Big Investments By Utilities Pave Road to Renewability, Profits

This article was originally published by Motif Investing.

About 750,000 American households are off the grid – no electricity, water, gas, telephone or cable television bills. And then there are the remaining 323 million Americans who literally rely upon utilities for their survival.

As a rule, the electricity, water and heating bills are paid first, even before the mortgage or auto loan payments are made. Utility stocks aren’t bothered much by recessions, and they’re a reliable source of dividends since they have a large amount of cash flowing into their treasuries on a monthly basis.

So why do big investors dislike utilities?

For one thing, utilities aren’t always efficient businesses. It makes sense for utilities to spend more on infrastructure than needed, since their profit is usually capped at a percentage of shareholder equity that’s tied up in infrastructure. That’s usually money that isn’t returned to investors in the form of dividends, which can top 3 percent at many well-run utilities.

More importantly, utilities have been an attractive investment over the last decade because interest rates have been near zero. When rates are so low, it makes sense for investors to buy utility shares because their dividend rates can exceed the interest rates. But a low interest rate environment also pushes more money into utilities, raising share prices – and fears that some utility stocks overvalued and will drop in value as rates rise.

So, if you believe that interest rates will rise rapidly soon, sell your utility stocks. Otherwise, plan on enjoying a stable stream of profits. 

Electric Avenue

Modern life essentially starts and ends with electricity, from the process that powers the alarm that wakes you up to computers used at work to the lights that you turn off before going to sleep. The grid, as it’s known, affects nearly every part of modern life.

If there’s a potential downside to investing in electric utilities, it’s that the potential for volatility has increased as awareness of climate change has grown. A raft of studies have conclusively shown that climate change is driven by carbon emissions, and high-carbon fossil fuels such as coal and natural gas account for roughly two-thirds of power generation sources in the U.S.

Eventually, utilities envision a grid powered largely by renewable sources such as hydropower and solar. Barclays plc BCS warned in 2014 that the price of solar power had reached parity with grid power in Hawaii, and similar trends were likely over the next five years in California, New York and Arizona. Southern California Edison, a subsidiary of Edison International EIX, released a white paper in late 2016 that imagines a grid composed of individual power sources sharing surplus electricity. And the distributed generation model posed an “existential” threat to utilities, the investment research firm Morningstar predicted in 2014, although it estimated that the threat wouldn’t make itself apparent for another decade.

That’s very good news for companies like American Electric Power Co. AEP, the Columbus, Ohio-based utility that’s one of the largest electricity providers in the U.S. Shares in the company have risen about 10 percent over the last year, buoyed by the election of Donald Trump. The company depends heavily upon coal-fired power plants, and the new president promised often to revive the fortunes of the ailing coal industry. In addition, American Electric was named No. 1 among the 10 best stocks to own over the next decade by 24/7 Wall Street, an online financial news service.

Share in other electric utilities, such as Alliant Energy LNT and Portland General Electric POR, have posted gains approaching 20 percent or more over the last year. While Portland has been downgraded by some analysts, institutional investors have continued to accumulate shares.

Water Works

Although they maintain a lower profile than their electric cousins, water utilities occupy a similarly important position in modern life. True, water covers 71 percent of the planet’s surface, but bringing clean water to U.S. homes – and removing waste water from them – is a uniquely complicated process.

American Water Works Co. AWK is the undisputed king of water utilities, serving 15 million people in 47 states. Its market capitalization hovers around $13 billion, or roughly two-and-a-half times more than its nearest competitor, Aqua America WTR. Here, too, the Trump administration may prove helpful to a different type of utility; the new president pledged a $1 trillion infrastructure plan that could boost maintenance and upgrades at hundreds of water and wastewater facilities in regulated jurisdictions.

Cooking With Gas 

Despite flat prices that have leveled parts of the natural gas market, utilities continue to thrive. NiSource NI, based in Merrillville, Ind., recently announced a 6 percent increase in its quarterly dividend. The company has long-term investments worth $20 billion identified, while keeping annual earnings growing between 4 percent and 6 percent.

WGL Holdings Inc. WGL and Northwest Natural Gas NWN also have registered share gains exceeding 20 percent over the last year. The Washington, D.C.-based WGL is currently the subject of a $6.4 billion acquisition bid from AltaGas Ltd., the Calgary gas giant. The deal is likely to be scrutinized heavily by regulators; meanwhile, WGL stock has risen almost 30 percent over the last year.

Cord-Cutting

Phone and cable television service are less essential to human life than electricity, water and heating – but only barely. A 2016 poll found 1 in 3 Americans would rather give up sex than surrender their smartphones. That’s bad for the species but excellent news for companies like AT&T T, the Dallas-based telecommunications giant that traces its corporate lineage back to Alexander Graham Bell. AT&T shares have risen more than 20 percent over the past year, even as it’s been engaged in a grueling fight over its proposed $85 billion acquisition of Time Warner TWX. The deal has been heavily criticized over antitrust concerns.

Less splashy stocks, such as Charter Communications CHTR, Comcast Corp. CMCSA and DISH Network DISH have reported even better results over the last year, with gains exceeding 20 percent. Although one-quarter of U.S. households are “cutting the cord” and eliminating their cable or satellite service in favor of internet-only video, the rate of people leaving the market has slowed slightly, and cable providers are taking advantage of new technologies to increase revenues by moving into the internet service provider market.