Utilities Sector Report

Sector report by Katarina Lau, 27 November 2020

Dow Jones Utility Average DJU

EXECUTIVE SUMMARY

The utilities sector typically encompasses companies that provide basic amenities, such as water, sewage services, electricity, dams, and natural gas. Utilities companies are often heavily regulated, due to their nature of being part of the public service landscape where governments are ultimately responsible for ensuring reliable universal access to basic amenities. However, several utilities companies nowadays have been privatised (e.g. UK National Grid), which in turn allow them to return profits.

There are different types of business models within the utilities sector, including large companies that offer multiple services like electricity and natural gas, smaller companies which may specialize in just one type of service like water and hybrid companies which utilities rely renewable energy sources like wind turbines and solar panels for energy production. The third type is becoming increasingly more common as the utilities industry is under rising pressure to be environmentally sustainable.  Investors can buy stocks in private utilities companies or invest in exchange-traded funds (ETFs) containing baskets of utility stocks.

Utilities have been known to provide stable, consistent and higher dividends than the average dividend paying company. This characteristic along with relatively low-price volatility make utilities good bond alternatives, which investors usually treat as long-term holdings to steadily inject income to their portfolios. Hence, utilities are defensive assets, which tend to perform well during economic downturns/risk-off climates, but then fall out of favour during economic booms/risk-on climates.

OVERVIEW OF SECTOR

Sub-sector Industries:

Generally, utilities companies fall into 1 of the following 4 supplier segments:

  1. Generators
    1. Operators create electrical power
  2. Energy Network Operator
    1. Grid operators, regional network operators and distribution network operators sell access to their networks to retail service providers
  3. Energy Traders and Marketers
    1. These companies help utilities secure a dependable supply of electricity at a stable, predictable price through the buying and selling energy futures, derivatives, complex structured products etc.
  4. Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their own retail service providers.

High Levels of Debt:

Utilities are known to carry large amounts of debt on their balance sheets, due to the significant amount of costly infrastructure required. As debt makes up a significant portion of utilities companies, they are particularly sensitive to changes in interest rate. For instance, from a purchasing perspective, since utilities infrastructure need a continuous inflow of funds to finance upgrades and new asset purchases, low interest rates would be ideal for cheap borrowing and vice versa. Intuitively, high debt levels result in high utility debt-to-equity (D/E) ratios, which can impact companies’ credit ratings and make it harder to borrow funds.

Recent Performance:

So far, the utilities sector has given a mixed performance this Q3 earnings season. The majority of S&P companies in the sector (77.8%) beat bottom-line estimates, but only 40.7% beating revenue estimates. Earnings rose 2.8% while revenues fell 3.1% Y-o-Y, according to the sector Earnings Trends issued on Nov 11. Overall, utilities remain best known for their non-cyclical nature, which is likely to see more demand near-term as investors cycle out of tech stocks and look for relatively rewarding safe havens as the world heads into 2021 with a good deal of uncertainty still looming over.

FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS

Consumer Impact on the Sector:

Utilities are very much linked to consumers as they are founded on essential services we use every day. For this reason, governments remain vigilant over the sector as part of their duty to ensure consumers receive access to basic utilities and at a reasonable price. In places where utilities companies are private, consumers have the freedom to switch from one utility operator to another, instead of being stuck to one local one. By nature, they will typically choose the least expensive local operator, thus creating a competitive environment for companies to cut their costs and lower prices. Higher-cost producers are eventually eliminated from the market, unless there is an oligopoly like the UK’s Big 6 (British Gas, EDF Energy, E.ON UK, Npower, Scottish Power, and SSE) which tacitly determine prices together. Long-term power purchase agreements between companies and consumers also impact profits. Similar to mobile phone contracts, when utility generation costs increase, companies must continue to honour the contract agreements and sell utilities at the current agreed-upon rate, which can often negatively impact profits.

Pros and Cons:

Utilities are recognized as stable investments that provide regular dividend income to shareholders, therefore making them a popular long-term buy-and-hold option. Their dividend yields are relatively higher than other equities. In low interest rate environments or economic downturns, utilities become more attractive as a safe haven asset, because they exhibit lower volatility and provide a desirable source of predictable investment returns from dividends. Utilities are very accessible to investors as it is quite easy to invest in utility company shares, industry sector ETFs, utility bonds or other debt securities.

However due to the utility sector’s intense amount of regulation and high levels of debt, it’s difficult for them to raise rates to increase revenue. Utilities require expensive infrastructure such as electric grids, water pipes, windmills etc. that requires routine maintenance and renovation. Upholding the infrastructure is a capital-intensive process, whereby utility companies often need to float debt products to raise capital. At the same time, their debt loads also increase, thus making utilities services particularly sensitive to interest rate risk. Utilities stocks usually behave inversely to interest rates: if interest rates rise, so do the yields of U.S. Treasury bills/bonds, therefore utilities companies must then offer higher yields to attract bond investors, which drive up costs. 

