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Industry Analysis: Electric Utilities
Most investors purchase electric utility stocks for their high dividend yields. At times, the average yield of stocks in this industry is more than twice the Value Line median. Another key attraction of these equities is their defensive characteristics. Most electric utility stocks are less risky, and less volatile, than nonutility issues. Capital appreciation is not a major consideration for electric utility investors.
Since the 1990s, companies in this industry have become much less homogeneous. That’s because roughly half of the states, in response to high electricity prices and an inability for customers to choose their electric supplier, enacted some kind of deregulation law. It’s actually a partial deregulation of just the generation function of the utility business. Distribution remains regulated by state commissions, and transmission is still overseen by the states or the Federal Energy Regulatory Commission. In the states that have had partial deregulation, many incumbent utilities own and operate nonregulated generating plants that provide power to customers of the regulated distribution company. In fact, some companies get more than half of their profits from the nonregulated side of their business.
Key Issues Facing The Industry
In traditionally regulated states, utilities build generating units. Unless they recover their costs as the facilities are under construction, they recover their investment, and earn a return on it, after the plant has attained commercial operation. Sometimes, other companies build units and sell the power to the local utility. And sometimes, companies build generating facilities without having a contract to sell the power. These “merchant” plants are riskier than other kinds of generation, but they can be very lucrative when market conditions are favorable. Even so, under some states’ deregulation schemes, it is not clear who will build generating capacity, or how plant owners will recoup their investment.
Environmental considerations have come to the forefront in recent years. Whether a generating facility is regulated or nonregulated, its owner must face the same rules concerning emissions of pollutants. (These rules became cloudier after a court overturned a federal clean-air provision earlier this year.) There has also been much talk about regulating the carbon emissions that are blamed for global warming. Although no rules have been put in place yet, most companies expect something to happen along these lines. Furthermore, it has become much more difficult for companies to build coal-fired generating facilities due to strident opposition from environmentalists and the public.
For much of the Eighties and Nineties, the real cost of electricity (i.e., adjusted for inflation) was declining. This is no longer true. Sharp increases in the costs of building materials and labor have made any kind of utility construction much more expensive. Utilities are also facing inflationary pressures in operating and maintenance expenses. So far, the bulk of these costs have been passed on to customers, but there is no guarantee that this will continue. Note, too, that after utilities file general rate cases, most wind up with a reduced return on equity once they receive final rate orders.
The Value Line Page
The first thing that many utility investors look for is the current yield of the stock, which is shown at the top of the Value Line page. This is a forward-looking yield, meaning that it reflects any dividend changes that we estimate in the next 12 months. If we believe that there is significant risk of a dividend cut at the next declaration, we show a split dividend at the top of the page. If there is possible risk of a cut due to an unfavorable event (e.g., a harsh regulatory order), but that risk is not imminent, then we will mention it in the commentary even if we do not show a split dividend.
A stock’s Safety rank is another important consideration. The Electric Utility Industry, as a whole, is less risky than most sectors, so it is not unusual (or noteworthy) for a stock to have a Safety rank of 2 (Above Average). Instead, utility investors who are highly risk-averse should seek the stocks that carry our top rank for Safety.
For electric utility equities, the Timeliness rank is not as important a consideration. Most utility investors are not trying to outperform the broad market averages. Furthermore, a stock’s dividend plays no part in our Timeliness ranking system, which is driven largely by quarterly earnings comparisons. Although annual earnings and earnings expectations are important for the companies in this industry, quarterly comparisons are not of particular concern. Utility stocks rarely rise or fall, materially, due solely to a quarterly earnings report, but they can move a lot if there is a revision of the company’s annual guidance. In this industry, things such as the timing of plant outages, the vagaries of mark-to-market accounting, or weather can skew year-to-year profit comparisons. In fact, some sell-side analysts don’t even bother making quarterly earnings estimates, although they all make annual estimates.
Regulatory climates are a unique factor to this industry. From time to time, we list the regulatory climate for each state in one of the three Electric Utility industry reports. The footnotes of each full-page report list the regulatory climate for that utility.
Utility investors with a long-term focus should look at each utility stock’s 3- to 5-year total-return potential. Although it will typically be below the market median, it might still be acceptable on a risk-adjusted basis.