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Utility Industry Stock Outlook - June 2013

Abhijit Ghosh


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

Utilities are by their very nature monopolistic businesses. As a result, the sector is highly regulated as the essential supplies cater to basic human needs, and governments try 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.

As per a recent U.S. Energy Information Administration (EIA) report, global energy use will increase to 770 quadrillion 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 energy market of non-OECD nations has a larger scope for improvement compared to the more mature OECD nations.

However, the addition of new power-generating units to meet the increasing demand for electricity comes the pertinent question of greenhouse gas emission. We are all aware of the pitfalls of global warming and initiatives are been taken to curb the release of greenhouse gas. The U.S. and European countries are taking serious strides in that direction.

However, the variance in the socio-economic structure of different countries and the quest for cheaper sources of electricity are making the task difficult, if not impossible. In fact, a recent study from International Energy Agency showed that the greenhouse gas emitted from China in 2012 offset the positive impact of lower emission from Europe and the U.S.

China has very recently adopted 10 measures to improve air quality and reduce emission in Beijing and in other major cities. Whether the promise will be kept time will tell.

Utility Drivers

The demand for utility services is primarily driven by the state of the economy. If the economy is doing well, it will create new jobs, resulting in demand for housing driving demand for utility services. In addition to growing demand through households, increasing demand from the business sector, particularly manufacturing, also plays a role in growth.

Weather plays a crucial role in determining the trajectory of demand for utility services. Extreme weather conditions tend to reinvigorate demand for electricity.

Population does play a significant role in demand creation. The gadgets we use every day consume considerable electricity. This issue is prevalent all over the world, but it is particularly notable in the emerging markets where huge swathes of population are entering the middle class.

The billions of cell phones, personal computers and laptops have increased the demand for electricity, which could have hardly been imagined only a decade ago. The clothes dryer, clothes iron and dish washers are a few among the numerous household appliances which consumes a considerable amount of electricity.

Ultimately, it all boils down to economic growth, as measured by Gross Domestic Product (GDP). As per the recent report of the Bureau of Economic Analysis, U.S. Department of Commerce, GDP increased 2.4% in the first quarter of 2013, compared with an increase of 0.4% in the fourth quarter of 2012. This is definitely a positive sign for the utility industry, as a portion of the increase will be directed toward household utility needs.

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 260 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 260+ industries 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.

Scanning the industries in the Utility sector, all three are currently ranked in the top 1/3rd. Gas Distribution has a Zacks Industry Rank #45, Electric Power is at Zacks Industry Rank #83 and Water Supply at Zacks Industry Rank #76. This implies that the prospects for gas, electricity and water look bullish at present.

Electric Utilities

The 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, increasing at 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.

As per EIA, the increasing demand for electricity and retirement of nearly 103 gigawatts (:GW) of existing capacity will result in an addition of 340 GW of power production units from 2012 to 2040.

Natural gas-fired plants will provide 63% of the projected capacity, while 31% will come from renewables, 3% from coal and 3% from nuclear. This proves that natural gas will continue to play a vital role in energy solutions in the coming three decades.

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

We expect electricity providers to continue to perform well in 2013 with the majority expected to exceed 2012 earnings numbers.  A near-normal winter to start of and expectation of above-average summer temperatures in the US will definitely boost the demand for utility services.

Natural Gas Utilities

Among the utility services, natural gas usage is increasing due to its abundance, cheap price and clean-burning nature.

However, natural gas prices are recovering from all-time lows. This might hamper the rising demand curve for natural gas in the near term. Over the long haul, we believe the demand for nat gas will pick up once more.

The EIA forecasts the use of natural gas in the U.S. to increase from 24.37 trillion cubic feet in 2011 to 29.54 trillion cubic feet in 2040, increasing at an average annual rate of 0.7%.

New fracking technology has multiplied natural gas production from rock and rock structures previously considered uncommercial.  A study from NaturalGas.org pointed out that the natural gas reserve in the U.S. increased by 39% from 2006 levels, thanks to the implementation of new exploration techniques.

The natural gas utilities are not only expected to benefit from the steady increase in domestic demand but also from exports that are expected to rise significantly. The new techniques used to drill natural gas will enable natural gas operators to export large volumes after meeting domestic demand. As per the EIA, natural gas exports will continue to increase by 17.7% per year from 2020 to 2040.

The positive dynamics are going to benefit natural gas utilities like Atmos Energy Corporation (ATO), Spectra Energy Corp. (SE), National Fuel Gas Company (NFJ), Sempra Energy (SRE), MDU Resources Group Inc. (MDU), Southwestern Energy Co. (SWN) and Questar Corp. (STR), among others. With more than 71 million domestic natural gas customers, the industry has enough room for nearly 1,200 natural gas utilities presently operating in the country.

Water Utilities

2012 was a good year for the water utilities as the overall warm weather increased the demand for water. 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.