ProsCons
Provides stable, long-term investments with a regular and attractive dividendIntense regulatory oversight makes it hard to raise customer utility prices to increase revenue
Defensive asset – acts as a haven investment during economic downturnsContinual upgrade and maintenance of utility infrastructure is very capital-intensive.
Utilities encompass many avenues for investment including bonds, ETFs, and individual company stocksIn high interest rate environments, utilities become less attractive (must increase their yields to match higher-yielding alternatives).

Future Outlook:

Utilities will continue to be pressured by younger consumers (Millennials and Gen Zs) to provide more environmentally sustainable services. Stemming mostly from younger demographics, consumers themselves are becoming more environmentally conscious and expect more from their utilities, such as cutting emissions, smart meters, energy-saving tech, EVs, etc. While more and more traditional energy companies are beginning to restructure their business models and invest in renewables, most utilities still have a long way to go in order to remain relevant to customers.

In December 2018, Xcel Energy became the first US utility to commit to going 100% carbon-free by 2050, and 80% by 2030. Similar company announcements became a regular occurrence with more than 50 companies making carbon pledges in 2019. In future years to come, this commitment will soon be a given for utilities companies. Other than rising customer demand for cleaner energy sources, investors are also paying more attention to ESG factors and credit rating agencies are signalling that they may gradually incorporate climate risk into credit assessments.

Utilizing battery storage will be a game-changer for utilities going forward. As battery storage from Electric Vehicles (EVs) become increasingly more advanced, so will their capacities to eliminate renewable energy intermittency, provide reliability during outages, replace fossil-fuel peakers and power EVs at the least. In the past few months, Tesla has thrown EVs into the spotlight, and several utilities/energy companies are catching on with the creation of their own EVs or EV development programmes. Future-minded utilities will embrace EVs not only as a new source of revenue, but also utilize flexible battery storage to maintain reliability and decarbonize their utilities infrastructure.

Best Value Utilities Stocks:

Utilities stocks with lowest 12-month trailing price P/E ratio – investors are paying less for each dollar of profit (or dividend) generated.

 Price ($)Market Cap ($B)12-Month Trailing P/E Ratio
NRG Energy Inc. (NRG)31.347.72.0
Sempra Energy (SRE)133.0438.410.3
Vistra Corp. (VST)18.629.110.4

NRG Energy Inc. is an integrated power company that provides energy production and cogeneration facilities, thermal energy production, and energy resource facilities. NRG Energy reported -33.1% net income as revenue fell -6.2% in Q3 2020.

Sempra Energy is an energy services holding company that generates electricity, delivers natural gas, operates natural gas pipelines and storage facilities, and operates a wind power generation project.

Vistra Corp. operates an integrated retail and generation business. It provides electricity generation, wholesale energy sales and purchases, commodity risk management, and retail sales of electricity. The company reported net income growth of 287.7% on revenue growth of 11.2% in Q3 2020, boosted by lower fuel costs, purchased power costs and delivery fees.

Utilities Stocks with Highest Returns (Y-o-Y):

Price ($)Market Cap ($B)12-Month Trailing Return (%)
PG&E Corp. (PCG)12.6525.178.4
American Water Works Co. Inc. (AWK)156.1928.333.7
NextEra Energy Inc. (NEE)75.79148.533.4

PG&E Corp. operates as a holding company with holdings in public utilities in California, electricity generation operations, natural gas operations etc. PG&E recently announced new CEO Patricia K. Poppe.

American Water Works Co. Inc is a holding company that provides water, wastewater, and other water-related services.

NextEra Energy Inc. is the world’s largest renewable energy company that generates electricity through wind, solar, and natural gas. The company also operates multiple commercial nuclear power units through its subsidiaries. In October, NextEra surpassed ExxonMobil as the largest US energy company.

 FUNDAMENTAL QUANTITATIVE ANALYSIS

Utilities Sector vs. Benchmark Returns (S&P 500, NASDAQ):

Given that utilities are defensive assets, indexes perform better during market rallies.

Sector Fundamentals (as of 11/25/2020):

Market Cap$1.57T
Market Weight2.99%
P/E (Last Year GAAP Actual)27.86
P/E (This Year’s Estimate)24.21
Enterprise Value$73.16B
Earnings Per Share (EPS)$2.17
EPS Growth23.69%
Revenue Growth -0.24%
Return on Equity8.60%
Return on Investment 3.03%
Total Debt/Equity170.93
Dividend Yield3.55%

MACRO OUTLOOK

Effects of COVID-19:

Even as a non-cyclical asset, the utilities sector was hit hard by the pandemic which disrupted conventional means of generation, transmission and distribution of public utilities. At present, the sector is down around -15% YTD. Now, the sector faces an unpredictable demand for energy, on the one hand there is a sector-wide decrease due to fewer commercial/ industrial activities this year, however on the other, increasing amounts stay-at-home activities have certainly bumped up utilities demand. In terms of segments, pandemic-induced WFH measures shifted demand for power from industrial and commercial (I&C) customer segments to residential segments, leading to a significant drop in the overall demand. As a result, power generation companies have been forced to either shut down or operate at low Plant Load Factor (PLF), at even 50% in certain cases, which make them economically unviable. Controlled movement orders also saw large amounts of white-collar workforce move from cities to semi-urban or rural areas. Many of these areas which were previously neglected will now require a more robust and reliable power supply network.

