Utilities Stocks: The Last Castles

June 27th, 2013
in contributors, syndication

Investing Daily Article of the Week

by Richard Stavros, InvestingDaily.com

In the wake of last month’s utilities sector selloff, a small group of strongly fortified, strategically advantaged utilities are emerging as the true defenders of long-term income and growth.

Which utilities are the first among equals? Over the last few years – in the fog of the utilities bull market that had seen the sector even surpass the S&P 500 – this was a difficult question to answer. Almost every utility stock seemingly could do no wrong, no matter how you sliced and diced the financials. And income-oriented investors attracted by dividends as well as growth drove valuations to unprecedented levels.

Follow up:

As we warned previously, the gravitational pull of the industry’s economic, financial and business fundamentals would eventually bring many of these stocks crashing down under the weight of competition from other fixed income (i.e., US Treasuries), weak fundamentals (declining electricity demand), and challenged business models (competing renewable technologies and low natural gas prices).

And so last month, a shakeout occurred in the sector: a 9.6 percent selloff in response to some investors who believe the Federal Reserve’s announcement of a potential pullback in stimulus will lead to significantly higher treasury yields than utilities.

But from this chaos, several utility companies emerged that not only withstood the onslaught to their valuations, but have continued to increase in value as their peers fall by the wayside. And these apparent fortresses of value presented us with a riddle wrapped in a mystery inside an enigma, to quote Winston Churchill, as none of them on the surface seemed to have a commonality.

Some of these utilities were deregulated, regulated or both, and while some could have been identified under common value investment principles, others would have escaped detection–a paradox, to be sure.

Sir Warren and the Moat

The term “economic moat,” coined and popularized by Warren Buffett, refers to a company’s ability to maintain competitive advantages over its peers in order to protect its long-term profits and preserve its market share.

In answering this illogicality, where seemingly different types of utilities were favored over the rest of the industry, analyzing an energy utility’s economic moat may seem like folly. After all, many companies have monopolies over their service territories and guaranteed rates of return that are practically the same, along with similar growth rates and challenges–and many of the big utilities have some form of merchant or renewables play. So how does a utility truly distinguish itself?

Longtime investors might chalk it up to some utilities benefiting disproportionately from sympathetic public utilities commissions or a favorable regulatory climate allowing higher returns. That’s sometimes the case, but not this time–even when considering firms that would derive an added earnings benefit by building renewables in states where renewable portfolio standards were set. And neither the size of the company nor its dividend seemed to play a factor.

However, applying Buffett’s approach to this sector reveals that when taking into account new state-by-state forward electric power demand levels, population trends, and where real economic activity is occurring in the US, some utilities are better positioned to earn superior returns to their peers in almost every forward scenario.

The New Knights of the Roundtable

The recent run-up in utilities sector stocks has concealed a new reality in the industry: Due to uneven population growth levels, electric power demand levels, and future temperature trends, certain utilities are poised to outperform others. And given the patchy US economic recovery, the sector will be defined by uneven growth across the US, where some regions grow faster than others.

The market clearly understands this new paradigm. For example, Michigan-based utilities CMS Energy Corp (NYSE: CMS) and DTE Energy Holding Co (NYSE: DTE) have been buoyed by the extraordinary reversal of fortune of the US automobile industry (See Chart A).

The auto industry is expected to continue its recovery through 2014, according to Polk, an automotive consultancy. Polk notes that new light vehicle registrations this year are expected to rise 6.6 percent over 2012 levels, to 15.3 million vehicles. And North American production volumes are expected to increase to about 15.9 million units, which would be a 2.4 percent increase from 2012. The numbers are driven by an improving economy and capacity expansion in the region.

Chart A. Michigan Utilities: Tracking the Return of the Motown 3
Created with YCharts
Click to enlarge

Similarly, industrial production surged 0.8 percent during June, according to Moody’s Analytics, far exceeding consensus expectations. The gain during the month was broad-based with nearly every major category posting a month-to-month improvement. And as Chart B shows, utilities that were located near industrial centers also benefited, such as American Electric Power Co Inc (NYSE: AEP) and PPL Corp (NYSE: PPL).

Chart B. Utilities That Have Benefited from the Industrial Recovery
Created with YCharts
Click to enlarge

The Order of Things to Come

To discover why some utilities performed better than others in the last month, we reviewed granular data on a state-by-state basis and discovered that utilities are trading very much in line with forecasted state-by-state GDP levels, population growth, and future climate change forecasts.

Before proceeding, it should be noted that the relationship between the US economy and electricity demand is changing: Growth in electricity demand has been significantly slower than GDP growth for decades. That’s why other metrics were used to serve as a counterbalance, to more effectively target utility growth.

According to a Texas A&M study that forecasts energy consumption through 2050, population growth will be the greatest factor in determining long-term trends in energy demand. The model projects an overall national population increase of almost 38 percent from 2010 to 2050. The states with the largest growth rates included Arizona, Nevada, Florida, and Texas.

Additionally, the model also used IPCC Regional Climate Projections to determine the change in energy consumption as a result of climate change in 2050. Heating and cooling degree days for each state in 2010 were provided by NOAA, as well as the average temperature for each month in that state. States with a combination of high population growth along with a large increase in the number of cooling degree days were determined to be the aforementioned Nevada, Arizona, and Florida, which all have high populations as well.

Add to this picture a view of state-by-state percentage changes in real GDP (See Chart C), and one begins to understand why Florida-based energy company NextEra Energy Inc (NYSE: NEE) trades at a premium to New York utility Consolidated Edison Inc. (NYSE: ED).

Chart C
Click to enlarge

Compared to the latter, NextEra’s service territory is expected to have superior real GDP improvement, population growth, and future power demand (See Chart D).

Chart D. Princes of the Universe: The New Order of Utility Valuation
Created with YCharts
Click to enlarge

And while no Texas utilities were listed because they would have skewed Chart D due to the state’s high growth levels, companies such as NRG Energy Inc (NYSE: NRG) are showing a significant total return over their utility peers.

As for those that have not fared well, such as Southern Company (NYSE: SO) and Exelon Corp (NYSE: EXC), the data are revealing. Of course, we should note that some analysts have pointed to different reasons for their respective selloffs, such as costs overruns on a new plant project and a dividend cut, respectively.

According to the Bureau of Economic Analysis, the Great Lakes region was the only region where growth decelerated relative to overall US growth in 2011 (one of Exelon’s primary service territories is in Illinois).

The case can be made that Southern’s and Exelon’s generally lower GDP and population growth estimates in their service territories have put them at a considerable disadvantage to peers such as American Electric Power and NextEra. So it’s the demographic and economic strength of the underlying service territories that suggest which utilities should be considered first among equals.

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