Utility stocks are now being priced as if they were the growth stocks they were in the 1950s. The TTM P/E is 20X. EPS growth has been low single digits.
How much upside versus risk there is in these names right now is the topic of this article.
The Utilities Select Sector SPDR ETF (NYSEARCA:XLU) has outperformed the large-cap stock market (NYSEARCA:SPY) by over 10 points over the past 12 months. It has also provided superior total returns over the past 2, 5 and 10 years. Powerful indeed.
I pay a bit more attention to utilities, and invest in them, more than I write about.
On May 29, 2014, I wrote my only Seeking Alpha article on an electric and gas utility. This piece, on Consolidated Edison (NYSE:ED), was titled: Con Ed Provides Income, Safety, And - Surprise! - Price Appreciation Potential
I concluded by saying:
While it may appear odd, ED has a chance to appreciate significantly simply on the basis that ED's yield may drop over time to "catch down" to prevailing Treasury bond rates.
When I wrote that article, ED had closed at $54.52. It has now closed at $74.75. That's quite an amazing total return for such a boring company. Over the past 24 months, ED's stock price has outperformed that of Celgene (NASDAQ:CELG) by almost 10 points while also providing an 8+% dividend yield versus none from CELG. It has outperformed AbbVie (NYSE:ABBV), Amgen (NASDAQ:AMGN) and Gilead (NASDAQ:GILD) by a huge amount.
Now it's time to reverse the bullish call on ED and by extension other utilities. Here's why: Their valuations have reached extreme levels. For accounts that lack tax consequences of selling at price spikes, such as IRAs, this looks to me like a time to be fearful when others are being greedy and cycle from utilities to assets with either greater safety of total return over the next year or several years, or that have lower P/Es and better secular growth potential.
I'll make the case that it could be lights out for utility stocks, i.e. they are at risk of a large zero to negative return in nominal terms for years to come. I'm not predicting any bankruptcies, but dividend cuts are possible for any utility. Here's my analysis, point by point. For purposes of discussion, I'm going to focus on electric generation. Many utilities distribute gas as well, and do renewables. But to keep things simple, I'll focus on traditional electric utilities that both generate and distribute electricity to retail customers.
1. Electricity is a no-growth business that has already achieved negative growth
A blogger presented a graph generated from the EIA showing annual growth of electric power generation in the US over the decades:
The downtrend is clear, as is the sensitivity to recessions.
The EIA shows the retail sales of electricity by year, in kilowatt hours, in an interactive tool. In 2005, that number was 3,660,969. In 2015, ten years later, that number had grown to 3,724,525. The CAGR over that decade was a pathetic 0.17%. Basically zero.
Worse, retail sales were 3,754,841 in 2010, the first non-recessionary year after the Great Recession. Obviously, there has been negative growth since then.
2. Prospects are for this downtrend to continue and perhaps worsen
Just think of the reasons why electricity volumes are flat to down over the past 5 years. Here are 6 reasons, in no special order, with comments as appropriate:
a. Aging population
The older you are, the more doctors you visit and the less electricity you burn.
b. Record low fertility rates
Fewer growing families limits power demands.
c. Growth sectors of the economy demand little power
At the turn of the millennium, I read a factoid that compared with the economy of 1900, the actual weight of the country's GDP had not increased. Yet obviously, GDP had increased greatly. To oversimplify, steel and cement production had given way in importance to bits, bytes, pharmaceuticals, etc.
This trend is clearly continuing.
d. Former customers are generating their own power via solar technologies
This is a big and growing situation given the trends have been poor for electricity power generators for years, as demonstrated above. Every rooftop solar installation that leads to hot water or swimming pool heating, or perhaps other tasks, goes directly out of a utility's sales. Worse, Tesla (NASDAQ:TSLA) and likely soon others are marketing enhanced electricity storage units for businesses and homes. As those gradually get used more, there will be no wastage of home solar power that gets generated.
