* All data are as of the close of Wednesday, November 5, 2014.
* Emphasis is on company fundamentals and financial data rather than commentary.
While the utilities sector is generally considered defensive, you'd be surprised at the stock performance over the years of some of its companies.
As noted in the graph below, since the economic recovery began in March of 2009, where the broader market index S&P 500 [black] has risen some 200%, and the SPDR Utilities ETF (NYSE: XLU) [blue] has risen only 100%, two of the three largest U.S. Gas Utilities - ONEOK Inc. (NYSE: OKE) [beige], and Integrys Energy Group, Inc. (NYSE: TEG) [orange] - have beaten both the S&P and XLU, rising 610% and 250% respectively.
Meanwhile, the second largest U.S. Gas Utility - CenterPoint Energy, Inc. (NYSE: CNP) [purple] - while not beating the broader market, has managed to outperform the utilities sector as a whole with gains of 175%.
On an annualized basis, where the S&P index has averaged 35.29% and the utilities fund XLU has averaged 17.65%, CenterPoint has averaged 30.88%, Integrys has averaged 44.18%, while ONEOK has averaged a spectacular 107.65% per year!
Just why have these so-called defensives been performing so well? Two reasons, really, and they both involve low interest rates.
Firstly, since the U.S. Federal Reserve lowered its overnight inter-bank lending rate to near-zero (between 0% and 0.25%) at the end of 2008 in order to help repair the damage to the economy caused by the financial crisis, capital has been extremely cheap to acquire. Companies that are heavily loaded with debt, therefore, have been able to refinance older more expensive debt with newer cheaper debt, lowering their operating costs and boosting their profits.
Since utilities are among the most indebted of all companies (the three utilities here compared carry debt burdens ranging from 57% to 78% of their market caps), these lower interest rates have made a huge impact on profitability by lowering debt costs.
Remember too that utilities are not growth companies given the restrictive territories they operate within. In a sector where growth is hard to come by due to these geographical constraints, anything that improves profitability by even a little will have a huge impact on the stock price.
The second reason they have performed so well over recent years is again due to low interest rates, as utilities offer more attractive yields than bonds. For instance, as the yield on the 10-Year U.S. Treasury bond fell from 4.25% in 2008 to below 2% in 2011 and 2012, and has remained perpetually below 3% since, the higher dividends offered by utilities (the three utilities here compared offer dividends ranging from 3.7% to 4%) have enticed not just individual investors but also large pension and investment funds.
But of you're thinking the good times in the utilities sector will continue, you might be in for a disappointment, as tabled below, where green indicates outperformance while yellow denotes underperformance.
While the Gas Utilities industry's earnings growth is seen outperforming the broader market's S&P average earnings growth in the current quarter, next quarter looks destined to underperform, as does 2015. This is likely due to rising natural gas costs which have already risen from a multi-year low of $3.63 per MMBtu to $4.19 for a rise of 15.4% in just the last two weeks. Constrained gas supplies in Europe are expected to deplete the surplus accumulated elsewhere over this past summer, resulting in further rises to the natural gas price, and cutting into gas utilities' profits.
Over the longer term as well, gas utilities are seen underperforming the broader market by some 16.9% less over the next five years, as tabled below. This is likely due to the expected rises in interest rates as the Federal Reserve gradually returns rates to their normal levels, once again making the utilities' debts more costly to burden and cutting into profits.
Zooming-in a little closer, the three largest American companies in the industry are seen underperforming the broader market as well with just two exceptions: Integrys in the current quarter and ONEOK in 2015. Apart from those two bucks against the trend, the overall trend is for the gas utilities' earnings to vastly underperform the market's average growth.
But if you still want to hold the gas utilities for their better-than-average yield, which of the three would make the best investment?
Let's answer that by comparing their company fundamentals using the following format: a) financial comparisons, b) estimates and analyst recommendations, and c) rankings with accompanying data table. As we compare each metric, the best performing company will be shaded green while the worst performing will be shaded yellow, which will later be tallied for the final ranking.
A) Financial Comparisons
• Market Capitalization: While company size does not necessarily imply an advantage and is thus not ranked, it is important as a denominator against which other financial data will be compared for ranking.
• Growth: Since revenues and expenses can vary greatly from one season to another, growth is measured on a year-over-year quarterly basis, where Q1 of this year is compared to Q1 of the previous year, for example.
In the most recently reported quarter, Integrys posted the greatest revenue growth while CenterPoint delivered the least, actually shrinking some.
Since CenterPoint's and Integrys' earnings growth are not available, the metric will not factor into the comparison.
• Profitability: A company's margins are important in determining how much profit the company generates from its sales. Operating margin indicates the percentage earned after operating costs, such as labor, materials, and overhead. Profit margin indicates the profit left over after operating costs plus all other costs, including debt, interest, taxes and depreciation.
Of our three contestants, CenterPoint operated with the widest profit and operating margins while ONEOK contended with the narrowest margins.
• Management Effectiveness: Shareholders are keenly interested in management's ability to do more with what has been given to it. Management's effectiveness is measured by the returns generated from the assets under its control, and from the equity invested into the company by shareholders.
In returns on assets and equity, ONEOK's management team returned the most in both, while CenterPoint's team returned the least on assets and Integrys' team returned the least on equity.
