Last year, 2013, was a difficult year for the U.S. utility sector. The utility sector underperformed the broad market in 2013, as it did in 2012. The underperformance of the utility sector can be attributed to various factors, which I believe will continue to prevail in 2014. As we moved in 2014, I believe conditions for the utility sector will remain challenging, and could offer investors a total return of 7%-9%, including expected earnings per share growth of 3%-5% and sector average dividend yield of 4%.
Utility Sector Performance Review of 2013
The start of 2013 was a strong one for the utility sector, as utility stocks rose about 20% through May. Then in May 2013, the Fed signaled to start tapering its $85 billion asset [bond] purchases, which didn't bode well for the sector and price multiples for the sector came under pressure. A rising interest rate environment, the strengthening of the U.S. economy, increasing investor risk appetite, slow electricity sales growth, and lower natural gas prices were among the major reasons for the utility sector's underperformance in 2013.
To make comparisons between the utility sector's performance and the broad market, and other indexes, I will be using the PHLX Utility Sector Index (UTY), utility sector ETF (NYSEARCA:XLU), the S&P 500, the Dow Jones Industrial Average Index (DJI) and U.S. GDP growth rate.
U.S. GDP Growth Rate
Source: Google Finance, Yahoo Finance and public data sources.
Investors with a low risk appetite in search of income favor the utility sector, as utility stocks have low beta and offer attractive dividend yields. Since 2006, utility stocks have four times outperformed the broad market, as displayed in the above table. The tables below display the five top and worst performing utility stocks for 2013.
Top 5 Performing Utility Stocks in 2013
Black Hills Corp. (NYSE:BKH)
MDU Resources Group (NYSE:MDU)
UNS Energy Corp. (NYSE:UNS)
AES Corp. (NYSE:AES)
Sempra Energy (NYSE:SRE)
Worst 5 Performing Utility Stocks in 2013
FirstEnergy Corp. (NYSE:FE)
Exelon Corp. (NYSE:EXC)
Southern Company (NYSE:SO)
Pepco Holdings (NYSE:POM)
Weak power prices, tougher environmental regulations and uncertainties regarding construction costs are factors other than the ones mentioned above that influenced the underperformance of the utility sector in 2013. Because of excess supply and lower natural gas prices, last year's capacity power prices remained weak, which adversely affected competitive power operations. As power prices remain weak and costs remain high, several utility companies have opted to shutdown their nuclear plants. Last year, Duke Energy (NYSE:DUK) opted to retire its Crystal River 3 nuclear unit and Dominion Resources retired its Kewaunee nuclear plant. Also, EXC is considering retiring some of its nuclear plants as power prices remain weak and costs remain high; Ginna and Clinton are the likely nuclear units that EXC can opt to retire in the near term.
Utility stocks have remained popular among income-seeking investors, because of their attractive dividend yields and dividend growths. Dividend increases in 2013 remained slightly weak in comparison to 2012; in 2013, 31 utility companies, out of 50 utility companies tracked by the EEI, raised their dividends, whereas 36 companies raised their dividends in 2012. Also, in 2013, 14 companies maintained their dividends and only one company, Exelon, lowered its dividends. During the first nine months of 2013, the industry's average dividend increase stood at 5.1%. The table below shows the dividend patterns for 50 publicly traded utility companies tracked by the EEI.
(click to enlarge) Source: eei.org
As utility stocks generally have high debt loaded balance sheets, credit ratings remain an important performance metric. The industry has an average credit rating of BBB, which the industry has successfully maintained since the last nine years. In 2013, there were 40 credit rating changes, including 34 upgrades and 6 downgrades. The following chart reflects the S&P utility sector credit ratings distribution.
(click to enlarge)
Capital Spending Outlook
For me, a robust capital spending environment remains a key earnings growth driver for the industry. Capital spending has been high in recent years and peaked in 2013, as companies are spending to upgrade existing plants, construct new plants and improve infrastructure to meet environment standards imposed by authorities. As utility companies are spending capital to develop infrastructure and meet environmental requirements, capital spending will be recovered through rate increases, which will translate into earnings growth in upcoming years. Also, capital spending has peaked in 2013, and will decrease gradually in upcoming years; strengthening cash flows for the industry, which may result in redeployment of capital, dividend growth acceleration and credit rating upgrades. Uncertainty regarding the up gradation of power generation fleet and construction of new plants poses a threat of cost overruns for utility companies, which may negatively affect the earnings and cash flows of utility companies. SO has faced several cost overruns for its Kemper plant, which has negatively affected its financial performance.
According to SNL Financials, capital spending is expected to peak to almost $92 billion in 2013, and decline gradually to $87 billion in 2014 and $83 billion in 2015. The chart below shows the capital spending trend.
(click to enlarge)
Source: EEI and SNL Financial Projections
Utilities continued to underperform the broad market in 2013, as they did in 2012. The sector is considered to be less risky, as it generates stable earnings, and offers predictable cash flows. However, a rising interest rate environment, tougher environmental regulations, and lower natural gas prices negatively affected the sector's performance in 2013.
In the next part of the article I will further discuss the utility sector's outlook for 2014. I will briefly discuss the sector's regulatory environment, electricity demand trend, rising interest rates and some other important themes for the sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.