Consumer demand for essential products remains relatively untethered from the shape of the economy. One of the sectors that produces and distributes recession-resistant non-cyclical products and services is utilities. Consumers can't do without the products supplied by utility companies and tend not to cut back on them even during turbulent times, which keeps the industry relatively insulated from economic shocks.
Although known for their defensive characteristics, utilities often outperform the broader market, as has been the case in the United States so far in 2016. The S&P 500 Sector Utilities (Total Return) Index is up 11.1% for the year to date as of Dec. 5, compared to a 10.1% total return for the S&P 500. In Canada, the S&P/TSX Utilities Index is up a healthy 9.6% so far this year, though it trails the S&P/TSX Composite Index's total return of 16%.
The expectation of a more favourable environment when U.S. President-elect Donald Trump moves to roll back environmental regulations has further brightened the outlook for the sector. Utility companies could be one of the biggest beneficiaries if Trump makes good on his campaign promise to relax or revoke pending limits on carbon emissions, making regulations less onerous, particularly for companies that run coal-burning power plants.
This creates attractive buying opportunities in selected utility stocks that enjoy high switching costs and a loyal customer base, according to Morningstar equity research.
| Southern Co. | ||
| Ticker | SO | |
| Current yield | 4.56% | |
| Forward P/E | 16.3 | |
| Price | $48.72 | |
| Fair value | $48 | |
| Data as of Dec. 12, 2016 | ||
Atlanta-based utility giant 
Southern Co. (SO) generates and sells electricity. The firm, one of the biggest coal-burning utilities, recently acquired natural-gas utility AGL Resources Inc for about US$12 billion, nearly doubling the number of customers. The deal improves the company's exposure to the growing U.S. natural-gas market and expands its natural-gas infrastructure.
"Southern's total returns remain appealing for patient investors in a world of few decent income alternatives," says a Morningstar report. "The company's utilities enjoy some of the best regulation in the United States, with strong, consistent regulatory relationships in its key service territories of Alabama and Georgia."
Morningstar equity analyst Charles Fishman expects the company to invest roughly US$23 billion in its business from 2016 to 2020. "The spending," he says, "can deliver 3.5% average annual earnings growth" during the period. Fishman also projects that the firm will increase its dividend 4% annually during the next few years.
One of Southern's main competitive advantages, and a crucial driver of its above-average returns, is its strong working relationships with regulators. Management places high priority on preserving goodwill with regulators, says Fishman. The company's transmission and distribution assets, he adds, are extremely difficult and costly to replicate, which serves to further sharpen its competitive edge.
| American Electric Power Co. Inc. | ||
| Ticker | AEP | |
| Current yield | 3.66% | |
| Forward P/E | 16.9 | |
| Price | $61.95 | |
| Fair value | $65 | |
| Data as of Dec. 12, 2016 | ||
One of the largest regulated utilities in the U.S., American Electric Power (AEP) provides electricity generation, transmission and distribution to more than five million retail customers in 11 states. As much as 51% of AEP's capacity is coal, and the rest is a mix of natural gas (27%), renewables (11%), nuclear (6%) and demand response (5%).
The firm stands particularly to benefit from Trump’s repeated promise of reviving the coal industry in a country that receives a third of its power supply through coal-fired power plants, according to the Energy Information Administration (EIA). Roughly half of AEP's power plant fleet burns coal, making it one of the largest coal-fired fleets in the U.S.
The company is pivoting away from unregulated and competitive power generation to focus on improving profitability at its regulated utilities. "Investors should focus on the company's regulated operations, where higher earned returns, environmental investments and transmission construction should drive earnings growth," says a Morningstar report. "Almost all of the company’s US$17.3 billion capital plan for 2017-19 focuses on regulated spending."
The company’s system size and grid operating experience provide it the resources and know-how to participate in just about any transmission project in the U.S. Morningstar equity analyst Andrew Bischof says the firm has several multi-billion-dollar projects in the works for the next five to 10 years.
He recently raised the stock’s fair value estimate from US$61 to US$65, incorporating the US$17.3 billion of infrastructure investments forecast for 2017-2019, and 7.8% rate base growth. "The additional growth opportunities raise our average annual earnings growth estimate to 6.6% from 5.5%," adds Bischof.
| Duke Energy Corp. | ||
| Ticker | DUK | |
| Current yield | 4.39% | |
| Forward P/E | 16.5 | |
| Price | $76.48 | |
| Fair value | $84 | |
| Data as of Dec. 12, 2016 | ||
Duke Energy Corp. (DUK) is the second-largest U.S. utility, providing electricity and gas to 7.1 million customers through its regulated utilities in the Carolinas, Indiana, Florida, Ohio and Kentucky. The firm operates in three segments: U.S. franchised electric and gas, commercial power and international energy.
Duke's main competitive advantage comes from territorial monopolies and economies of scale. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on the capital they spend to build, operate and maintain their distribution networks.
Duke's regulated distribution businesses make up about 90% of consolidated earnings as the company continues to move toward being a fully regulated utility. "In recent years, Duke's utilities have been able to win higher customer rates from regulators, translating into higher profits," says Bischof, who pegs the stock’s worth at US$84.
The company plans to invest an estimated US$42 billion through 2020, much of which will be allocated to growth and expansion initiatives including new power generation, infrastructure and environmental upgrades. Based on these spending figures, Bischof projects the company to generate long-term earnings growth of 5.5% annually.
The company's president and CEO, Lynn Good, announced in July 2016 an approximately 3.6% increase in the quarterly dividend payment, reflecting management's confidence in the strength of the company's core businesses and cash flows.
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