These Stocks Could Get Hit by Rising Rates

Utilities could suffer from higher borrowing costs as interest rates take their toll.

Vikram Barhat 1 November, 2023 | 4:48AM
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The word caution spray painted on pavement

Central banks on both sides of the U.S.-Canada border have steadily raised interest rates. And they may not be done just yet since inflation remains stubbornly high.

This has implications for some sectors that are negatively impacted when interest rates soar. For opportunistic investors, this may be a time to take a fresh look at utility stocks that tend to underperform whenever there is a run-up in the rates.

Utility stocks, being capital-intensive, often require substantial borrowing for growth, infrastructure and maintenance. As interest rates tick higher, borrowing costs increase, which can strain these interest-sensitive businesses due to the inverse relationship with dividend-paying utility stock prices.

 

NextEra Energy NEE owns regulated utility Florida Power & Light, which is Florida’s largest rate-regulated utility (accounting for roughly 70% of operating earnings). The company’s renewable energy division, NextEra Energy Resources, boasts over 25 GW of generation capacity and operates across the U.S. and Canada.

The two businesses offer investors the best of both worlds: a secure dividend and industry-leading renewable energy growth potential. “NextEra's regulated utility, Florida Power & Light, benefits from constructive regulation that offers high allowed returns, little regulatory lag, and increases in allowed returns to incorporate higher interest rates,” says a Morningstar equity report.

The utility is expected to invest over US$40 billion through 2027, supporting 9% rate base growth, primarily supported by solar generation buildout, storm-hardening investments, and transmission and distribution infrastructure.

NextEra is making a strategic pivot towards solar energy. As a result of that transition, more than half of its planned renewable energy growth through 2026 is projected to come from solar and energy storage. “There is a long runway of strong demand for renewable energy resources beyond our five-year outlook,” says Morningstar equity analyst Andrew Bischof, who puts the stock’s fair value at US$82.

The company was also an early adopter of wind generation, building a competitive advantage by securing 20-year contracts with price escalator clauses, he adds.

 

One of the largest regulated utilities in the U.S., American Electric Power AEP boasts more than 5 million customers across 11 states. Coal represents about 41% of AEP's capacity, while the rest comes from a mix of natural gas (27%), renewable energy and hydro (23%), nuclear (7%), and demand response (2%).

American Electric Power runs a variety of utilities, offering investors a hedge against the impact of any single unfavourable regulatory decision. “Nearly all of the company’s US$40 billion capital investment plan through 2027 focuses on regulated investments, supporting annual earnings growth within management's 6%-7% target,” says a Morningstar equity report.

Investing in transmission infrastructure is a key long-term growth strategy for AEP, especially considering the federal incentives aimed at improving the efficiency of the U.S. power grid.

“Moaty transmission and distribution investments account for two thirds of AEP's five-year capital investment plan,” points out Bischof, adding that the firm is one of the best-positioned transmission developers in the U.S., given its scale and execution.

Environmental regulations, aging infrastructure, and renewable energy expansion create a long runway of growth at the unit, notes Bischof, who pegs the stock’s fair value at US$97.

Given the company’s strong investment in renewable energy, AEP could generate nearly 50% of its total power from wind, solar and battery storage by 2032, up from roughly 20% today, he contends.

 

The largest investor-owned U.S. water and wastewater utility, American Water Works AWK provides water and wastewater services to3.5 million residential, commercial, and industrial customers in 16 states. The utility operates predominantly in regulated markets. The company also operates nonregulated water services for military bases under long-term contracts.

American Water Works has consistently increased earnings, outpacing its peers despite core retail water use steadily falling due to efficiency savings.

The utility has been replacing and upgrading infrastructure across its system, spurring organic growth. “We also expect the company to grow by acquiring small, typically municipal-owned water systems,” says a Morningstar equity report, noting that more than 80% of the U.S. population is served by a municipal water utility, which offers a long runway of acquisition growth opportunities.

The increase in profits has been supported by favourable regulatory frameworks and enhanced operational efficiency. “The company's regulatory strategy is to work proactively with regulators to ensure timely recovery of rising costs and gain support of continued investments,” says Bischof, adding that this has helped the company mitigate the headwinds of rising operating and interest costs.

AWK’s only nonregulated business, a small military service group, produces regulated-like earnings based on long-term government contracts that are longer than 30 years, says Bischof who appraises the stock to be worth US$137, and forecasts earnings growth to continue beyond the next five years.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
American Electric Power Co Inc88.00 USD0.11Rating
American Water Works Co Inc129.30 USD0.06Rating
NextEra Energy Inc73.06 USD-0.16Rating

About Author

Vikram Barhat

Vikram Barhat  A Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry, Vikram also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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