Furthermore, the sector continues to face issues with funding, albeit for infrastructure maintenance or mere day-to-day operations, which have been impacted by tight, if not negative cash flows and large-scale furloughing as part of efforts to cut costs and stay afloat. There is also lower bill payment collection due to movement restrictions and government schemes that allow consumers to defer bill payments. Even energy distribution companies (DISCOMS) are taking a big hit with lockdown being imposed all around the world at different times. During lockdown, distribution companies typically agree to deferred bill generation, losing out on profits, especially when the lockdown is imposed during peak periods, like summertime in India where energy demand is at its highest.

As each country relies on their own utilities infrastructure, the sector is less affected by the international trade environment.

PRICE TARGETS

Future Outlook:

Utilities will continue to be pressured by younger consumers (Millennials and Gen Zs) to provide more environmentally sustainable services. Stemming mostly from younger demographics, consumers themselves are becoming more environmentally conscious and expect more from their utilities, such as cutting emissions, smart meters, energy-saving tech, EVs, etc. While more and more traditional energy companies are beginning to restructure their business models and invest in renewables, most utilities still have a long way to go in order to remain relevant to customers.

In December 2018, Xcel Energy became the first US utility to commit to going 100% carbon-free by 2050, and 80% by 2030. Similar company announcements became a regular occurrence with more than 50 companies making carbon pledges in 2019. In future years to come, this commitment will soon be a given for utilities companies. Other than rising customer demand for cleaner energy sources, investors are also paying more attention to ESG factors and credit rating agencies are signalling that they may gradually incorporate climate risk into credit assessments.

Utilizing battery storage will be a game-changer for utilities going forward. As battery storage from Electric Vehicles (EVs) become increasingly more advanced, so will their capacities to eliminate renewable energy intermittency, provide reliability during outages, replace fossil-fuel peakers and power EVs at the least. In the past few months, Tesla has thrown EVs into the spotlight, and several utilities/energy companies are catching on with the creation of their own EVs or EV development programmes. Future-minded utilities will embrace EVs not only as a new source of revenue, but also utilize flexible battery storage to maintain reliability and decarbonize their utilities infrastructure.

ETF Price Targets:

Fidelity® MSCI Utilities ETF

The fund invests at least 80% of assets in securities included in the MSCI USA IMI Utilities Index, which represents the performance of the utilities sector in the U.S. equity market. 

Previous CloseExpense Ratio
$41.910.08%
YTD ReturnVolume
3.11%126,370
1-Year ReturnNet Assets
7.50%$1.18B
Shares OutstandingDividends
27,800,000$0.32 (Quarterly)

Price Target: $46.00 (Jan 2021)

Just before the pandemic hit, the Fidelity ETF was at a record high of $46.30. It subsequently declined sharply to a record low of $29.13 in March 2020, however since then it has only climbed to its current level at $41.90. Given the existing upward trend and the foreseeable long-term low interest rate environment, utilise are likely to continue performing well as their yields should continue to remain more attractive over regular bonds. Therefore, by Jan next year, the ETF value should return to pre-COVID levels.

Vanguard Utilities ETF

The fund seeks to track the performance of a benchmark index – the MSCI US Investable Market Index (IMI)/Utilities 25/50, an index made up of stocks of large, mid-size, and small U.S. companies within the utilities sector. The fund is non-diversified and investment proportions replicate the target index.

Previous CloseExpense Ratio
$142.430.10%
YTD ReturnVolume
3.01%247,386
1-Year ReturnNet Assets
7.39%$5.89B
Shares OutstandingDividends
31,591,480$0.89 (Quarterly)

Price Target: $155.00 (Jan 2021)

Similar reasoning as above. Right before the pandemic, the Vanguard ETF was at a record high of $155.80. It fell sharply to a record low of $98.77 in March 2020, however since then has only trended upwards to its current level at $142.43. With this positive trajectory, foreseeable long-term low interest rate environment ideal for utilities and the similar nature of Vanguard’s ETF to Fidelity’s ETF mostly focusing on US utilities, by Jan next year, the ETF value should also return to pre-COVID levels.

Leave a Reply

Your email address will not be published. Required fields are marked *