For exurban and rural homeowners, larger-scale solar installations are becoming more common.
e. Appliances are getting much more efficient, and doing so much faster than the population is growing
Under the new energy rules, everything from hot water heaters to A/Cs to dishwashers and fridges are more efficient than the old stuff. If the average age of these machines is in the 10-12 year range, that turnover is vastly greater than the new housing units that create greater numbers of these machines. This is going to bring electricity usage down substantially and inexorably.
Beyond large machines that draw electricity, the little things such as smartphones are increasingly energy efficient.
f. LEDs are a big deal
The phasing out of the incandescent light bulb is a multi-year process that leads in the same depressing direction for utilities. LEDs and fluorescent bulbs draw a lot less power than incandescents. In addition, LEDs especially have a secondary benefit, namely they are so much cooler than incandescents that A/C usage is decreased. This matters a lot in the still-growing Sunbelt.
Interim conclusion: Electric utilities are in a bad business
3. Valuations are at extreme levels for a no-growth industry
Investors appear to have been driven mad by a combination of ZIRP and near-ZIRP along with momo investing. I never, ever thought that utilities would be momentum stocks, but here we are. Even Value Line has named some utilities as #1-ranked stocks. That's because in the land of shrinking EPS, utilities have shown some EPS growth mostly due to friendly regulation and declining financing costs (thank you, Fed and other central banks). Then Value Line takes momentum into account. The result is that, for example, two Wisconsin-based utilities are ranked in the top 6% of stocks for price performance over the next year.
Take MGEE. Its dividend yield is 2.34%. Per its investor presentation, page 28, its CAGR of the dividend since 1909 is 3.6% per year. If this continues, then in about 20 years, the dividend will double - and that's not certain, as demonstrated above. A doubling of the dividend will give a 4.68% dividend yield in 2042 if the share price does not change from now until then. That would give an average dividend yield of about 3 1/2% annually.
Let's say that occurs. It should be no trick to get that much from a tax-free bond over that time frame, or from a safe corporate bond.
Then we need to ask, why shouldn't investors now rotate into AbbVie, yielding around 4%, or Amgen, yielding more than MGEE. Don't those companies have greater long-term growth prospects than MGEE?
The same goes for WEC, which has done a takeover and may have some transiently depressed earnings as a result.
But, basically, these are trading as if they are bonds "yielding" the reciprocal of their earnings. That's how their 25X P/Es can be justified.
And off of these extreme P/Es for leading utilities, less strong companies are seeing their P/Es surge, ranging from ED to yet more troubled companies.
XLU was trading at 19.77X TTM EPS per its sponsor as of 3/18.
4. Neither utility earnings nor dividends are really good bond substitutes in today's world
Modern utilities are debt-heavy entities that are subject to regulation. Based on the economy of the 1950s through the 1990s, returns on invested capital and other metrics that regulators look at, allowed returns in the 10% range look high, possibly far too high in today's slow-growth, low-price inflation economy. Since the allowed returns on investment only apply to the equity tranche of the company's capitalization, not the debt, declines in allowed rates of return have a disproportionate effect on profitability.
Investors need to understand that their safe world of gradually rising utility profits and dividends can end even if some degree of demand growth recovers.
5. A rising rate, rising inflation world could be worse for utility stocks than for bonds
It's a strange but true phenomenon. You can buy a 10-year Treasury, and in 10 years, $100 invested will turn into $120. Guaranteed, aside from taxes and interest on interest. Yet even if some growth and inflation return to the economy, allowing some increases in the dividend payouts from utilities, in 10 years their P/Es can easily drop so that their total return is zero or even negative. This was a disastrous problem for utilities in the much higher-growth 1965-81 period and could be the same or worse if 3-5% inflation returns without a lot of demand growth for electricity.
6. Technicals on XLU are extended
A simple 50-200 day EMA chart shows XLU at $48.58 and the 50- and 200-day EMAs at $46.37 and $44.53, respectively. As recently as Dec. 11, XLU traded as low as $41.50 and was below both those EMAs.
This is so dangerous because all we need is for XLU to drop to a much more normal 15X P/E, or a 25% drop, and it will take a 33% price gain to return to today's price.
