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posted on 28 July 2016

The New Utility Castles

by Richard Stavros

Investing Daily Article of the Week

The notion that demographics is destiny doesn't just apply to geopolitics, it also has bearing on the utility sector.

Although we usually employ fundamental analysis when searching for the next great utility stock, we also use a top-down approach to identify promising names, while avoiding possible dogs.

While regulated electric utilities are among the safest companies in which to invest, they still ultimately depend on demand for the electricity they generate.

That's why we periodically examine the key factors that drive this demand: demographics and economics.

In the past, we've approached demographics from different angles. For instance, a few weeks ago, we wrote about how utilities whose service territories have high concentrations of Millennials and Gen Xers could be better positioned for long-term growth since these groups are willing to pay more for green energy.

Interestingly, shortly after we published that article, my colleague Ari Charney happened to receive a promotion in the mail from Dominion Resources (NYSE: D) that touts its GreenPower program, which encourages customers to pay an average of $13 more per month to power their homes with 100% renewable energy. Naturally, those who sign up for this program receive a free tote bag.

Anyway, that's a somewhat narrow mode of demographic analysis, and it remains to be seen whether Millennials and Gen Xers are truly willing to pay more for green energy or just enjoy the easy virtue of saying they would.

Our usual approach to demographics is much broader. As statistics junkies, we look at state-by-state population growth, as well as each state's gross domestic product (GDP) growth, and variations in electricity prices.

One utility that continues to be a demographic standout is NextEra Energy (NYSE: NEE), whose Florida service territory benefits from above-average economic growth and the influx of retiring baby boomers.

Recent figures from the U.S. Bureau of Economic Analysis showed that Florida's economy continues to grow at a faster pace than the average state, with GDP rising 2.7% during the fourth quarter of 2015.

Utah is also enjoying strong growth, with GDP increasing by 2.8%. This bodes well for Dominion's acquisition of Utah-based gas utility Questar (NYSE: STR).

However, some states are not doing as well as they were when we last observed state-by-state quarterly and annual GDP figures, particularly Texas, Missouri and Kansas.

Texas Tanks on Oil Price Collapse

In previous years, Texas saw robust economic growth thanks to the strength of the energy market and the new workers it attracted from other states.

But the oil crash has clearly taken a toll, as the state's economic growth has more than halved, to 1.4%.

However, if the oil industry recovers over the next couple years, this could prove to be a short-term trend and, therefore, a buying opportunity for Texas-based utilities. In fact, five of the nation's eleven fastest-growing cities are in Texas, according to the Census Bureau.

Given future growth dynamics, companies such as CenterPoint Energy (NYSE: CNP) could eventually surpass their peers, as long as newly minted Texans don't leave the state during the downturn to seek jobs elsewhere.

Meanwhile, Missouri saw GDP growth decline to 1.8%, while Kansas suffered an outright contraction, as GDP dropped by 0.7%. Perhaps the proposed Westar (NYSE: WR) and Great Plains Energy (NYSE: GXP) merger was more about survival than growth.

California Clouds, but the Northwest Is Cheap

On the West Coast, we have a darker picture. California's GDP has declined substantially since we last reviewed the numbers, though it's still above average, at 2.7% growth.

Although its rate of population growth is steady, at around 1%, we're concerned that the Golden State's population growth will continue to slow. According to the Census Bureau, California's population isn't likely to grow much faster than the nation as a whole for the next half-century.

This would be a departure from its high rate of population growth for many decades. And with the highest electricity rates in the nation, there's concern that California utilities such as PG&E (NYSE: PCG) won't be able to find growth to support their ambitious renewable-energy projects.

Even worse, California's neighbors, such as Washington State, Oregon and Nevada have seen significant drops in GDP - all three are either well below average or barely growing.

This has implications for utilities such as Avista Corp. (NYSE: AVA), Portland General Electric (NYSE: POR), and Nevada utilities. At the same time, they do offer lower retail electricity prices than their California neighbors, which could attract businesses seeking cheaper power options.

One wrinkle in this analysis is that GDP growth may no longer have the strong correlation with electricity demand that it once had, as rising efficiency erodes the link between the two.

But for now, we believe this analysis is still a useful way to augment fundamental stock selection in our never-ending search for the new utility castles.

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