (DUK), Entergy Corp. (ETR), FirstEnergy Corp. (FE), NextEra Energy Inc. (NEE), PPL Corporation (PPL) and Southern Company (SO), among others.

Natural Gas Utilities

Natural gas usage is increasing among the utilities due to its abundance, cheap price and clean-burning nature. The EIA pegs the usage of natural gas in 2013 and 2014 at 70.3 billion cubic feet per day (Bcf/d) in 2013 and 70 (Bcf/d) in 2014, up from the previous expectations of 69.7 Bcf/d and 69.4/Bcf/d in 2013 and 2014, respectively. The expectation of normal winter conditions in 2013 and 2014 will increase the consumption of natural gas for residential and commercial space heating.

EIA reports suggest that as of Feb 1, 2013, the working gas stock was 2,684 Bcf, down by 226 Bcf from 2012 levels, mainly due to dropping temperatures in Jan 2013 driving demand. Given the accumulated stockpiles of natural gas in the recent past, and the fracking technology accounting for the nat gas boom, the increase in usage forecast by the EIA bodes well for the utilities.

This is going to benefit the natural gas utilities like Atmos Energy Corporation (ATO), Spectra Energy Corp. (SE), Northwest Natural Gas (NWN), Southwest Gas Corporation (SWX), New Jersey Resources Corporation (NJR) and Questar Corp. (STR) among others.

Water Utilities

2012 was a good year for the water utilities as the overall warm weather in 2012 increased the demand for water. This has boosted the performance of the water utilities like American States Water Company (AWR), American Water Works Co. Inc. (AWK), Artesian Resources Corporation (ARTNA) and Aqua America, Inc. (WTR), among others.

However, the major challenge ahead of the water utility operators is the aging water and sewer infrastructure. Maintenance and development of facilities play a key role and will test the financial capabilities of the water utilities.

Tailwinds

Unending demand: 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. As per the EIA, the energy usage in the U.S. industrial sector will increase from 24.0 quadrillion Btu in 2011 to 27.8 quadrillion Btu in 2040. In the commercial sector consumption will increase from 8.6 quadrillion Btu in 2011 to 10.2 quadrillion Btu in 2040. In the transportation sector the demand will hover around 27 quadrillion Btu from 2011 through 2040.

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 marks the most fundamental strength for the industry.

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 (AN) has the highest dividend yield of 9.99%. Among the natural gas utilities, TransAlta Corporation (TAC) has the highest dividend yield of 7.2%, while within the water utilities Middlesex Water Company (MSEX) has the highest dividend yield of 3.9%.

Mergers and acquisitions: Apart from growing organically, the players in the utility industry are either engaged in strategic merger and acquisition deals or enter into partnerships which lead to cost synergies and better utilization of resources.

We believe that in a mature energy market like the U.S., mergers and acquisitions represent a good way to enhance market share. Mergers and acquisitions also have their share of risks, but even then these deals are formalized across the board and the utility sector is no exception.

In one of the mega mergers in this space, North Carolina-based Duke Energy Corporation completed the acquisition of Progress Energy Inc. in Jul 2012. The deal was valued at $32 billion including the outstanding debt of the acquired company. This acquisition created one of the largest U.S. utilities and increased Duke Energy’s capability to build new power plants to meet future greenhouse-gas emissions limits.

Huge Initial Capital Outlay: Utility operations need huge initial investments and a large consumer base to generate revenues to recover costs. For these reasons, we generally do not find many new entrants in the market. Also, government regulations and the hard toil for new entrants to establish a loyal consumer base put the existing players in an advantageous position.

Headwinds

Vulnerable to weather changes: Utility operations globally depend on weather patterns that determine the extent of demand. Erratic weather patterns thereby impact the profitability of these operators so much so that their operational goals remain unmet.

Superstorm Sandy impacted utility operations in 17 states, with major disruptions in 8 East Coast states. The total damage is expected to touch $50 billion. The recent blizzard impacted the north eastern states with power outages impacting more than half million customers. Natural calamities like these undermine the profitability of the utility operators.

Buyers' market: The utility service markets are gradually transforming into buyers’ markets. A good many states allow consumers to migrate from one utility operator to another 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.

Capital intensive: The utility business is a capital-intensive industry and needs huge capital investments. Particularly when a company goes into an expansion or modernization mode, the funds generated internally are insufficient to fulfill the capital needs. So, the company has to borrow money from the markets to execute development work. Prevailing interest rates in the market play a key role. High interest rates make a project costlier while low or declining interest rates suits the operators as they can borrow at a cheaper rate.

Government intervention & emission control: The U.S. government is implementing stringent laws and regulations, which affect 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.

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 greenhouse gas emissions levels to 90% below their uncontrolled levels.