Yet I'm dubious about any EPS gains at all going forward. So an extended chart and 20X P/E carries with it potential major danger.
7. Technicals on Treasuries are looking dangerous as well
If a sector is trading as a bond proxy, it would be well to check out whether Treasuries carry with them a lot of embedded optimism.
Right now, Treasuries may reflect over-optimism. Per FINVIZ, the positioning of the funds is heavily long the 30-year T-bond. This has been associated with trading bottoms in rates before:
The green line (net positioning of the commercials) is far below the zero line, really near a record level of speculators being long this bond. Since a 30-year bond trading at an interest rate of 2.7% is itself pretty speculative, I don't love that set-up. Worse, back in 2010 and again in 2012, we saw a similar level of commercial shorting, and major interim peaks in bond prices (minima in yields) proved to have been present in short order.
If I were still a utility stockholder, I'd be nervous about a back-up in long-term rates that compete with my stock for investor interest. (I've also been taking a good amount of trading profits in long-term Treasuries the past several weeks.)
8. Many utilities have large underfunded pension plans
The accounting for these is complex. My understanding is that at the least, if a pension manager assumes a traditional 7% rate of return in the old-fashioned defined benefit plans that most utility stocks I have looked at continue to have, then earnings are going to be overstated. These can be material. As of 12/14, per Value Line data, ED's pension plan was underfunded by over $3.5B. That's material given annual profits just above $1.2B.
The longer that interest rates stay low, superficially making utility stocks popular with investors due to their high dividend payout ratios, the greater the pension deficit goes as assumed rates of return decline. This problem worsens if at the same time, the SPY does not meet its total return assumptions.
Can the uptrend and outperformance continue?
Sure. Some growth can return to the industry; a proliferation of electric vehicles would help a lot.
From a more strictly financial standpoint, interest rates could stay low or decline more; that decline could occur in junk bond yields which compete with dividend payouts from utilities.
Another possibility is that cyclical parts of the economy could decline, and even though that would affect most electric utilities, their sensitivity to general business conditions is relatively limited. A resumption of faster population growth would help utilities as well.
My judgment is that the headwinds against further outperformance of this sector are stronger than the tailwinds. But, of course, there's always a good deal of unpredictability in these matters.
Concluding thoughts - better alternatives than utilities exist for investors
If one wants to be defensive, one can look at different types of insurers. Many of them are inexpensively valued.
If one wants exposure to cyclicals, I'd rather pay a 20X P/E for Deere (NYSE:DE) than the XLU. DE's only at 20X (based on its FY 2016 guidance).
Then we have Apple (NASDAQ:AAPL) at 11X and three dividend-paying large biotechs all trading cheaper than XLU: AbbVie , Amgen and Gilead. The average dividend yield of these three strong companies is similar to that of XLU. My view is that their growth prospects are superior in the long run to those of utilities.
Switching back to defensive plays, it's reasonable to think that bonds, whether junk bonds, high-grade corporates, Treasuries of different durations, or munis, could easily also outperform utilities.
The more I have thought about the utility sector in general and electric utilities in specific, the more I favor a modified 'lights out' scenario for the stocks relative to a number of other alternatives. The combination of no growth, high P/E, underfunded pension plans, high corporate debt levels outweighs a 3+% dividend yield in my mind. Add to that the fact that utilities and their stocks can be harmed both by unwanted inflation and unwanted deflation, and I look at the sector as unattractive for new money. Of course, tax and other considerations make long-term holders of the shares look at matters differently. Nothing said in this article is suggesting that the companies are headed for serious operating trouble. However, P/Es can drop quickly and/or substantially, and a significant decline in XLU at some point in the months and years immediately ahead may occur. If so, how the investing public would react is unknown if this is accompanied by fundamental weakness in operations of the companies.
To summarize, utility stocks used to be 'risk off' stocks. When they turn into performance vehicles, they transform to 'risk on' stocks, but a coat of fresh paint does not make an old house new.
I thus believe there are superior investment choices available in the markets today to XLU or the leading stocks in the index.
Disclosure: I am/we are long AAPL,AMGN,GILD.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.