The Utility sector is at a crossroads after the release of the new emission standards by the U.S. Environmental Protection Agency (EPA) last August. The finalized version of the Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels.

The beginning of the New Year turned out to be a nightmare for investors. China-led weaknesses in the international markets and continuously falling oil prices have resulted in a 5.5% decline in the value of Dow and a 6.9% fall for the S&P 500 in January. The sell-off in the markets has made a further rate hike in March almost impossible. The gyrations in the market enhance the appeal of relatively stable sectors like the utilities known for their dividend yields and assured returns.

 
As would be expected, larger utilities with more financial strength and better access to capital are better placed to achieve regulatory compliance. This is also likely to trigger more consolidation in the utility landscape, with a definite focus on generating electricity from natural gas and renewable sources. As a result, we expect to see higher solar installations across the U.S. The extension of investment tax credits and production tax credits will further support solar and wind installations in the next few years.

The combination of steady electricity price gains and stable-to-improving demand will drive the utility sector. A decline in the unemployment rate, increase in hourly earnings of average workers and higher demand in residential and other customer classes are tailwinds for the utilities.

Rising up to the environmental challenge, utility companies are steadily improving their operations by investing in more environment-friendly power generation facilities. Per a recent release from the U.S. government’s Energy Information Administration (EIA), the electricity industry retired nearly 14 gigawatts (GW) of conventional steam coal-fired generating capacity during 2015. These retirements represented 5% of the amount of operating steam coal capacity at the end of 2014.

The industry plans to further retire 10.7 GW of coal fired units during 2016 and 2017. Apart from the Clean Power Plan, the recent spate of coal-fired plant retirements has largely been influenced by the need to comply with the Mercury and Air Toxics Standards. Low natural gas prices have also been a stimulus.

We believe a constructive utility rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will enable the utilities to efficiently serve a larger customer base.

In the segment below, we discuss the basic strengths of the utility sector.

Regular Dividend & Share Buybacks

Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008–2009 when utilities continued to pay dividends without fail.
 

We have a long list of companies who are sharing profits consistently with their shareholders. Notable among them are companies like CenterPoint Energy (CNP - Analyst Report), Consolidated Edison Inc. (ED - Analyst Report) and Duke Energy (DUK - Analyst Report) who have raised dividend rates annually for more than 10 years now.

In Jan 2016, CenterPoint Energy increased its quarterly dividend rate by 4% to 25.75 cents per share; in Jul 2015, Consolidated Edison raised its quarterly dividend by 3.1% to 67 cents and in Jan 2016 Duke Energy raised its quarterly dividend by 3.8% to 82.5 cents per share.

Stable & Growing Demand

The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for their services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.

Despite the planned reduction of coal-powered units in electricity generation, the EIA forecasts total U.S. electricity generation in 2016 to average 11.3 terawatt hours per day, 0.4% higher than 2015 generation. The EIA also expects total electricity generation to grow by an additional 1% in 2017.

Focused on R&D

In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, and transmission and distribution lines, into operation without compromising on energy efficiency.

Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.

Mergers and Acquisitions

Utility sector operators don’t shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.

We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and also lowers operating costs through the usage of common back office space.

In Jun 2015, Wisconsin Energy Corp. completed the acquisition of Integrys Energy, forming WEC Energy Group (WEC - Analyst Report). The enlarged company provides electricity and natural gas to nearly 4.4 million customers across four states.

On Feb 1, 2016, Dominion Resources Inc. (D - Analyst Report) announced that it has entered into a definitive agreement to acquire Questar Corporation (STR - Analyst Report). Dominion will require to shell out nearly $4.4 billion and assume Questar's outstanding debt. The transaction is expected to close by the end of 2016 subject to regulatory approvals.

Most importantly, with the merger completion, both players will be able to jointly serve 2.5 million electric utility consumers and 2.3 million gas utility clients in seven states. The combined entity is also expected to be the operator of natural gas transmission, gathering and storage pipelines – spreading over 15,500 miles.

To Sum Up

We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water does not have any viable substitute. This is perhaps the most vital driving factor for the industry.

Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features.

Without a doubt, the increase in interest rates in Dec 2015 has raised the borrowing costs for the utilities. However, the Fed might not increase rates anytime soon citing weakness in international markets and the continuous collapse of oil price, which in a way will be beneficial for the utilities.

Volatility in the markets has also driven investors to seek protection in the utility space. These regular dividend payers are often regarded as a “bond substitute,“ and consistent performing utilities continue to be a safe investment option for jittery investors.

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