Lower Multiples are a Good Case for Utility Investing

Virus Impact on Utilities is Low, Should Utility Stocks be Down Sharply?

Utility stocks, as measured by the Philadelphia Utility Index (UTY), have fallen 12% year to date. This compares to a 16% decline in the Dow Jones Industrial Average, a 10% decline in the S&P 500 Index, and a 22% decline in the Russell 2000 Index. Utility stocks are conservative investments befitting their low Beta numbers. When broader markets rise, they go up, but by a smaller amount. When broader markets fall, they decline, but by a smaller amount. With the drop in utility stock prices, valuation multiples have declined as earnings, and cash flow projections have largely held steady in recent months. Do lower multiples make a strong case for utility investing? Leading utility analysts such as Andrew Weisel of Scotia Capital argue as much. Or, are there other factors related to COVID-19 to consider before diving into the stocks?

The Case
for Utility Stocks

High yields protect returns. Stocks of Utilities generate steady cash flow because rates are regulated, and sales are predictable. This allows utility management to return a portion of its cash flow back to investors through a high dividend. Investors find this comforting because a portion of their expected return is stable even if a utility’s stock price is not. With an average utility yield around 3%, the spread between utility yields and government bonds has risen fivefold in the last two years.
Demand for utility services is
stable. The economic downturn will undoubtedly force consumers to cut back on discretionary spending. Electric, gas, and water services are not discretionary, especially when people are spending more time in their homes. Industrial and commercial demand will undoubtedly fall. However, margins on larger-user rates are small, and the impact of lost sales will be muted.
Utility stocks should perform well in
today’s low-interest-rate environment. Utility stocks perform well when interest rates are low or falling. This is because their high yield makes them investment surrogates to bonds. It is also because most utilities are highly leveraged, and lower interest rates mean lower financing costs.
Regulated returns protect utilities
against any negative effects of COVID-19. Utility pricing is set by individual state regulators and designed to provide utilities the opportunity to earn a fair return on their shareholders’ investments. This limits a utility’s upside but also protects it against competitive pressures, decreases in demand, rising costs, etc. If there is a negative impact from COVID-19, a utility would have the option to file for higher rates to offset the impact.
Lower fuel costs could help demand. Oil, natural gas, and coal prices have fallen in response to expectations for decreased demand due to the economic downturn. As the cost to produce utility services fall, it is typically passed on to customers through fuel adjustment clauses. Thus electric and gas costs to customers will be lower. To the extent that demand is price-sensitive, utility sales could increase.

The Case Against
Utility Stocks

Uncollectable expenses will rise. A 2018 report by the Energy Information Administration (EIA) found that a third of all Americans have trouble paying off their energy bills. A 2016 McKinsey report found that utilities wrote off approximately two percent of their non-collectible revenues as bad debt. That percent will undoubtedly increase in response to a sharp rise in unemployment.
Demand is falling. The U.S. Energy Information Administration expects electric demand to fall by 3% overall this year because of business closures. If you think that lost electric, gas, and water sales to business will be offset by increased use at home, think again. Most homeowners do not adjust their thermostats when they leave their homes and will not consume more services when they are at home more.
Rate relief will be tougher to obtain. As regulated entities, utilities can petition for a rate increase if they feel it does not have an adequate chance to earn a fair return on equity. However, a fair return is typically defined as a level above risk-free rates designed to compensate investors for additional risks taken. With government bond yields at historical lows, the allowed returns granted utilities are also declining. In addition, regulators are facing increased political pressure to lessen the burden on constituents given economic hardships. Therefore, it’s possible that regulators may recognize that utilities are earning less due to decreased demand or higher costs but still not grant rate relief.

Take-Away

Utility stocks have been largely ignored over the last fifteen with the economy and the broader market soaring. They are receiving increased attention in response to COVID-19 and a decline in the stock market. Like all industries, utilities will be negatively affected by an economic slowdown. However, the impact is likely to be less than in other industries. Meanwhile, utility stock prices have fallen sharply, almost as much as the overall market, making now a good time to review your portfolio and consider investing in utilities.

Virus Impact on Utilities is Low, Should Utility Stocks be Down Sharply?

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