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Utility companies have always remained popular investment prospects for income-seeking investors, as these companies offer high dividend yields. Utilities are also generally perceived to be low risk, low growth businesses, which enjoy stable earnings and offer high dividend yields coupled with high dividend payout ratios. The utility sector on average has a dividend payout ratio of almost 60%, higher than other sectors. Lately, the utility sector fundamentals have been challenged as lower demand growth, a rising interest rate environment and weak forward power prices have created headwinds for the sector. I believe the headwinds that the utility sector has currently been facing have offset the defensive nature of the utility business. In the present contest, utility companies are scaling down their merchant power assets, increasing the exposure to regulated operations and containing costs to grow earnings. In this article, I will briefly discuss important takeaways of the recent EEI Conference.

Weak forward power prices have remained a critical headwind for diversified power companies, who have merchant power assets. In the last five years, capacity power prices for merchant assets have declined almost by half, because of which the companies are struggling to maintain their profitability and positive cash flows. In the given difficult situation for the merchant power producers, the companies are scaling down their merchant operations and are increasing exposure to regulated operations. The companies, which are being most adversely affected by lower capacity power prices, are Exelon Corp. (EXC), FirstEnergy (FE) and Entergy Corp. (ETR). Utility companies, during this year's EEI conference, stated that they are evaluating several options to survive the difficult times for merchant business operations, including selling off merchant assets, shutting down of unprofitable plants and undertaking strategic acquisitions. Recently, EXC indicated that it might opt to shut down one or more of its nuclear power plants in reply to weak power prices. Duke Energy (DUK) plans to sell off almost a dozen of its merchant power plants to support its consolidated earnings, and use the sale proceeds to repay debt and expand its regulated operations. As we move ahead, FE might opt to cut its dividends to strengthen its balance sheet and credit outlook. Also, PPL Corp. (PPL) might opt for a strategic merger or spin-off of its merchant business and reinvest the proceeds to strengthen its regulated operations in the U.S. and the U.K.

Lower electricity demand growth is another challenge faced by utility companies. The demand growth has been slower in recent times primarily because of the economic slowdown and efficient energy usage measures being observed, which lowered electricity usage per customer. Utility companies, during the EEI conference, stated that electricity demand growth for 2014 is expected to range from 0.5%-1%.

To offset the impact of lower demand growth and weak forward power prices, utility companies are spending to expand and strengthen their regulated operations, which will fuel their future earnings growth. DUK, Southern Company (SO), American Electric Power (AEP), PPL, Dominion (D), and Consolidated Edison Inc. (ED) are the leading utility companies who have been incurring capital expenditure (CapEx) to increase exposure to regulated operations, which in return will lead to rate base and earnings growth. CapEx incurred by utility companies to increase exposure to regulated operations is done through spending towards infrastructure development, transmission assets expansion and renewable energy portfolio expansion. However, as capital spending is expected to remain high in the near future, utility companies will need external funding in the rising interest rate environment, which will result in higher interest cost.

As utility companies have been historically offering high dividend yields, the rising interest rate environment in the U.S. remains a headwind for the sector. The rise in interest rates will put downward pressure on utilities' stock prices to keep dividend yields competitive to rising interest rates. I believe a positive aspect of rising interest rates for utility companies is that it will lower pension costs, as discount rates used for finding present value of pension costs will increase. The graph below shows the rising interest rate in the U.S.; indicated by the rising 10-year Treasury yield.
(click to enlarge)
Source: bloomberg.com

Final Words

I believe that in the present challenging environment for the utility sector, regulated utilities will outperform diversified utilities, and companies with higher growth remain good investment prospects for investors. I am bullish on DUK, SO, PPL and AEP, and believe these companies are good investment prospects for income-seeking investors. Following are links to my recent articles on the four companies I am bullish on: DUK, SO, PPL and AEP.

Source: Regulated Utilities To Outperform Diversified Utilities