As a consequence, 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 operation and impact margins.

Pending rate cases: Consumers expect to have an uninterrupted supply of utility services. The operators to ensure this supply make 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. 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 and Zacks Rank

Within the Zacks Industry classification, the industry is broadly grouped in the Basic Materials sector (one of 16 Zacks sectors) and is further sub-divided into three industries at the expanded level: Mining – Gold, Mining – Iron and Mining – Non-Ferrous. All the industries within the Basic Materials sector like chemicals, paper, steel and mining are economically sensitive, but the level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all of the more than 250 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank.

The way to look at the complete list of Zacks Industry Rank for the 250+ companies is that the outlook for the top one-third of the list (Zacks Industry Rank of #85 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #170 and higher) is negative.

For the Mining Industry, Iron Mining barely makes into the top 1/3rd with its Zacks Industry Rank #77, while the Non-Ferrous (aluminum, copper, etc.) and Gold Mining industries are barely in the bottom 1/3rd at Zacks Industry Rank of #187 and #182, respectively. The exact location of the three mining industries on the Zacks Industry Rank aside, one could safely say that the near-term outlook for the group is leaning towards a Neutral outlook.

Zacks Rank indicates the movement of the stocks over the short term (1 to 3 months). The rank along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Method) helps in predicting the probability of earnings surprises.

The names with a Zacks Rank #1 (Strong Buy) include Alliant Energy Corporation (LNT), Ameren Corporation (AEE), Aqua America, Inc. (WTR), Otter Tail Corporation (OTTR) and TransAlta Corporation (TAC) among others. Except Alliant all the other companies surpassed the respective Zacks Consensus Estimates in the last reported quarter.

A few of the Zacks Rank #2 (Buy) stocks which surpassed the Zacks Consensus Estimates in the last reported quarter were  ALLETE, Inc. (ALE), DTE Energy Company (DTE), Sempra Energy (SRE), The Laclede Group Inc. (LG) and IDACORP Inc. (IDA).

However, most of the stocks we cover in the utility industry have a Zacks Rank #3 (Hold). A good many of these stocks, such as Integrys Energy Group, Inc. (TEG), Entergy Corporation (ETR), NextEra Energy, Inc. (NEE), MGE Energy, Inc. (MGEE), CenterPoint Energy, Inc. (CNP) and American States Water Company (AWR), succeeded to beat the Zacks Consensus Estimates in the last reported quarter.

We presently have a few stocks having Zacks Rank #4 (Sell) and Zacks Rank #5 (Strong Sell). AGL Resources Inc. (GAS) and TransCanada Corporation (TRP) have a Zacks Rank #5, with both missing the Zacks Consensus Estimates in the last reported quarter.

In Conclusion

The demand for their services notwithstanding, 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.

It is also important to keep in mind that expansion of the customer base of the utility operators does not necessarily mean a surge 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 raise both the customer base and usage.

The majority of new electricity in the next two decades in the U.S. will be generated from natural gas and renewable sources. Besides the abundance of natural gas, as many as 30 U.S. states and the District 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.

Our Zacks Rank and Recommendation are reliable indicators of the likely movements of these utility stocks. Investors willing to invest in utility companies can bear in mind some of the following points: 1) debt levels and cash flow generation capabilities, which indicate the prospects or need for funding for 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 the streams of revenue generation.

Since the utilities operate in a regulated environment, they charge a fixed rate for power supply as approved by the different commissions. We hardly find utilities posting eye-catching numbers, but these companies are generally stable due to the regulated nature of operations, and they are loyal to shareholders. Investment in the utility sector is more suited for income-oriented, long-term investors looking for a modest but stable return.

AMER ELEC PWR (AEP): Free Stock Analysis Report

AES CORP (AES): Free Stock Analysis Report

PINNACLE WEST (PNW): Free Stock Analysis Report

DUKE ENERGY CP (DUK): Free Stock Analysis Report

NEXTERA ENERGY (NEE): Free Stock Analysis Report

ENTERGY CORP (ETR): Free Stock Analysis Report

NISOURCE INC (NI): Free Stock Analysis Report

NORTHEAST UTIL (NU): Free Stock Analysis Report

EXELON CORP (EXC): Free Stock Analysis Report

PUBLIC SV ENTRP (PEG): Free Stock Analysis Report

PNM RESOURCES (PNM): Free Stock Analysis Report

PEPCO HLDGS (POM): Free Stock Analysis Report

PPL CORP (PPL): Free Stock Analysis Report

SCANA CORP (SCG): Free Stock Analysis Report

SOUTHN COMPANY (SO): Free Stock Analysis Report

DOMINION RES VA (D): Free Stock Analysis Report

INTEGRYS ENERGY (TEG): Free Stock Analysis Report

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