Strong Dividends, Steady Earnings & Stock Gains

There are many factors that influence utility stock performance and dividend tax policy is but one. Nevertheless, the numbers serve to highlight the importance of the 15% dividend tax rate to the industry’s ability to attract capital.

Stock Performance

The EEI Index posted a solid 10.8% gain for the first half of 2013, a move that will make for a strong year if utility stocks can hold their ground during the second half. But it wasn’t enough to outperform the broad market, as the Dow Jones Industrials gained 15.2%, the S&P 500 climbed a slightly weaker 13.8% and the tech-heavy NASDAQ, held down by sluggish performance by technology shares, posted a 12.7% gain. This grouping of first half returns within a reasonably close band masked what proved to be the most volatile stretch for utility stocks since the financial crisis of 2008/2009 threw all markets into turmoil.

The year-to-date period has been quite unusual, as market gains through May—fueled by massive support from the Federal Reserve’s quantitative easing program and augmented by Japan’s even more vigorous experiment with exceedingly loose monetary policy under new Prime Minister Shinzo Abe—were led by defensive, dividend-paying sectors such as utilities, healthcare, consumer staples and telecom services. Strong market advances are usually led by economically sensitive cyclical sectors, as investors anticipate that strengthened economic activity will lead to broad-based earnings gains.

Indeed, utility shares surged 20% from the start of the year through mid-May, then sharply dropped 13% through late June when talk by Federal Reserve officials hinted the central bank may “taper” its quantitative easing program if economic data improves. While Fed statements indicated no substantive policy change, the mere thought of a reduction in monetary support for markets was enough to cause a spike in interest rates, as the yield on the 10-year Treasury bond jumped from 1.6% in early May to 2.6% by late June.

The EEI Index’s quarterly results convey a similar pattern—returning 13.3% in Q1 then -2.2% in Q2—but the data alone doesn’t reveal the considerable volatility during the period.

Macro Forces

The first half of 2013 amplified a theme that has characterized utility stock performance since the financial crisis: Broad-based global macroeconomic trends, such as changes in commodity fuel prices, interest rates and the pace of economic growth, have governed the movement of share prices more than any significant change in industry fundamentals, which are fairly slow to evolve given the industry’s focus on regulated business models and the mostly predictable nature of electricity demand growth.

Indeed, the industry’s multi-year migration to an increasingly regulated structure continued in 2012. At year-end, EEI’s group of regulated companies (where more than 80% of assets are regulated) totaled 37 of a total 56 companies, while the Mostly Regulated group (50% to 80% assets are regulated) totaled 17. The Diversified group (less than 50% of assets are regulated) fell to only two companies, one of which (Energy Futures Holdings) is privately held. The figures at year end 2005 were Regulated (33 of 68), Mostly Regulated (24 of 68) and Diversified (11 of 68), illustrating both the magnitude of structural change in the industry over the past eight years as well as the impact of M&A and buyout activity on the total number of companies.

The reduction in the number of Diversified companies to only one publicly traded stock makes category returns less indicative of trends within the industry than they used to be. During the first half of 2013, the Regulated and Mostly Regulated categories showed fairly similar returns of 13.0% and 15.8%, respectively, in Q1 and 0.4% and -3.4% in Q2, while the Diversified’s two positive returns, 15.0% and 7.6%, were all derived from sole constituent MDU Resources. The company’s oil business benefitted from increased production at its Baaken and Paradox basin properties and its construction services business grew its contract backlog. Both developments prompted stock upgrades by Wall Street analysts and supported a rally through quarter-end that defied late-quarter weakness among most other utilities.

Demand Growth

The first half of the year brought an extension of another key industry trend—slow end-user electricity demand growth. While a cold March, when heating degree days were 11% above the historical average, helped power a 3.3% rise in electric output during Q1 (for the lower 48 states), output fell 2.2% in Q2, bringing growth during the year’s first half to just 0.5% year-to-year. Due to a combination of energy efficiency measures, the decline in industrial output as a contributor to U.S. economic growth and a slow-growth economy, nationwide power demand has shown no growth since 2007, when U.S. electric output was 4,100,611 gigawatt hours.

Output has declined slightly in each of the past three years, falling to 3,995,885 gigawatt hours in 2012 from 4,065,051 in 2011 and 4,090,200 in 2010. The industry’s forward looking expectation is only a modest 0% to 1% overall growth rate, with variations across different regions of the country tied to local economic trends and weather, a marked slowdown from the higher-single-digit growth that characterized much of the last several decades.

Competitive Generation

Natural gas spot prices, an important factor that has shaped power prices and industry fortunes in recent years, showed some strength during Q1, rising from $3 per million British thermal units to near $4 per million BTU by quarter end, but then held around $4 through the end of Q2. And the natural gas futures curve showed no net change from yearend 2012 to the end of June. There was little relief for competitive generators, who are suffering from a multi-year decline in natural gas prices that has eroded power prices in many competitive markets.

Combined with stagnant demand and generally adequate reserve margins nationwide (with the exception of the Texas market, where analysts see demand growth and opportunities for generators with a footprint there), the year’s first half brought no evidence of impending change in competitive market trends. The bearishness was reinforced by weak capacity auction pricing in the PJM Regional Transmission Organization (RTO) auction in May, where pricing for some locations fell by more than 50%, driven down by weak demand and significant new natural gas plant additions in recent years.

