Corporate earnings, a key fundamental driver of stock performance, continued to trend favorably in the utilities sector during the past six months. Year-over-year earnings per share (EPS) growth was strong on an absolute basis in the first quarter of 2013, following robust growth in the fourth quarter of 2012.
However, the first quarter results came in slightly below Wall Street analyst expectations (see "Corporate earnings" chart below right). More specifically, government-regulated electric utilities generally posted earnings growth at a pace of roughly 5% on a year-over-year basis, but those collective results were slightly shy of expectations due largely to weaker-than-expected overall power demand, particularly from the industrial segment of the U.S. economy.1 The lack of industrial power demand—often seen as an artery to the economy—suggests that there has yet to be material improvement in domestic economic output.
Weaker-than-expected power demand
Big yields in utilities
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During the past year, domestic power demand was up only 0.05% (through April 2013), according to the U.S. Energy Information Administration. Going into 2013, the leaders of many utilities were anticipating a 1% average rate of year-over-year sales growth in power. As first-quarter earnings results were reported, most companies revised their sales growth estimates lower for the remainder of 2013.
For example, the primary utilities operating in the states of Virginia and Florida lowered their sales growth guidance to 1.0% and 0.7%, respectively, from 2.0% and 1.7%, respectively, at the start of 2013.2 Generally speaking, overall electric power demand growth is now estimated within a range of 0% to 0.5% for the remainder of 2013.3
Return to more typical winter temperatures provided a boost to earnings growth
Many companies that managed to exceed analysts' earnings expectations during the past six months were those that benefited from the return to more seasonable winter weather.
Typical weather temperatures in many U.S. regions during the winter season of 2012–2013, in addition to below-average temperatures in March 2013, provided a favorable backdrop for earnings growth in the sector. Colder temperatures require greater use of power for heating and other needs. This seasonally cold weather, in contrast to unusually warmer weather that existed during the 2011–2012 winter months, was particularly helpful in year-over-year earnings comparisons.
Rising natural gas prices aid deregulated electric utilities
The earnings of deregulated utilities, which are more influenced by commodity price movements, by and large were supported by the rising price of natural gas—a key input to power generation.
Historically, natural gas and power prices have tended to be highly correlated. So far in 2013, the price of natural gas has increased 19%, to $3.91 per million British thermal units (Btu's), and had moved over $4.00 per million Btu's in late April.4 Unlike regulated utilities, whose ability to adjust power prices is controlled by government entities, deregulated utilities have the ability to pass along higher input costs to customers in the form of higher power prices. Given this pass-though ability, higher natural gas prices tend to have a positive influence on corporate earnings for deregulated utilities.
Generally speaking, deregulated utilities expect this upward trend in the price of natural gas to continue, and several took steps to slow down their hedging activity of the commodity to benefit from higher anticipated future prices.
Cost management efforts
Cost control remains a major focus in the utilities sector. Many companies have continued to keep their operating and maintenance costs down in the face of weaker-than-expected topline power growth trends. Such efforts have also contributed to favorable year-over-year EPS growth during the past six months.
Assessing equity valuations
The combination of low interest rates, a slowly improving U.S. economy, and increased demand from yield-seeking investors has driven many utility stocks to above average valuations. The average price-to-earnings ratio (P/E based on forward earnings estimates) of utility stocks in the S&P 500 Index was 15.9 as of May 10, 2013, above the group’s long-term average P/E of 13.4 (see "S&P 500 Utilities P/E Ratio" chart right).
The last time the sector’s P/E hit this level was in 2006-2007, when rising natural gas prices drove up the cost of power. Utility stocks' P/E multiples also reached this level in 2000, when there was a secular peak in power supply and California was experiencing power shortages and rolling electricity blackouts.
Today, the primary reason why utility stocks are expensive on a P/E basis is strong demand from income-seeking investors in an environment of extremely low bond yields. On a yield basis, the utilities sector looks cheap relative to U.S. Treasury bonds. As of May 10, 2013, the yield on a 10-year U.S. Treasury bond was 1.9%, compared to an average dividend yield in the utilities sector of 3.8%.5
Relative to investment-grade corporate bonds, utility stocks also look attractive (see "Sector dividend yield" chart right). The 3.8% average yield on utility stocks stood above the 3.3% average yield for corporate bonds. For the majority of the past 25 years, utility stocks have not yielded more than corporate bonds.6 Historically, the average dividend yield of the utilities sector has been roughly 25% lower than the average yield offered by BBB-rated U.S. corporate bonds.7
Given their relatively more attractive yields, many income-seeking investors may have allocated a greater portion of their portfolios to utility stocks. For example, investors nearing or in retirement may have been willing to devote a greater portion of their portfolio to utility stocks, given their relatively attractive yields and the additional potential for capital appreciation in one of the historically less volatile sectors of the equity market. In addition, tax rates applied to dividend yields on utilities may also be more advantageous to some investors, as the income from bonds is generally treated as ordinary income and taxed at a higher rate.
In the near term, I do not expect the strong demand for utilities to abate, provided there are not any dramatic shifts in the trajectory of the U.S. economy or monetary policy (e.g., quantitative easing8 or interest rates) from the Federal Reserve. In fact, I would not be overly surprised if P/E multiples in the sector moved even higher in the near term as more yield-seeking investors allocated more capital to utility stocks. It is possible that there is a secular shift in demand for utilities and other high-dividend-paying equities based largely on the maturing of the baby boom generation and shifting investor preferences.
Outlook for utilities stocks over the next six months
Elevated valuations and weaker-than-expected power demand are two potential headwinds for the earnings and stock performance of utilities companies. However, while traditional P/E valuation suggests utility stocks may be expensive, investors should keep in mind that the increased demand for this sector could be a secular trend and continue for some time, provided the current backdrop of low interest rates, accommodative Fed policy, slow economic growth continues, and other potential factors. As more members of the baby boom generation enter retirement, the attributes of utility stocks may come increasingly into play: dividend income and capital appreciation from a conservative business that tends to be less economically sensitive than other sectors.
Further, given the current market backdrop and the prevailing risks to the sector, investors may be well served by focusing on the utilities that are best positioned to grow dividends at above-average rates. As our analysis shows, utilities that have generated the highest dividend growth over time have tended to be the top performers in the sector. Among the areas most likely to experience better-than-average dividend growth are utilities that focus on transmission and natural gas infrastructure development.