Due for a Pullback But Positioned for the Long Term

In the more than 20 years that I’ve covered utilities and other providers of essential services, I’ve noticed that the same investors who feel compelled to add to positions when stocks look overbought are the same ones who panic at the first sign of weakness.

With shares of many utilities trading at frothy valuations, the sector is at risk for a modest correction and favorable buying opportunities are limited. But investors shouldn’t associate any pullback with an imminent threat to the sector’s dividends, which have grown reliably for almost a decade. When utility stocks drift lower, investors should remind themselves of the sector’s historically documented resilience.

Source: Bloomberg, Conrad’s Utility Investor

Since the end of World War II, the S&P 500 Utilities Sector Index has declined by more than 20 percent from its highs on seven occasions. In each instance, the sector rebounded sharply, vindicating investors who had the conviction to add to their position. Note that the returns in my table exclude dividends, which would have cushioned the losses suffered during these downdrafts and bolstered the gains.

Four of these seven corrections reflected trends in the economy and/or broader stock market. For example, the most recent major pullback to afflict the sector stemmed from the indiscriminate selloff that occurred at the height of the 2008 financial crisis and overlapping Great Recession.

What stands out about this most recent stress test is the lack of crack-ups in the utility space; only three utilities–Constellation Energy Group (NYSE: CEG), Ameren Corp (NYSE: AEE) and PNM Resources (NYSE: PNM)–trimmed their dividends from 2008 to 2009. All three companies faced a diminution of cash flow from their unregulated operations.

My table also includes three corrections that were catalyzed by sector-specific woes. The most recent of these blow-ups stemmed from the collapse of Enron and the challenges faced by the dozen or so utilities that sought to copy the company’s business model.

The sector’s response to this shakeout positioned the group to weather the 2008 financial crisis with relative aplomb. Management teams sought to get back to basics of providing electricity safely and cheaply to customers. The industry also repaired relations with regulators, slashed debt and reduced operating risk.

Future Regulatory Risk

Bears sometimes point to regulatory risk as a reason to doubt utilities’ strength. Without question, salutary relations with regulators historically have separated the winners from the losers.

Warning signs have cropped up in a few states. For example, the staff of the California Public Utilities Commission recently recommended that PG&E Corp (NYSE: PCG) be charged an additional $2.25 billion in damages related to the 2010 gas line explosion in San Bruno.

That being said, the relationships between utilities and regulators remain constructive in most states, particularly those where the most capital spending is expected to occur. SCANA Corp (NYSE: SCG) and Southern Company (NYSE: SO), for example, have recovered costs associated with their investments in new nuclear power plants as they are incurred. This policy marks a major shift from the previous building cycle, when utilities petitioned for rate increases after new power plants came onstream.

This model prevails in many markets around the country and for a wide variety of projects–from spending on smart meters and transmission improvements to renewable energy and pollution controls on existing thermal-powered plants. Assuming that the utilities execute these projects effectively, investors will reap the rewards of earnings growth and dividend increases.

Disruptive Technologies

Even the rapid adoption of rooftop solar in some areas–touted by some as a long-term risk to utilities’ revenue–should prove to be more of a boon than bane for the sector. By virtue of their access to capital and unmatched customer contacts, utilities are in prime position to dominate this business.

In the 1990s bearish commentators asserted that fuel-cell companies and unregulated power producers were sowing the seeds of industry destruction. The real endgame for the upstarts, however, was to combine with utilities themselves for a hefty premium. Interlopers that weren’t absorbed went bust.

Despite wishful thinking by some, a similar fate will likely befall SolarCity Corp (NSDQ: SCTY) and other upstarts that finance rooftop solar installations.

Interest Rates

What about the threat posed by rising interest rates? The conventional wisdom holds that when interest rates tick up, utility stocks go down. But every major correction in the S&P 500 Utility Sector Index since World War II has stemmed from industry-specific factors or an overall market firestorm.

Over the past 20 years, utility stocks have behaved more like stocks than bonds. Even the increase in borrowing costs that would accompany higher interest rates won’t necessarily spell doomsday for the sector.

For one, regulated utilities rates of return are often pegged to interest rates. And companies have taken advantage of the low-rate environment to refinance near-term debt and extend maturities; the sector is far less vulnerable to a spike in rates than critics assume.

The linchpin is regulation. Fortunately, this is an era of good feelings between utilities and the officials setting their rates. Of course, these relationships can deteriorate–one of the reasons I closely monitor developments on this front.

The Verdict

Although income-starved investors have bid up the shares of some utilities to frothy levels, regulated utilities in states with supportive regulators face few risks.

However, business conditions remain challenging in unregulated, wholesale power markets. With US natural-gas prices considerably lower than they were five years ago, operators are forced to sell their electricity at lower prices in either the spot market or under new contracts.

At this juncture, the risks posed by unregulated operations are well-understood by the market. Exelon Corp (NYSE: EXC), for example, has slashed its dividend to a level that can be sustained by the cash flow generated by its regulated operations. Entergy Corp’s (NYSE: ETR) unregulated business faces similar challenges, but the reliable revenue generated by its regulated power plants provide ample support for the payout.

Meanwhile, Dominion Resources (NYSE: D) and other companies have slashed their exposure to this business line by selling assets and taking writedowns. After these moves, the Virginia-based company is left with a portfolio of assets that produce a steady stream of cash flow and offer a visible pipeline of growth opportunities.

Keep these facts in mind the next time someone tells you to sell Dominion Resources, Southern Company or any other stalwart utility.

Roger S. Conrad is founder and chief editor of Conrad’s Utility Investor, Capitalist Times and Energy & Income Advisor.