Utility Stocks - The Shift Is On - Industry Outlook - American Electric Power (NASDAQ:AEP), Atmos Energy (NYSE:ATO)

Overview

Utility services undoubtedly play a major role in a nation's economic progress as cheap and abundant supply of power keeps the wheels of development rolling. With development comes the need for more power, as cities expand and the use of new gadgets increases. However, everything comes at a price, as green-house gases emitted by large utilities cause irrevocable damage to the environment.

The utilities have been under review for a long time. The climate action plan of the U.S. President followed by the U.S. Environmental Protection Agency's (EPA) proposal for tightening the rules to set up new power plants are putting immense pressure on power producing units.

Utilities are now gradually shifting their emphasis towards natural gas and alternate energy sources to produce power. Global concerns about the pitfalls of green-house gas emissions supported by increasingly stringent government regulations have brought alternative energy into the limelight.

In such a scenario, progressive steps from the U.S. alone will not be enough to counter the negative impact of global greenhouse gas emissions. The disparity in the socio-economic structure of different countries and the quest for cheaper sources of electricity are making the task difficult, if not impossible. In fact, increasing emission from the developing nations is undermining the positive steps taken in the U.S. and Europe to curb pollution.

Energy Landscape

While fossil fuel is the predominant source of generating power in the U.S. renewable and alternate energy sources are gradually making inroads into this dominance. Per a U.S. Energy Information Administration EIA report, U.S. energy demand totaled 97.5 quadrillion British thermal units (quads) in 2013 out of which 81.7 quads or 84% were produced domestically. Out of the total energy consumed in the U.S. in 2013, 82% were from fossil fuel, as per EIA.

The EIA report indicates that the total energy use in the U.S. will increase to 106.3 quadrillion Btu in 2040 from 95 quadrillion Btu in 2012. Most of this demand is expected to come from the Industrial sector followed by the Commercial sector.

Presently, the country is working towards attaining energy independence. Hence, the utilities have scope to increase their production volumes to meet rising demand and help the nation achieve its goals.

Zacks Rank

Within the Zacks Industry classification, Utilities are a stand-alone sector, one of 16 Zacks sectors. The rural wire-line telephone companies are also grouped within the Zacks Utility sector, but the three major industries within this sector include Electric Power, Gas Distribution and Water Supply.

The Utility sector's defensive attributes reflect the group's lack of correlation with the broader market/economy. Of course, the sector's reputation as a dividend payer also adds to its perceived defensiveness.

We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank. http://www.zacks.com/rank/industry.php

The way to look at the complete list of Zacks Industry Rank for the 260+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

Scanning the industries in the Utility sector, three prominent industries under this sector are currently ranked in the top category. Electric Power is at a Zacks Industry Rank #28, Gas Distribution has a Zacks Industry Rank #38, while Water Supply has a Zacks Industry Rank #69.

Earnings Trends

In the first quarter of 2014, total earnings for the Utility sector were up 18.0% on 11.2% higher revenues. The sector's strong earnings performance makes sense as they were the primary beneficiaries of the quarter's frigid weather. The majority of utilities benefitted from dropping mercury levels in their service territories.

For 2014 and 2015, earnings from this sector are expected to increase at rates of 10.0% and 4.9% year over year. In 2014, the Utility sector is expected to surpass the S&P 500 growth of 6.8% but lag the 2015 projection of 11.5%.

For more information about earnings for this sector and others, please read our 'Earnings Trends' report.

Electric Utilities

The EIA reported that electricity consumption in the U.S. will increase from 3,826 billion kilowatt hours in 2012 to 4,954 billion kilowatt hours in 2040, implying an average annual rise of 0.9%. For the fuel type in energy generation, renewables and natural gas will play an increasing role while coal will gradually fall out of favor.

The EPA has proposed a new plan to curb pollution from domestic power plants. The objective is to reduce emissions by 30% by 2030 from 2005 levels. If these proposals go into effect, electric utilities relying primarily on coal and without adequate retrofit to scale down the carbon footprint will be the worst affected.

