The Case For Utility Stocks

by: Roger S. Conrad

Historically, even best-in-class utilities have been tortoises when it comes to earnings growth, increasing their net income by 3 percent to 5 percent annually. With the Dow Jones Utilities Average trading at more than 18 times earnings, some pundits, naturally, have questioned whether the sector trades at frothy valuations.

But some of our favorites have accelerated their annual earnings growth to between 5 and 7 percent. And NextEra Energy's (NYSE:NEE) guidance calls for investments in gas-related infrastructure and renewable energy to drive earnings growth of as much as 10 percent per year.

This isn't the first time that the utility sector has accelerated its rate of earnings growth.

In the late 1990s, for example, utilities copied Enron's doomed business model to drive double-digit earnings growth. And in the 1960s and 1970s, utilities built power plants with abandon until soaring costs led to billions of dollars worth of regulatory disallowances.

In both of these examples, utilities also ratcheted up their business risk in ways that neither investors nor management teams foresaw until it was too late. This irrational exuberance resulted in dozens of dividend cuts, and a handful of companies slid into bankruptcy. Even the sector's strongest players suffered from slower growth, prompting investors to decamp for greener pastures.

Fortunately, the growth drivers behind the utility sector's latest earnings boomlet suggest that these gains will prove more sustainable this time around.

For one, much of this upside comes from an unprecedented need for system investment to address ongoing changes in how utilities generate and distribute electricity - namely, growing adoption of renewable energy and demand for low-cost natural gas to fuel power plants. (For more on the trends, see In the Land of Infrastructure, Capital is King.)

Equally important, salutary relations with federal and most state regulators mean that utilities can recoup these capital expenditures - and a solid return - via increases to their rate base. Hewing to the traditional model provides a high level of visibility to future revenue - in contrast to the 1990s, when utilities took on significant exposure to commodity prices.

These days, many utilities earn a return on these investments before completing the project and/or without filing a formal rate case. Consider SCANA Corp. (NYSE:SCG) and Southern Company's (NYSE:SO) ongoing construction of new nuclear power plants in their service territories - two of the most expensive construction projects underway in the sector.

Both companies have already recovered the vast majority of their incurred costs in their rate base, though the plants won't operate until the end of the decade. In the 1960s and 1970s, utilities couldn't request a rate increase to recover their costs until the plants were up and running. When regulators balked at approving the desired rate increases, utilities took huge write-downs on their investments.

Much of the current boom in capital expenditures focuses on reducing service costs, improving system reliability and reducing carbon dioxide emissions. In Michigan, CMS Energy Corp. (NYSE:CMS) has kept the increase in customers' bills below the rate of inflation while growing its rate base in the upper single digits by investing in efficiency.

Lower prices for raw materials and relatively flat wages also boost utilities' returns - another sharp contrast to the 1960s and 1970s.

Not every utility stands to benefit from these trends to the same extent. Some companies have exposure to commodity prices in other business lines or operate in states where hostile regulators make it difficult to earn a fair return on investment.

That being said, more than a decade of reducing debt and operating risk in response to the 2001-2002 meltdown has made utilities stronger than ever.

The number of dividend cuts in corporate America exceeded levels from 2008, and a bumper crop of payout reductions looks like a distinct possibility this year. Utilities, in contrast, have raised their payouts at the fastest pace since the 1960s.

And the two utilities in my coverage universe that have slashed their dividends over the past several years - Exelon Corp. (NYSE:EXC) and FirstEnergy Corp.(NYSE:FE) - did so because of their exposure to depressed wholesale electricity prices.

Both companies have adjusted their business models since then. In fact, Exelon announced its intention to resume regular dividend growth this year, while FirstEnergy could follow suit by early 2017.

A slide into recession, a nasty deterioration in regulatory relations and/or a letdown in operating performance could derail utilities' earnings growth in coming years. But even in these scenarios, the financial strength that comes from more than a decade of risk reduction limits downside to dividends. In an uncertain economic environment, this relative strength will only enhance utility stocks' appeal.