One Bright Spot In Utilities
By Editorial Dept - Jul 25, 2014, 1:42 PM CDT
If you consider a time span measured in years rather than days, weeks or months, it is hard to make a good case for investing in power utilities. Most are aware that over the next few years utility stocks are going to get hit with a double-whammy of epic proportions.
New EPA emissions regulations are going to force them to shutter many coal powered plants and move to cleaner energy sources. The U.S. Chamber of Commerce has estimated that this will cost utilities $28.1 Billion a year. No doubt some of those ongoing costs will be passed on to the consumer, but the initial cost of transition will be huge and not welcomed by an industry that is already highly leveraged.
That is not a good scenario from a fundamental profitability standpoint, but the price of the stock of electricity producers will also likely come under pressure for another reason. Much of the value of these companies to investors has traditionally been as income producing instruments. The industry as a whole has an average yield of around 3.5 percent, about 1.5 percentage points above that for the S&P 500. That, combined with the inelastic nature of electricity demand has made them a favored defensive play for income seekers.
The downside to a high yield is that it makes stock prices sensitive to moves in interest rates, and that could well prove a vulnerability over the coming years. The Fed may continue to delay the inevitable, but at some point most believe that interest rates will begin…
If you consider a time span measured in years rather than days, weeks or months, it is hard to make a good case for investing in power utilities. Most are aware that over the next few years utility stocks are going to get hit with a double-whammy of epic proportions.
New EPA emissions regulations are going to force them to shutter many coal powered plants and move to cleaner energy sources. The U.S. Chamber of Commerce has estimated that this will cost utilities $28.1 Billion a year. No doubt some of those ongoing costs will be passed on to the consumer, but the initial cost of transition will be huge and not welcomed by an industry that is already highly leveraged.
That is not a good scenario from a fundamental profitability standpoint, but the price of the stock of electricity producers will also likely come under pressure for another reason. Much of the value of these companies to investors has traditionally been as income producing instruments. The industry as a whole has an average yield of around 3.5 percent, about 1.5 percentage points above that for the S&P 500. That, combined with the inelastic nature of electricity demand has made them a favored defensive play for income seekers.
The downside to a high yield is that it makes stock prices sensitive to moves in interest rates, and that could well prove a vulnerability over the coming years. The Fed may continue to delay the inevitable, but at some point most believe that interest rates will begin to normalize. A rising rate environment itself hits utilities in two ways. Firstly the yield looks less attractive compared to alternatives such as bonds and secondly any new debt becomes more expensive to service. Both put downward pressure on utility stocks.
There is, however, one power company that is growing rapidly, will not face a huge burden of new debt and will be shielded from the effects of the EPA regulations; NextEra Energy (NEE).
The key here is that NextEra has already made the transition that the EPA is trying to force on others, meaning that the massive increase in debt at potentially higher rates that some face will not apply to them. According to the company’s website, around 95 percent of the electricity they generate comes from clean energy sources, including extensive wind and solar plants. If anything, as others raise prices to account for the cost of conversion, that general higher price for electricity will serve only to increase Nextera’s margins.
NEE is not cheap. The forward P/E of 17.82 is high for the industry, but forecast earnings growth of 20 percent makes it look more reasonable. That growth looks set to continue as the general demographic shift to sunshine states in the U.S. continues. From a technical perspective, now is a good time to buy. After a sustained run up the stock has lost ground from recent highs but support around $97 has held twice. It looks to have settled and a break back up above $100 looks to be on the cards in the near term.
NextEra won’t be immune from the coming problems for utilities when interest rates rise, but their focus on alternative energy will mean that they will be better placed than many to overcome them. The 2.9 percent yield that the stock offers is not earth shattering, but unlike some higher yielders in the industry, NEE may well still look like a decent investment five years from now.
