A Dim Long-Term Outlook For Utilities ETFs

At a time when Treasury yields are near historic lows and the Utilities SPDR (ETF) XLU sports a dividend yield of 3.1 percent with a year-to-date return of nearly 20 percent, it is easy to understand investors' enthusiasm for the utilities sector.

By virtue of its bond-like characteristics but hearty yield, XLU, the largest utilities sector exchange-traded fund by assets, is a favorite among defensive-minded, yield-starved income investors. That much is confirmed year-to-date inflows of $1.51 billion to XLU, one of the best totals among all sector ETFs.

In other words, it takes a bold soul to say something negative about XLU and rival utilities ETFs. Returns confirm betting against utilities sector this year has been a losing bet. However, that does not mean the long-term outlook for the sector is sanguine. A case can be made that the opposite is true.

What's Ahead?

“Fundamentals haven’t kept pace with stock prices. Earnings per share has barely grown at all in the past five years [...] and as a result the sector’s P/E ratio has soared more than 55 percent to 18.6x. Meanwhile, yields have fallen from 4.7 percent five years ago to 3.4 percent today,” said AltaVista Research in a recent note.

Related Link: Utilities ETFs: Maybe Not As Pricey As Rumored

AltaVista's concerns regarding XLU are not new. The research firm recently tagged XLU with an Underweight rating.

"Environmental regulations and distributed generation represent dual threats to profitability — witness the declining trend in Return on Equity in the last few years, which may appear small but are forecast to result in only 1 percent annual earnings growth between 2011–16E. Meanwhile the recent rebound in share prices has returned the P/E ratio near its highs of the past five years, and pushing the sector down into Underweight territory," said AltaVista.

Nor are the research firm's concerns about XLU unfounded.

Justification

“While that still looks good compared to the 10-year Treasury yield around 1.4 percent, profits — and ultimately the dividends they support—face a competitive threat from distributed generation. Distributed generation is a disruptive technology enabled in part by improved storage ability, where power is generated near the point of consumption instead of at a large, central plant and distributed over great distances,” added the research firm.

Utilities are also saddled with heavy debt burdens, which could eventually pinch payout sustainability. XLU has a debt-to-equity ratio of 1.3, according to AltaVista data.