Barron's Bashes Utility Stocks For All The Wrong Reasons

| About: Utilities Select (XLU)

In early July, Barron's published an article warning that The Sun Will Set on Electric Utilities. The article could appear prescient for a time; as we've warned Conrad's Utility Investor subscribers, the sector could be due for a pullback on valuation reasons alone.

The Dow Jones Utilities Average trades at about 20 times earnings and yields barely 3 percent - levels last seen before the sector collapsed in late 2000, when excitement about the opportunities created by industry deregulation soon gave way to worries about California's power crisis and Enron's implosion.

From the Dow Jones Utilities Average's top in December 2000 to its bottom in mid-October 2001, the index gave up about 60 percent of its value.

Fundamentals suggest that the sector won't experience a selloff of this magnitude during the current cycle. As we explained in The Case for Utility Stocks, US electric utilities have spent much of the past 15 years reducing operating risk and shoring up their balance sheets by paying down debt.

But just retracing this year's gains would shave more than one-fifth off the Dow Jones Utilities Average, while a reversion to a typical price-to-earnings ratio would translate into a pullback of about 35 percent.

And consider the case of California Water Service Group (NYSE:CWT), which trades at almost 40 times trailing earnings and yields barely 2 percent - an untenable multiple for a company that's growing its dividend at an annual rate of 3 percent and operates in an unpredictable regulatory environment.

Given the elevated valuations in the utility and telecom sectors, we've advocated a three-part strategy that involves:

  • High-grading your portfolio by exiting any riskier names (ideally for a profit) that you wouldn't want to hold through a bear market;
  • Taking partial profits on big winners that have rallied to historically elevated valuations and have outstripped their underlying growth prospects; and
  • Adding some hedges with an eye toward using the profits to buy best-in-class utility stocks on a pullback.

Although our near-term outlook remains cautious, this strategy takes a bullish view on essential-service stocks over the long haul. Ultimately, we aim to raise some powder when utility stocks trade at unsustainably high valuations and take advantage of the eventual selloff to accumulate shares in the names on our shopping list.

Taking Barron's to Task

In contrast, the bearish article that recently ran in Barron's paints the utility sector with a broad brush and warns investors to avoid these stocks as longer-term holdings.

The authors pin the bearish case for electric utilities on a "recent" survey in "a trade journal" which found that the majority of participating industry executives expected their companies to enter a "death spiral" within 10 years.

Although the article's lack of citations makes pinning down the aforementioned survey a challenge, the authors likely refer to a 2014 study conducted by the Edison Electric Institute, the power industry's primary trade group.

At the time, the cautionary tales of E.On (OTCQX:EONGY), RWE (OTCPK:RWEOY) and other German electric utilities loomed large on investors' minds. Surging adoption of distributed renewable energy in Germany has eroded these companies' sales and balance sheets, forcing them to slash their dividends and attempt to spin off their baseload power plants.

But US utilities have learned to live with, if not love, distributed power since early 2014.

For example, California-based utilities continue to invest billions of dollars in their grids to accommodate more power from rooftop solar panels and other intermittent generation sources. These incumbent electricity providers have grown their rate bases while cutting costs by shutting down some of their capacity and improving their operating efficiency.

These days, solar-power companies and electric utilities tend to work together instead of against one another. In fact, SunPower Corp. (NASDAQ:SPWR) co-sponsored the Edison Electric Institute's annual financial conference last year.

At the conference, nobody called for the industry to enter a death spiral. In fact, Tom Werner, CEO of SunPower, dismissed the "noise and rhetoric" on "popular blog sites" and called the idea that utilities are slow-moving dinosaurs destined for extinction "a myth." Werner emphasized that the industry remains on "the leading edge" of a push for cost-effective, cleaner and more reliable electricity.

Werner's comments reflect SunPower's increasing cooperation with incumbent electric utilities. At the conference, the company unveiled a new business segment that will combine rooftop solar power, energy storage and management systems to sell electricity in the California market.