• Earnings Per Share: Of all the metrics measuring a company's income, earnings per share is probably the most meaningful to shareholders, as this represents the value that the company is adding to each share outstanding. Since the number of shares outstanding varies from company to company, I prefer to convert EPS into a percentage of the current stock price to better determine where an investment could gain the most value.
Of the three companies here compared, Integrys provides common stock holders with the greatest diluted earnings per share gain as a percentage of its current share price with CenterPoint not far behind, while ONEOK's DEPS over stock price was the lowest.
• Share Price Value: Even if a company outperforms its peers on all the above metrics, however, investors may still shy away from its stock if its price is already trading too high. This is where the stock price relative to forward earnings and company book value come under scrutiny, as well as the stock price relative to earnings relative to earnings growth, known as the PEG ratio. Lower ratios indicate the stock price is currently trading at a cheaper price than its peers, and might thus be a bargain.
Among our three combatants, ONEOK has the most overpriced stock relative to forward earnings, company book value and 5-year PEG. Better value can be found in the other two stocks, with Integrys being the cheapest relative to forward earnings and company book, while CenterPoint is the cheapest relative to 5-year PEG.
B) Estimates and Analyst Recommendations
Of course, no matter how skilled we perceive ourselves to be at gauging a stock's prospects as an investment, we'd be wise to at least consider what professional analysts and the companies themselves are projecting - including estimated future earnings per share and the growth rate of those earnings, stock price targets, and buy/sell recommendations.
• Earnings Estimates: To properly compare estimated future earnings per share across multiple companies, we would need to convert them into a percentage of their stocks' current prices.
Of our three specimens, both CenterPoint and Integrys offer the highest earnings percentages over their current stock prices over the near term, while Integrys offers the highest percentage over the next 5 years. At the low end of the scale, ONEOK offers the worst earnings over current stock price for next quarter and 2015.
• Earnings Growth: For long-term investors this metric is one of the most important to consider, as it denotes the percentage by which earnings are expected to grow or shrink as compared to earnings from corresponding periods a year prior.
For earnings growth, Integrys is projected to deliver the greatest growth in the near quarters, while ONEOK is expected to deliver it in 2015 and beyond. At the low growth end of the spectrum, both CenterPoint and ONEOK are seen shrinking their growth over the current and next quarters respectively, while Integrys offers the lowest growth over the next 5 years.
• Price Targets: Like earnings estimates above, a company's stock price targets must also be converted into a percentage of its current price to properly compare multiple companies.
For their high, mean and low price targets over the coming 12 months, analysts believe Integrys' stock has the least upside potential and greatest downside risk, while ONEOK's stock has the greatest upside potential and CenterPoint's has the least downside risk.
• Buy/Sell Recommendations: After all is said and done, perhaps the one gauge that sums it all up are analyst recommendations. These have been converted into the percentage of analysts recommending each level. However, I factor only the strong buy and buy recommendations into the ranking. Hold, underperform and sell recommendations are not ranked since they are determined after determining the winners of the strong buy and buy categories, and would only be negating those winners of their duly earned titles.
Of our three contenders, CenterPoint is best recommended with 4 strong buys and 5 buys representing a combined 64.28% of its 14 analysts, followed by ONEOK with 3 strong buy and 2 buy recommendations representing 35.72% of its 14 analysts, and lastly by Integrys with 0 strong buy and 0 buy ratings representing 0% of its 6 analysts (all of whom recommend holding).
Having crunched all the numbers and compared all the projections, the time has come to tally up the wins and losses and rank our three competitors against one another.
In the table below you will find all of the data considered above plus a few others not reviewed. Here is where using a company's market cap as a denominator comes into play, as much of the data in the table has been converted into a percentage of market cap for a fair comparison.
The first and last placed companies are shaded. We then add together each company's finishes to determine its overall ranking, with first place finishes counting as merits while last place finishes count as demerits.
And the winner is… CenterPoint by a sizable lead, outperforming in 12 metrics and underperforming in 7 for a net score of +5, followed by Integrys, outperforming in 10 metrics and underperforming in 10 for a net score of 0, and finally by ONEOK in the distance, outperforming in 8 metrics and underperforming in 13 for a net score of -5.
As a sector, investors ought to recognize that while utilities are viable as defensive instruments that provide higher than average dividend income with less than average downside risk during corrections, they are not growth companies by the nature of their territorial boundaries, and will be slowed over the coming years as rising interest rates cut into their profits, given their disproportionately high debt burdens.
Hence, where the Gas Utilities industry is expected to outperform the S&P broader market modestly this quarter, underperform substantially next quarter and in 2015, and underperform modestly beyond, the three largest U.S. companies in the space are expected to underperform moderately to substantially over both the near and long terms, with only the two exceptions of Integrys this quarter and ONEOK in 2015.
Yet after taking all company fundamentals into account, CenterPoint stands first among its peers given its lowest stock price relative to 5-year PEG, highest cash over market cap, widest profit and operating margins, highest EBITDA over market cap and revenues, highest future earnings over current stock price near term, best low price target, and most strong buy and buy analyst recommendations - handily winning the Gas Utilities industry competition.