An EIA report indicates coal-fired power generation to drop from 310 gigawatts (GW) in 2012 to 262 GW in 2040. The decline is a function of greater dependence on natural gas, usage of alternate energy sources and stricter regulations. The utility operators are implementing new technologies for the generation and distribution of power. The introduction of smart meters will benefit customers while the smart-grid technology is likely to increase efficiency.

The important electric utilities that play a vital role in meeting the demand for power are American Electric Power Inc. AEP, FirstEnergy Inc. FE, NRG Energy Inc. NRG, Duke Energy Corp. DUK, NextEra Energy Inc. NEE, PPL Corporation PPL, Exelon Corporation EXC, Dominion Resources, Inc. D and Southern Company SO among others.

Among the 74 electric utilities in our coverage, 9 stocks sport a Zacks Rank #1 (Strong Buy), 17 stocks have a Zacks Rank #2 (Buy), 41 stocks hold a Zacks Rank #3 (Hold) and the remaining 7 stocks have either a Zacks Rank #4 (Sell) or a Zacks Rank #5 (Strong Sell).

Natural Gas Utilities

The country has huge volumes of natural gas reserves and the new fracking technology has multiplied natural gas production from rock and rock structures previously considered uncommercial. The wide availability, its clean burning nature added to stringent government regulations to curb pollution make natural gas a favorable choice for electricity production as well as for other industrial and commercial usage.

An EIA report shows that natural gas will become the largest source of electricity generation in the U.S. by 2035 and will topple coal in the process. The EIA forecasts the use of natural gas in the U.S. to increase from 25.6 trillion cubic feet (“Tcf”) in 20112 to 31.6 Tcf in 2040.

These positive dynamics are going to benefit natural gas utilities like AGL Resources Inc. GAS, Atmos Energy Corporation ATO, WGL Holdings Inc. WGL, National Fuel Gas Company NFG, New Jersey Resources Corp. NJR, Questar Corp. STR, Sempra Energy SRE and MDU Resources Group Inc. MDU among others.

Multi-fuel producer CONSOL Energy Inc. CNX has shifted its focus on natural gas and has thus divested a few of its coal assets. CONSOL Energy's emphasis on natural gas assets has started to yield results and the company's earnings in first quarter 2014 surpassed the Street expectation by a wide margin. Buoyed by this success, the company aims to increase its natural gas production by 30% over the next couple of years.

The U.S. is presently working towards gaining energy independence and, as per a report from the EIA, it will become a net exporter of natural gas by 2020, after meeting domestic demand. So, from a net importer of 1.5 Tcf of natural gas in 2012, the U.S. will likely be a net exporter of 5.8 Tcf in 2040.

The natural gas utilities are not only expected to benefit from the steady increase in domestic demand but also from exports that are expected to rise significantly.

Given the abundance of natural gas in the U.S., after much deliberation, the U.S. Department of Energy (DOE) has granted permission to export liquefied natural gas LNG. To date, DOE received 31 applications from natural gas producers to export gas. Seven U.S. projects have until now received approval from the DOE to export gas. The facilities also need to secure approval from the Federal Energy Regulatory Commission (FERC) before exporting gas.

As present, Cheniere Energy, Inc. LNG received all necessary permits and approval to export natural gas from its Sabine Pass site.

We believe this decision will allow U.S. nat gas producers to channelize their production volumes (after meeting domestic demand) to feed the ever increasing appetite for power in the global market.

We track 24 gas utilities, of which 1 stock has a Zacks Rank #1 (Strong Buy), 7 stocks have a Zacks Rank #2 (Buy), 14 stocks hold a Zacks Rank #3 (Hold) while 2 stocks have a Zacks Rank #4 (Sell).

Water Utilities

The major challenge ahead for water utility operators is the aging water and sewer infrastructure. Maintenance and development of facilities play a crucial role and will test the financial capabilities of these utilities.