In other words, as we explained in "The Sun is Setting on SolarCity Corp, But Renewable Energy is for Real," the push for renewable energy in the US has created more opportunities for incumbent electric utilities than catastrophes.

The authors of the Barron's article also assert that electricity sales have peaked in the US, citing efficiency initiatives and the ongoing transition to LED lighting - a trend that they estimate could ultimately reduce power consumption by 10 percent. Conveniently, these savings would offset any emerging sources of demand, including the adoption of electric vehicles.

The article also assumes that stagnant power sales will force electric utilities to cut costs or raise prices to cover investments in the grid and power plants. According to the authors, the industry has "cut costs for two decades" so "they will have to raise prices."

This environment will create "an easier entry for competitive products," resulting in further erosion in sales and price increases to "pay for all of the overhead they installed unnecessarily" while competitors continue to take market share.

Two technologies threaten incumbent power producers: advances in lithium-ion batteries and micro-grids that allow "local customers to band together to distribute electricity and possibly even to reduce or store power."

The authors cite Apple (NASDAQ:AAPL), SolarCity Corp. (NASDAQ:SCTY) and Alphabet's (NASDAQ:GOOGL) (NASDAQ:GOOG) Google as companies with the "name recognition, deep pockets and marketing smarts" to "substitute for the legacy utility."

Completing the scary narrative, the authors charge that utilities have taken on significant leverage and find themselves in a weakened financial position "on the eve of dramatic challenges." For these naysayers, the recent wave of mergers and acquisitions in the industry represents "a tacit admission of failure." All these headwinds will culminate in a consumer movement toward micro-grids.

These dire warnings may sound familiar because they constituted the conventional wisdom among bears in early 2014. Investors who heeded this call missed out on a more than 60 percent return in the Dow Jones Utilities Average.

Utility stocks trade at unsustainably high valuations today - a cause for concern. But the doomsday scenario laid out in Barron's has a number of glaring holes.

Let's start with the question of whether electricity sales have peaked in the US. Yes, the replacement of older household appliances with new models has resulted in energy savings, especially as American consumers have stepped up their spending on durable goods after the Great Recession.

However, this trend may be losing steam. Weather-normalized electricity sales reported by utilities have actually picked up in many regions, despite lackluster US economic growth.

Further energy savings will likely come primarily from investment in the transmission grid to improve reliability and reduce waste. The installation of smart meters represents the first wave of these investments; the second phase will include storage technologies and even distributed generation, eliminating the significant costs associated with buying electricity under contract or building power plants.

Utilities in California have managed to reduce costs and expand their rate bases, growing their earnings while reducing the size of customers' bills. It's no accident that Edison International's (NYSE:EIX) Southern California Edison became the first adopter of grid storage technology.

As for the prospect of Apple or Google disrupting the power industry, major technology companies have adopted distributed generation - usually in partnership with incumbent utilities. Dominion Resources (NYSE:D), for example, developed an 80-megawatt solar-power farm that serves Amazon.com (NASDAQ:AMZN).

Apple and Google are also far more likely to spend their time, energy and money competing with AT&T (NYSE:T) and Verizon Communications (NYSE:VZ) in familiar businesses than to enter a new arena that has claimed so many failures.

SolarCity has lost a progressively higher proportion of every dollar that it earns in incremental revenue over the past three years. With these reverse economies of scale, the solar-power company's business poses more of a threat to its own solvency than to US electric utilities, many of which enjoy access to low-cost debt and equity capital.

Over the past decade-and-a-half, electric utilities have systematically reduced operating risk and shored up their balance sheets by cutting interest expense and extending debt maturities. This financial strength has enabled the sector to take advantage of investment opportunities related to growing demand for natural gas and renewable energy.

Make no mistake: Utility stocks trade at unsustainably high valuations, as lackluster US economic growth and the Federal Reserve's reticence to hike interest rates have prompted the thundering herds to stampede into the sector.

Utility stocks may be overdue for a pullback in the near term, but their future prospects remain undiminished.