A report from Economic Development Research Group Inc. suggests an alarming gap between the water infrastructural requirement and actual investments planned for the coming years. The gap is expected to reach $84 billion in 2020 and widen to $144 billion in 2040. The report also revealed that without proper renewal or replacement, nearly 44% of the existing pipelines will become too poor for operation by 2020.

The utility operators have begun to invest in their ageing infrastructure, but it appears the initiatives are inadequate to bridge the gap. The government should consider taking adequate measures before things blow out of proportion.

Among the water utilities, American States Water Company (AWR), Aqua America, Inc. (WTR), Connecticut Water Service, Inc. (CTWS) and Middlesex Water Company (MSEX) registered positive earnings surprises in their latest reported quarters.

We expect the water utilities on the whole to perform better than last year, driven by higher demand.

What Keeps the Utilities Going?

The biggest positive for the utilities is that there is hardly any viable substitute for utility services. This is the most fundamental strength of the industry. Moreover, increasing demand drives this industry forward.

As per the EIA, energy usage in the U.S. industrial sector will increase from 24.0 quadrillion British thermal units (Btu) in 2011 to 28.7 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, demand will hover around 27.1 quadrillion Btu from 2011 through 2040.

The utility operators in North America often resort to merger and acquisitions or enter into partnerships, which lead to cost synergies and better utilization of resources. As per a report from PricewaterhouseCoopers, utility M&A deals valued at more than $50 million added up to $2.99 billion in the first quarter of 2013.

A recent announcement from MidAmerican Energy Holdings Company, a subsidiary of Berkshire Hathaway Inc. (BRK.B), to acquire NV Energy (NVE) in a way exceeded the combined value of all merger deals announced in the first quarter of 2013. The transaction, which has been unanimously approved by the board of directors of both companies, has an enterprise value of approximately $10 billion. The deal is expected to close in the first quarter of 2014, subject to regulatory approvals and approval of shareholders of NV Energy.

We believe the synergies of merger and decline in overlapping overhead operating expenses could allow the companies to concentrate more on the development and maintenance of infrastructure.

Another inherent advantage of these utilities is their size and the requirement of huge initial capital outlay.  For this reason, we generally do not find many new entrants in the market. Also, stringent government regulations and the hard toil for new entrants to establish a loyal consumer base put existing players in an advantageous position.

Finally, utilities have been known to pay dividends consistently, thereby retaining investor confidence. This was evident during the economic crisis of 2008-2009 when these operators continued to pay out dividends without fail.

The Future of Utilities

Undoubtedly, the focus and emphasis to generate power from renewable sources have increased. But will this pose a threat to the more traditional power producers using fossil fuels? The answer is largely "no," at least for now.

Having said that, the gap between these two groups of power generators will continue to shrink as we move forward. Eventually, renewable power producers may overtake traditional electric utilities in due course.

The Middle East has the largest volume of fossil fuel reserves. Even there we are noticing a large number of solar power projects coming up in the region. An EIA report suggests that by 2040 nearly 20% of the total power produced will come from renewable sources. Solar generation capacity is expected to increase by a whopping 1000% to 46 GW in 2040 from 2011 levels.

We are all aware of the pitfalls of greenhouse gas emissions and the limited life of fossil fuel. In addition, the increasing conversion rate of solar cells makes it cheaper and cost effective in comparison to conventional sources. Renewables can thus be the final answer for the inevitable exhaustion of fossil fuel reserves.

In Conclusion

Despite the assured demand for services, 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.

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.

Moreover, hurricanes, storms, and blizzards disrupt the normal operation of the utility operators. American weather tracking body National Oceanic and Atmospheric Administration ("NOAA") has projected a very active hurricane season in the second half of 2013, and storms are expected to exceed the seasonal averages. With the havoc caused by Superstorm Sandy still fresh in our memory, we are keeping a cautious eye on Mother Nature.

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.

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

BERKSHIRE HTH-B (BRK.B): Free Stock Analysis Report

CONN WATER SVC (CTWS): Free Stock Analysis Report

DUKE ENERGY CP (DUK): Free Stock Analysis Report

ATMOS ENERGY CP (ATO): Free Stock Analysis Report

NEXTERA ENERGY (NEE): Free Stock Analysis Report

MDU RESOURCES (MDU): Free Stock Analysis Report

QUESTAR (STR): Free Stock Analysis Report

MIDDLESEX WATER (MSEX): Free Stock Analysis Report

ENTERGY CORP (ETR): Free Stock Analysis Report

AQUA AMER INC (WTR): Free Stock Analysis Report

SEMPRA ENERGY (SRE): Free Stock Analysis Report

PPL CORP (PPL): Free Stock Analysis Report

SPECTRA ENERGY (SE): Free Stock Analysis Report

SOUTHERN CO (SO): Free Stock Analysis Report

NV ENERGY INC (NVE): Free Stock Analysis Report

AMER STATES WTR (AWR): Free Stock Analysis Report

SOUTHWESTRN ENE (SWN): Free Stock Analysis Report

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