A report from Economic Development Research Group Inc. suggests an alarming gap between the water infrastructural requirement and actual investments planned for the coming years. The gap is expected to reach $84 billion in 2020 and widen to $144 billion in 2040. The report also revealed that without proper renewal or replacement, nearly 44% of the existing pipelines will become too poor for operation by 2020.

The utility operators have begun to invest in their ageing infrastructure, but it appears the initiatives are inadequate to bridge the gap. The government should consider taking adequate measures before things blow out of proportion.

Since the water utility industry is highly fragmented it poses a serious challenge in meeting infrastructural requirements. Presently, there are nearly 53,000 water system operators in the U.S. (as per American Water Works). This in a way stops them from enjoying economies of scale and pass the same to their consumers. Presently, the top operators in this space have started to make strategic acquisitions to expand and consolidate operations.

A prominent water utility, American Water Works Company, Inc. AWK has lately resorted to the inorganic route to expand its footprint. We view this as a smart move as larger companies will likely have better provisions to address the infrastructure needs of this industry.

Other top operators in the water utility space have also fallen back on acquisitions. Apart from American Water Works, its peers Consolidated Water Co. Ltd. CWCO, Connecticut Water Service Inc. CTWS and Aqua America Inc. WTR utilized inorganic strategies to enhance their scale of operations.

We presently cover 11 water utilities, of which 2 have a Zacks Rank #2 (Buy), while the rest have a Zacks Rank #3 (Hold). Five out of the 11 water utilities we track registered a positive earnings surprise in the last quarter.

What Keeps the Utilities Rolling?

The biggest positive for the utilities is that there is hardly any viable substitute for utility services. This is the most fundamental strength of the industry. Moreover, increasing demand drives this industry forward.

Another barrier to entry is their size and the requirement of huge initial capital outlay. For this reason, we generally do not find many new entrants in the market. Also, stringent government regulations and the hard toil for new entrants to establish a loyal consumer base put existing players in an advantageous position.

Finally, utilities have been known to pay dividends consistently, thereby retaining investor confidence. This was evident during the economic crisis of 2008-2009 when these operators continued to pay out dividends without fail.

In Conclusion

Despite the assured demand for services, the utilities have to constantly meet the high expectations of its wide customer base, adapt to a changing global economic scenario, and upgrade technologies to meet stringent environmental norms. In fact, new technology to produce power at a cheaper rate and emerging alternative resources for the generation of green power is likely to drive the industry going forward.

The majority of new electricity in the next two decades in the U.S. will be generated from natural gas and renewable sources. Besides the abundance of natural gas, as many as 29 U.S. states and the District of Columbia have enforceable renewable portfolio standards or other renewable generation policies. We expect this count to go up, compelling producers to generate more green power to meet the renewable standards fixed by the states.

Fuel cell technology, an alternate method of power generation, has been making a lot of buzz lately. We, however, admit that this technology has a long way to go if it were to provide power plant solution on a large scale. The lead players in this field engrossed in R&D are FuelCell Energy FCEL, Ballard Power Systems BLDP and Plug Power Inc. PLUG. For now, it is a wait and see situation to find out whether fuel cell can offer a realistic solution to power generation and greenhouse gas emissions or whether its potential is only good on paper.

All said, utility operations globally depend on weather patterns that determine the extent of demand. The frigid weather in the U.S. during the last winter season showed how dependent we are on these utilities for basic needs.

To sum up, LNG exports will increase the profitability of the U.S. natural gas operators but the bottlenecks in granting permission are a concern. At the same time a concerted effort will have to be made to remove the funding requirement in the water utility sector. Otherwise the aging water infrastructure will lead to more wastage, leading to a hike in cost of operation and a related increase in the price of water supplied.

As for the electric utilities, we expect more investment in natural gas and alternate energy projects, wrenching the initiative from the pure-play coal based electricity companies.

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Utility Stocks - The Shift Is On - Industry Outlook

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