- The industry business model is no longer sustainable.
- Regulators will hold down profits.
- Rising interest rates tend to depress utility stocks.
In the good old days, investment advisors recommended electric utility stocks for their high dividends, steady growth and safety. Times changed, thanks to nuclear cost overruns, more energy-efficient consumers, disastrous diversification and deregulation which turned electric generation into a cyclical business suited best for those ready to contemplate bankruptcy as an outcome. Electric utilities, however, still pay high dividends, and yield-starved investors need that income.
So what else is new?
Let's start with the product. Electricity sales have grown more slowly than the economy since the 1980s. The nation needs less electricity than before to produce a dollar of real gross domestic product (Figure 1). More recently, usage per capita has begun to decline (Figure 2). Overall, sales growth now verges on the nonexistent. Sales to ultimate customers actually declined 0.2% per year in the five years through 2013 despite the economic growth that ensued after the Great Recession.
Figure 1. Kilowatt-hours consumed per $1000 of real GDP
( 2009 dollars)
(click to enlarge)
Figure 2. Kilowatt-hours consumed per capita.
If sales barely increase, how will utilities generate growth? They will invest more money in rate base. Regulators set profit to produce a return on rate base, so the bigger the rate base, the bigger the earnings. One former utility CEO noted that his was the only business in which he could increase profits by redecorating his office. (This formula does not apply to unregulated generators, at least not yet, but that's not the sector of the business that attracts low-risk, yield -seeking investors.) The industry has opportunities to invest in new rate base, especially to replace old and dirty power plants and install facilities to boost sagging reserves and preserve reliability. These are necessary investments but they do not lead to more sales. They just increase costs.
Analysts predict 4% annual increases in income. How do the companies achieve that when sales go up only 1%? Simple, get the regulators to raise prices. That 's what they did before. It usually worked. But there is a difference, one noted by a study financed by the industry's own trade organization ( Peter Kind, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business, Edison Electric Institute, January 2013). Future consumers will have greater ability to generate their own electricity, store it and control what they take from the electric grid. (Think about cheaper solar power, storage batteries and smart thermostats.) If electric companies attempt to charge more than customers want to pay, they could lose customers. Trolley car lines could not make riders pay to maintain the lines once the riders discovered that they could take buses instead. Electric companies want to grow by charging more for the same service to customers who want less of it and might soon have alternatives at hand. That is an unsustainable business model.
Let's just ignore the trolley analogy and consider how regulators set rates of return. Bond yields give a market-based foundation for their cost of capital analyses. During the 1960s-1980s, when interest rates rose, return allowed by regulators on common equity rose, but not as fast as interest rates. During the three decades of falling interest rates that followed, regulated returns fell, but not as fast as interest rates. Thus, in a sense, a falling interest rate environment boosts the margin between interest rates and return allowed on equity and a rising interest rate environment diminishes that margin. After three decades of declining interest rates, regulators now set a return on equity roughly five percentage points above bond yields, a premium not seen since the 1960s. (See Figure 3.) If historical precedent holds, regulators looking out at a weak economy and a rising tide of populism, will increase the return on equity much more slowly than capital costs rise, and that will put a squeeze on what shareholders should earn.
Figure 3. Returns allowed on equity in electric rate cases and yield on seasoned Baa corporate bonds (%)
What's wrong with earning a 10% return on a low risk investment? Nothing, but the odds are that shareholders will not earn that regulated rate of return, partly due to delays inherent in the regulatory process and partly because utility managements make poor investments when they diversify outside the regulated arena. Back in the 1960s, utilities earned more than the return set by regulators. Maybe they could do it again, especially if power prices turned upward for their unregulated generating subsidiaries, but those operations seem unable to maintain high returns for long and many utilities have begun to shed unregulated operations due to poor returns. (See Figure 4.)
Figure 4. Return on equity earned vs return allowed in rate cases (%)
Back to the stock market. Utility stocks are bond substitutes: their dividend yield tends to move with in line with bond yields, although not necessarily on a one-to-one basis (Figure 5). Stock investors accept a lower current yield than bond holders, though, because they expect to make up more than that lost yield in the form of capital gains. Historically, they have managed to earn a total return (dividend yield plus capital gain) of more than three percentage points higher than the bond yield in order to compensate for the greater risk of equity investment.
From the mid 1960s to mid 1980s, interest rates rose and utility dividend yields stayed roughly two percentage points below bond yields, as they did in the subsequent long bond bull market that seems to have ended. In the old days, investors expected utilities to grow 6% per year. Add that growth to an average dividend yield of about 8% produced a total return expectation of about 14%, which was four percentage points over average bond yield of 10% to compensate for risk. Nowadays, the gap between bond and stock yields is around one percentage point. The industry's trade group, the Edison Electric Institute, estimates that investors expect 4% annual growth, which on top of a 4% dividend yield would produce an 8% total return, indicating that investors expect three percentage points as their excess return over the bond yield, not a high equity risk premium but everyone says these are low risk stocks, right?
Figure 5. Baa bond yields and electric utility stock dividend yields (%)
When Interest rates rise, dividend yields will rise, meaning that utility stocks will decline absent big big increases in earnings and dividends. (Eventually, higher interest rates translate into higher returns on rate base, but that could take years.) Fortunately, the gap between dividend and bond yields is so small now (roughly one percentage point) that when interest rates begin to rise, dividends yields might not increase as much until the old relationship (about two percentage points) re-establishes itself. But long term, higher interest rates depress utility stocks. That's life.
Perhaps the stock price already incorporates the possibility that rising interest rates beginning at an indeterminate date will depress utility shares. The market, however, rarely predicts how badly a regulator can mess up a company, as evidenced by the way stocks tanks after a bad regulatory order. Nor do analysts look as critically as they might at management competence or strategy. Most importantly, the financial community does not question the prevalent utility business model that depends on raising the price of a product the demand for which is weak. Ask utility executives how they now intend to build the business. Most will reply that they plan to de-emphasize unregulated activities and "grow the rate base." Utilities, though, might discover that they have settled for a low, regulated return on what turns into a high risk business once customers decide that they do not want to pay more for the same service and can take a walk when alternatives appear. That is the biggest unrecognized risk. This is not your father's electric utility investment anymore, and his was both safer and more profitable.
Investors have put their money into utility stocks, funds and ETFs. which are often promoted as low risk investments. They buy the funds and ETFs to obtain the benefit of diversification. They can mitigate the impact of a few bad eggs because they buy a package, not one stock. Yet the problem is not one or two stocks, but the secular and cyclical issues that almost all electric utilities face.
Investors who hold ETFs such as the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) or the Vanguard Utilities ETF (NYSEARCA:VPU) as well as other utility ETFs or funds need to consider how these scenarios could affect their portfolios. Maybe they need to look around for a different package of high yielding, low risk investments.
Industry financial data including estimate of consensus growth rate of EPS from Edison Electric Institute, sales data from Energy Information Administration, economic and interest rate data from Federal Reserve Bank of St. Louis (NASDAQ:FRED). 2013 financial numbers partially estimated by the author. For an analysis with a longer time frame and data from the USA and UK, see Leonard S.Hyman, "All You Need to Know", Public Utilities Fortnightly, November 2013. (subscription required)