Summary: A rising interest rate environment is rarely good news for the rate-sensitive utilities sector, yet there are transformational changes on the horizon which should boost electric utilities going forward and override the negative impact of higher rates.

Stocks of utility companies have had a rough couple of years, with the Utilities ETF (XLU) lagging the S&P 500 ETF (SPY) by almost 37% over that period. Meanwhile, the street’s current stance appears to be mixed. Moody’s just downgraded the U.S. regulated utility sector to negative, citing the new tax law as having an adverse impact on cash levels. In contrast, Morgan Stanley has upgraded the sector to Outperform, due to its role as a defensive stock market play. Given these mixed views, we thought it would be a good time to review MRP’s Long Electric Utilities theme.

As can be inferred from our theme, all utilities should not be lumped together; the electric segment has a much brighter outlook for the first time in many years, particularly in places like the United States. Although America’s electricity industry has struggled with flat demand for power in recent years, the nation is moving towards more electricity consumption, not less. Indeed, the growth of renewable energy, advances in energy storage, cryptocurrency mining, the explosion of connected devices which feed into data centers, and the increase in electric-powered transportation – from scooters, to cars, buses, ships, and even planes – all point to greater electricity consumption going forward. This makes electric utilities a convenient picks-and-shovels play on all these trends.

As noted in previous DIBs reports, the EV revolution on its own represents a massive secular growth opportunity for electric utilities. In the U.S. a typical electric car would use 261 kWh monthly, which could increase that household’s demand for electricity by 25 to 40%. In Europe, the revenue opportunity is even greater, as an electric car driven 15,000km per year would approximately double the household’s energy use.

In preparation, many power companies are already rolling out EV charging infrastructure programs. In California, for example, San Diego Gas, Southern California Edison, and Pacific Gas and Electric plan to build 12,500 charging stations across public locations.

Meanwhile, the EV adoption rate is accelerating. Sales of electric vehicles in the U.S. are on track to rise almost 60% this year, from the 198,000 sold in 2017. With EVs accounting for a mere 1.5% of new U.S. car sales, the growth opportunity is tremendous. Electric utilities are positioning themselves to make money from either selling energy for charging cars and/or managing charging points. Some power companies are even looking to provide electric cars to customers as a service, with the fees for energy and car rental combined into one bill.

And, while the entire electric utility sector itself is in flux due to a rapidly changing market structure, companies are creating new business models to survive. Some have given up producing power themselves, and simply trade what others produce. Others have switched to managing distributed supplies, while yet more have become suppliers of energy management services.

MRP added Long Electric Utilities as a theme on November 20, 2017, and although it has underperformed the market since that launch date, the rationale of the theme remains intact. The rise of electric transportation, cloud computing, IoT devices and cryptocurrencies, combined with the growing pool of distributed energy sources should increase demand for electricity going forward. Although the real impact of these changes on kilowatt consumption is still down the road, these are seismic shifts and they are unfolding right in front of us every day. In our view, it is only a matter of time before their impact is felt.

As the market begins to recognize that electric utilities will become a growth business, rather than the zero-growth they’ve been known to be over the past 20 years, the industry will be re-rated, pushing the share price of electric power companies higher.

As a dividend-paying sector, utilities traditionally experience headwinds in a rising-rate environment. However, the secular changes noted above are transformational enough to counter that headwind. In fact, despite two rate hikes over the past 3 months, utilities have been performing notably better as shown in the 3-month chart below.

There is no pure play electric utilities ETF, but investors can still gain exposure via the Utilities Select Sector SPDR Fund (XLU) and the Invesco S&P SmallCap Utilities ETF (PSCU), both of which are heavily weighted towards electricity producers. Going forward, MRP will monitor the theme via the PSCU, given our preference for small cap value companies in the current interest rate cycle.

Here are some previous DIBs reports on the subject:

We’ve also summarized the following articles related to this topic…

 

Utilities: Big Coalition Releases Vision for Electrified Future

A diverse group of more than 50 businesses, clean energy advocates and consumer groups including NRDC, General Motors, Siemens, Consumers Union, and Advanced Energy Economy, today released a new national vision for a clean, modern, and electrified future of mobility with a groundbreaking Transportation Electrification Accord.

This deployment, in partnership with EV charging companies, should:

Foster innovation in EV charging services by providing new avenues for competition;

Encourage the use of new technologies that enable EVs to help keep the grid running smoothly; for example, technologies that encourage EV charging when renewable energy is abundant on the electric transmission system; and

Create a charging experience that is open and accessible for all, meaning that you don’t need a wallet full of plastic payment cards from every charging station company to charge on the way from Point A to Point B.

