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.
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.
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.
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).
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.
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