A strong rise in wind power production has also had an impact, pushing off-peak capacity needs and pricing down as wind production is strongest at night and is supported by the production tax credit. The weak PJM auction was cited by many analysts as a factor that compounded the June sell-off in utility shares, weighing on those with merchant exposure to the region.

Rate Base Growth

Slow demand growth and adequate capacity across most of the country is taking a toll on the industry’s formerly torrid pace of capital expenditure and rate base growth. EEI’s latest projections for industry capex anticipate a slowing from $95.3 billion in 2013 to $92.0 billion in 2014 and to $85.0 billion in 2015. Many analysts have ratcheted down slightly their expectation for earnings growth by regulated utilities, although they still expect that many are capable of low- to mid-single-digit gains in both earnings and dividends.

A review of consensus analyst estimates for the 50 publicly traded EEI Index companies confirms that general outlook. The average revenue growth across the industry (calculated as an arithmetical average of analyst projections, not accounting for market capitalization) shows projected growth of 4.6% in 2013 slowing to 3.0% in 2014. The average projected five-year earnings growth rate for the industry is 4.3% as of mid-July, ranging from small single-digit declines for some utilities exposed to weak prices for competitive generation to as high as 7% to 8% for companies undertaking relatively strong capital investment programs and/or benefitting from supportive regulatory outcomes in recent rate cases.

Carbon Capture

In recent years, there has been a general expectation across the industry that widespread public and political concern over global warming would eventually lead to some form of nationwide CO2 regulation, and President Obama made this a second-term priority with a policy speech delivered in late June in which he called on the Environmental Protection Agency (EPA) to develop measures to reduce greenhouse gas emissions under the authorization provided by the Clean Air Act.

It’s possible that a future carbon remediation regime will eventually require significant investment in carbon capture and storage technologies, but it will take several years before mandated requirements are clear. The president’s directive sets a time frame of June 2014 for the EPA to develop proposed standards for existing plants, with finalization of standards targeted for June 2015 (a goal was set to propose rules for new plants by September of this year).

There appeared to be little about the president’s plan that wasn’t consistent with general expectations on the part of the industry and Wall Street analysts. And it is not until late in the decade that final rules—in whatever form they ultimately take—would go into effect. As a result, the speech had little impact on the current or even medium-term outlooks for utility stocks; other forces impacting industry fortunes will likely have a far stronger role in shaping stock price changes over the next few years.

Yet it’s fair to note that the financial burden of longer-term investment stemming from carbon regulation will fall most heavily on competitive coal generators, which cannot finance capital spending in regulated rate base and run the risk that market forces could make such investment un-economic. And given the myriad forces at play—from economic growth, fuel price changes, technological change that may affect electricity usage patterns, movement of interest rates, to name just a few—any predictions as to the ultimate impact of CO2 regulation on the industry’s stock prices would be speculation.

Share Valuations

The Federal Reserve’s relentless support of the financial system through near-zero short-term interest rates and its suppression of long-term yields through the purchase of Treasury bonds and mortgage-backed securities have held interest rates at multi-decade lows since the financial crisis. Whether the May-June rate spike marks the first stage of an inevitable bear market for bonds, with a prolonged period of rising rates, remains to be seen. But there’s no doubt that historically low market yields have distorted traditional regulated utility valuation metrics.

Analysts observed that the 20% jump in utility share prices through early May brought utility price-to-equity (or PE) ratios, based on 2014 earnings, to their highest premium relative to the S&P 500 since the 1960s—a rich 25%. And when the utility industry’s approximate 4% dividend yield is compared against the S&P 500’s 2% yield, utilities also look pricey; analysts note utility dividend yields would have to climb to 5% (meaning share prices would have to fall) to bring the difference back to its historical average.

Of course, such metrics aren’t precise indications of fair value at any point in time—market trends can take stocks away from fair or historically average values for extended periods—but they do serve as rough indicia of valuation patterns. On the other hand, compared to today’s very low corporate bond yields, utilities are decidedly cheap, with dividend yields only 1.5% below BBB corporate bond yields versus a historical average of about 3%. This means either utility shares can rise (reducing yields and increasing the gap to more normal levels) or bond yields can rise (meaning dividend yields and utility stock prices might remain stable even in an environment of rising rates).

Industry balance sheets are sound, dividends appear to be generally safe and supported by healthy business fundamentals, and the industry’s regulated focus offers long-term stability in an uncertain economy. Utility investors get dividend growth potential in addition to favorable tax treatment relative to bonds, an attractive mix for investors willing to assume the share price risk.

Utility stock price trends in the immediate future will probably mirror those of the past few years. Utilities will likely do better than the broad market if economic growth stalls, interest rates fall and the fears that stalk markets return—whether in the form of instability in Europe, slowdown in China, or eruption of geopolitical risks in emerging markets such as Brazil, Turkey or in the Middle East.

Conversely, if all is quiet on the risk front and confidence in economic growth strengthens, interest rates will likely continue to rise. Whether that means utility shares fall remains to be seen, but they will probably lag the performance of other sectors when bullish sentiments dominate markets.