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Making Sense of Utility Stocks Performance During the Pandemic Market Rout

image credit: SPDR UTIL 500 Performance during this quarter
Rakesh  Sharma's picture
Journalist Freelance Journalist

I am a New York-based freelance journalist interested in energy markets. I write about energy policy, trading markets, and energy management topics. You can see more of my writing at Rakesh Sharma  

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In the stock market, utilities are a defensive sector. Investors put money into utility stocks to escape market volatility. For fans of regular income, utility companies also offer a steady stream of dividend payouts. Utility stocks were safe havens during the financial crisis of 2008. Investors poured funds into electric and water companies because they were safe bets against hemorrhaging markets. 

But the script has gone awry during the current pandemic. After years of slow and steady growth, one that mirrored the more rambunctious bull run of the broader market, the S&P 500 Utility Sector also crashed and burned as markets screeched to a halt after a decade-long bull run. Investors scrambled to find a safe haven from the market’s gyrations. In slightly more than a month, the S&P 500 Utility index plunged by 36.5%. (It has clawed back some of that ground since, rising approximately 30% in the last week). 

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How then should we analyze future prospects for utility stocks? 

Some Perspective and Business Fundamentals

Perspective is necessary to get a handle on the utility sector’s recent performance. According to Barron’s, the Utilities Select Sector SPDRETF (XLU) had an annualized 11.6% return in the last 10 years and 10% in the last five years. 

But last year’s bull run has produced a valuation premium overhang for utility stocks. A bunch of electric utilities - Dominion Energy, Southern Co., Duke Energy, and American Electric Power - entered 2020 with their stock prices trading at a premium of 20 times their expected earnings. 

Such premiums would be welcome or justified as investor enthusiasm for the industry’s future prospects. For example, the stock market has proved to be an invaluable source of cash for electric car maker Tesla. The Palo Alto company is valued at $95.4 billion, a valuation multiple that of established car makers like General Motors and Ford which are valued at $29.6 billion and $18.8 billion respectively. For context, Tesla sold 367,500 cars last year while Ford and General Motors had global sales of 5.3 million and 7.7 million respectively. Tesla’s price premium is indicative of investor faith in the future of electric cars. But it is difficult to apply similar reasoning for the high premiums in stocks that operate in a highly-regulated industry with profit caps. 

Still, the utility industry’s changing business fundamentals means that companies that are further along this transition are rewarded by investors. Consider the case of NextEra Energy (NEE), which is the world’s largest producer of solar energy and wind power. The company’s stock is a favorite with analysts, many of them recommending either a hold or buy position. It lost ground last week and is currently trading at $223 per pop, up 23% from its nadir a week ago. Exelon, a Chicago-based utility with a large nuclear holding, was another stock that was being supported by analysts because it had sufficiently “de-risked” its nuclear holdings and offered 3.3% dividend payouts. Falling stock prices can also boost dividend payouts per share. According to reports, the dividend payouts for NextEra increased by 2.8% amidst the general market rout that occurred in the coronavirus aftermath. Duke Energy's dividend payout increased by 5% during this time. 

How will COVID-19 Affect Utility Stock Performance? 

While it is still too early to forecast possible revenue outcomes from the current pandemic, a couple of news developments offer a peek into possible factors that may hinder growth for utilities. 

The first one is the return to zero or negative interest rates. When interest rates capsize, trader money moves into other sectors because the rates signal an era of economic growth. It hasn't happened yet because most of the American economy remains on pause. Once quarantine restrictions are lifted, however, it is likely that economic fundamentals will roar back to life. (Though it might be some time before we see its effects on the stock market). It is likely then that utilities will properly resume their defensive perch once again. 

The second interesting factor to watch out for is dividend payouts. The good news for investors in utility stocks is that the sector has not received federal bailouts. Thus, companies are not prohibited from making share buybacks or dividend payouts. While others have suspended or cut their dividend payouts, utilities are yet to make a public declaration. Classification as essential services has also helped keep the lights on literally, ensuring revenues through the door. 

But an increasing spate of restrictions on their bill collection and field worker operations is sure to make a dent on their revenue prospects. Consider recent state notices forbidding them from collecting dues. A 2018 report by the Energy Information Administration (EIA) found that a third of all Americans have trouble paying off their energy bills. That figure will multiply as workers are laid off or their incomes are slashed. 

As I mentioned in an earlier post, those unpaid bills can snowball into revenue losses. For example, a 2016 McKinsey report found that utilities wrote off approximately two percent of their non-collectible revenues as bad debt. The current pandemic could force a bigger percentage of losses for utilities that operate in jurisdictions that are especially vulnerable to debt crises. Utilities have racked up debt equaling $14 billion of their own by selling corporate bonds in the open market. While utility bonds generally carry a high rating, it will be interesting to see how utilities handle the twin pressures of paying their bond holders even as they contend with increased debt from consumers and industries on their balance sheets.

 

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