July 25th, 2013
by Richard Stavros
The last few years may one day be described as having been a period of lawlessness, during which Federal Reserve stimulus depressed Treasury yields and compelled many investors to buy almost any utility stock to preserve wealth and protect income – regardless of the underlying fundamentals or rules of valuation.
But with the Fed’s announcement that it plans to taper its stimulus program, and the prospect of higher Treasury yields offering competition to utilities, investors are starting to take a cold, hard look at earnings in advance of that day (See Chart A). And the fact that the US economy will have to sustain itself could mean a violent shakeout in every sector, as investors begin to identify which companies have the best prospects for growth and income once stimulus ends.
And looking at the past earnings growth performance of some utilities is alarming. Indeed, some are so bad they’re ugly enough to make Clint Eastwood wince twice. There are various utilities that have missed consensus quarterly earnings per share (EPS) estimates (See Chart A) or have been exhibiting a trend of negative quarterly EPS growth (See Chart B). Even income from continuing operations has completely flat-lined in the last couple of years for some companies (See Chart C), as the result of lower electricity demand, renewable competition, and the impact of low natural gas prices on various markets.
In fact, the situation has become so tenuous, the majority of energy utilities no longer issue quarterly guidance (as they once did), and many haven’t done so since the 2008-09 Financial Crisis. Instead, most utilities only give full-year guidance. Even Wall Street’s quarterly estimates are subject to change until the very last minute of the earnings call.
According to one utility investor relations representative, given the difficult business environment, where margins are lower, unforeseen situations such as a weather-related disaster, plant shutdown or a rate increase denial can have a more significant effect on a utility’s ability to meet earnings growth targets than in the past, as unregulated earnings are not what they once were.
The Quick and the Dead
It stands to reason that investors will shoot first this earnings season, as growth is really going to be the key driver going forward. And those firms not quick on the draw to produce growth will likely find their valuations flattened. If past performance is any guide, almost half of the utilities space could fall short on this metric (See Chart D). In the last quarter, for instance, 39 percent of S&P 500 utilities reported earnings that were below expectations.
According to a recent Thomson Reuters study,
“As the beginning of the second quarter approaches, the negative guidance sentiment is weighing on analyst estimates. So far, S&P 500 companies have issued 97 negative earnings preannouncements and only 15 positive ones, for a negative-to-positive (N/P) ratio of 6.5. The guidance has contributed to a downward slide in second-quarter growth estimates, with EPS currently estimated to grow 3 percent, down from the 8.4 percent estimate at the beginning of the year.”
And when looking at revenue growth, the picture has been even bleaker. After a first quarter when S&P 500 companies reported an aggregate revenue growth rate of 0.0 percent, the consensus currently calls for 1.8 percent growth in the second quarter. In fact, the aforementioned study found that revenue growth has been holding back earnings for several quarters – and is at its most bearish.
In the third quarter of 2012, the revenue negative-to-positive ratio hit its highest point since the financial crisis, at 3.6. That was also the first quarter where revenue fell, with growth declining 0.8 percent. Since then, company management teams have continued to provide lower revenue estimates than analysts, which have accompanied weak revenue growth.
According to Thomson Reuters,
“Looking forward to second-quarter revenue results, management teams have been more conservative, with 3.1 negative pre-announcements for each positive one. With the exception of last year’s third quarter, this is the most negative N/P ratio of the economic recovery. The second-quarter revenue growth estimate has fallen to 1.8 percent, as the negative guidance has come out, down from 3.9 percent at the start of January.”
These negative broad market trends could weigh heavily on some utilities in the second quarter, particularly since during the first quarter, the sector posted generally weak earnings growth of 1.5 percent and revenue growth of 6.5 percent.
Hang 'em High: A Potential Wave of Dividend Outlaws and Horse Thieves
In a world of almost unlimited Fed stimulus, many utilities could afford to pay robust dividends, enjoying spectacular valuation increases as income-hungry investors fled Treasuries and piled into the sector.
But as Utility Forecaster has long advised, the day is coming when, in the absence of such stimulus, some utilities will simply not have the wherewithal to be reliable earnings producers and, therefore, a stable source of income. Thus, there will likely be more dividend cuts in the future, and the only way to avoid a cut to income is to really focus on the high-quality names in the sector.
For example, we favor firms that have maintained consistent earnings growth, sport relatively low debt levels, and still have a lot of slack in their payout.
DTE Energy Co (NYSE: DTE) is one of the good. The firm boasts year-over-year growth in diluted quarterly EPS of 47.3 percent, a dividend yield of 3.8 percent, and a 60 percent payout ratio, which indicate the firm has a lot of potential to boost its payout in the future.
Additionally, the utility has posted almost 10 percent profit margins each quarter and is benefitting from the automobile industry’s recovery in Detroit. And 30 percent of the firm’s earnings come from its non-utility business segments, such as from its gas pipeline and storage business. These non-utility businesses have helped diversify DTE’s earnings away from a sole emphasis on electric utility earnings.
Then there’s Dominion Resources Inc (NYSE: D) – the bad. As an alumnus of this firm, it gives your correspondent no satisfaction to detail its recent shortcomings.
Despite Dominion’s quarterly profit margin of 14 percent, the firm has had zero percent year-over-year growth in its quarterly diluted EPS. Beyond that, it has a debt-to-equity ratio that is 159 percent, and a payout ratio that is a whopping 373 percent.
Certainly, many have made the case that the firm deserves its price-to-earnings (P/E) ratio of 114 (its average P/E multiple over the last 10 years was 14) because of the earnings the firm may generate from its Cove Point LNG facility, which is in the process of being repurposed to export liquefied natural gas. Further, those proponents point out the extensive natural gas pipeline and storage network that will also be well positioned to take advantage of the shale natural gas boom.
But critics say Dominion is not a growth stock: It’s largely a slow-growing regulated utility, and natural gas prices actually have to increase for the firm’s assets to truly benefit.
Additionally, it’s still not clear how much of the cheap shale gas will be allowed to be exported by the US government. The government has taken a case-by-case review of export facilities, given the debate over whether more exports would raise US natural gas prices and stifle the country’s manufacturing renaissance. And Dominion will have its work cut out for itself competing with global natural gas behemoths that are better capitalized and more ruthless.
For its part, the company believes earnings growth will be driven by its newly completed growth projects at Dominion Energy, sales growth at Virginia Power, and higher rider-related revenues.
That all may be true, but major improvements need to be made in terms of value, as it doesn’t appear the balance sheet can both support these new aggressive projects and investors seeking dividend growth. And with the mix of analyst sentiment on the stock standing at 14 “holds” and just seven “buys,” this seems to be the consensus view on Wall Street.
The one company whose recent financial performance has been just plain ugly is Pepco Holdings Inc (NYSE: POM). The firm’s quarterly revenue has dropped 31 percent year over year, while its profit margin was negative 50 percent. Though the stock currently yields 5.3 percent, its payout ratio of 119 percent suggest that Pepco’s earnings growth is challenged at best.
Pepco has several rate cases in its service territory that may improve the situation, but abnormal weather in the last quarter as well as losses from its retail energy supply business and cross-border energy lease investments have been weighing on the firm’s financial performance.
So for those seeking utilities stocks with long-term earnings and income growth post-stimulus, there is no substitute for exceptional performance.