In short, utility investments that support these principles and beget utility customer benefits should be approved in service of driving transportation electrification forward. NRDC

 

Utilities: Utilities are in need of a new model

Over the past 10 years, energy utilities across the world have delivered average cumulative shareholder returns of just 1%. By comparison, the performance of a global index of overall corporate performance showed a gain of 55%. What has caused this chronic underperformance?

One problem is the failure of individual companies to adapt to a rapidly changing market structure. The old model of large-scale, centralised power stations pumping out electricity to passive consumers is out of date. But the preference for renewables that produce power when the wind blows or the sun shines leaves many utilities with older assets such as gas-fired power plants, which are needed to maintain continuous supply but are running at far less than capacity and quickly become uneconomic.

The utilities have begun to identify new ways of working. Some have given up producing power themselves, and simply trade what others produce. Others have switched to managing distributed supplies, while yet more have become suppliers of energy management services.

The sector is in flux and only those most capable of adapting will survive. It is not hard to imagine investors giving up on traditional utilities or to envisage new players that will apply technology, especially around data management, to create entirely different business models. FT

 

Utilities: A Defensive Play: Morgan Stanley Upgrades The Utilities Sector 

Morgan Stanley has upgraded the utilities sector to Outperform, and analyst Michael Wilson said the fact that stock prices aren’t keeping pace with earnings growth so far in 2018 suggests the market may be subtly pricing in slowing earnings growth down the line.

In the near-term, Wilson expects mean reversion will result in relative outperformance for low-risk assets such as utility stocks. For now, Morgan Stanley will be watching 10-year Treasury yields closely for signs that the tide is beginning to turn.

The inability of the 10-year Treasury yield to break above 3 percent last week coupled with the inability for financial stocks to gain any traction could be an indication that the “risk on” trade has already begun, Wilson said. Benzinga

 

Utilities: Moody’s goes negative on regulated utilities for first time, citing tax law impacts

Moody’s Investors Service on Monday lowered its outlook on the U.S. regulated utility sector to negative from stable for the first time since it began conducting sector outlooks. The lower outlook reflects what Moody’s sees as increased financial risk due to lower cash flow and holding company leverage for regulated utilities.

Utilities have typically set aside payments from customers to pay for future taxes. Those deferred tax payments boosted utilities cash flow to the point where they accounted for about 14% of Funds From Operations, or FFO. With the cut in the corporate tax rate to 21% from 35%, utilities will collect less cash from customers and retain less cash for deferred taxes. Lower cash levels also affect debt metrics that are a critical component of debt ratings. For regulated utilities, Moody’s sees FFO-to-debt levels falling to 15% from 17% over the next 12 to 18 months and for utility operating companies to 20% from 24%.

So far, Moody’s noted, many state commissions have provided for the 21% tax rate to be implemented into rates in 2018 but have said they will address the return of excess deferred tax liabilities to customers at a later date, adding to the uncertainty of the cash flow impact on the sector.

And while many utilities are estimating a decline in capital spending after 2018, Moody’s expects that utility capital spending — for items such as smart grid deployments, resilience and renewable resource acquisitions — will continue to increase by about 5% annually compared with a 2012-2017 compound annual growth rate of 5.7%. UDive

 

Utilities: How a Florida Utility Became the Global King of Green Power 

NextEra Energy has grown into a green Goliath, almost entirely under the radar, not through taking on heavy debt to expand or by touting its greenness, but by relentlessly capitalizing on government support for renewable energy, in particular the tax subsidies that help finance wind and solar projects around the country. It then sells the output to utilities, many of which must procure power from green sources to meet state mandates.

NextEra, as America’s most valuable power company, has a market capitalization of $74 billion. In 2001, the company, formerly Florida Power & Light, was the 30th largest U.S. power company, with a $10.2 billion valuation. It said in 2017 federal filings it produced more megawatt-hours of electricity from wind and solar farms than any company in the world; regulatory documents suggest it is, indeed, a bigger wind and solar producer than its largest global competitors, in Europe and China.

The way it captured the lead in the renewables market has allowed NextEra to grow despite the fact that the electricity industry has struggled with flat demand for power. The U.S. government expects power companies to generate $4.8 billion in renewable-energy tax credits this year, and NextEra is poised to be the largest generator of them, selling some to other corporations interested in lowering their tax bills and using the rest to shrink its own.

NextEra is now expanding beyond its traditional utility customers to build wind farms and solar parks directly for large corporations such as Google parent Alphabet Inc., some of which want to run facilities with green energy for financial and public-relations purposes. WSJ

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