Utility Sector Ideas

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>>> Utilities Plunge: Making Sense Of The Sector's Big Decline


Seeking Alpha

Mar. 23, 2020

by Ian Bezek


https://seekingalpha.com/article/4333697-utilities-plunge-making-sense-of-sectors-big-decline


Summary

Utility stocks dropped nearly 20% between last Tuesday and last Friday.

This has to be concerning to investors that bought these stocks as strong defensive plays.

There are two factors that could hurt utility profitability going forward.

The sector offers fine yields, but isn't compelling yet aside from the income.

This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner. Get started today »

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Last week, the Utility Select Sector SPDR (XLU) sector got utterly smashed. From Tuesday's high onward, the XLU ETF lost 18% of its value. I don't recall these names ever getting hit this badly, even in 2008. It's simply been an incredible drop, with the sector giving back 5 years of gains in a little over a month:

Even more incredibly, if you go way back, XLU was trading for $43 prior to the financial crisis. Thus it's only gone up 10% over the past 13 years, with all other returns coming from dividends. Even farther back, XLU traded for as much as $34 in the year 2000, meaning that the ETF is up only 40% over the past 20 years. Of course, with dividends, things look a lot better. Still, it's a stunning turn of events for a sector that had looked unstoppable over the past two years. On a longer-term chart, you can see that XLU is rapidly threatening to breach price levels from more than a decade ago:

What can we take away from this? For one, utilities have reverted to form - they're simply not a great (nor particularly bad) industry historically. Over the past 82 years (data through 2015) utilities were the median sector, coming in 15th out of 30 in the market, producing essentially market-matching returns:

That table comes from this article, where I discussed this data in much more detail. The fundamental return is calculated based on the real annual growth of dividends over the past eight decades.

As for the question of utilities being defensive, though their stock prices suddenly gave way last week, the companies are still favorable ones to hold in an economic downturn. But investors were using them to play offense throughout 2019, hoping that falling interest rates would lead to sustained higher valuation ratios for the sector. In theory, that's probably still a reasonable hypothesis; reliable dividend streams are worth a lot more in a zero interest rate world.

In the short-run, however, above average valuation ratios become their own risk factor. When people are getting margin calls, or simply wanting to shift funds into more beaten-up names, they're going to sell the stuff where they are still showing a profit. Defensive assets can turn into a source of funds during a panic; even gold (GLD) started selling off at the height of the market panic. Simply put, people will get funds in the short-term wherever they can find them.

Over the long-haul, however, utilities should remain a defensive sector. Thus, is now the time to be buying as prices have come in dramatically? In some cases, yes. A lot of individual utility stocks have come down a great deal in March. That said, before you get too aggressive with your purchases, here are a couple of things to keep in mind.

Potential Issues: Declining Demand, Declining Returns On Equity
Interestingly, there's been (at least that I've seen) little discussion of the economic impact of the current situation on utility companies. Sure, some folks are considering the possibility of the government stopping utilities from collecting on past due clients for the duration of the crisis. That could hurt a bit on a marginal basis.

But zoom out. If the economy grinds to a halt for a few months, what happens to electricity usage? Over in the oil market, traders have quickly reacted to the slowdown by absolutely slamming the price of crude, and its refined products such as gasoline. Oil is more sensitive to the economy than electricity, as oil is the dominate transportation fuel. Most electricity uses, by contrast, aren't greatly impacted by a near-term economic slowdown.

Still, it probably isn't reasonable to think that electricity demand will remain steady. What do we have for data? I haven't seen much yet, but I did run across this interesting data point on New York City electricity usage. There's a ton of caveats here, as it's just one city, the weather could be a factor, and so on. But there appears to be a sharp rollover that started in the week of March 16th:

Historically, we can also look back to 2000 and 2009. Interestingly, due to rises in efficiency, electricity usage per person has pretty much stopped going up in the U.S. - it peaked in 2000 and has gone no higher:

Looking at the data, we can see there was a noticeable decline between 2000 and 2001, in some part likely due to the overall economic slowdown and then also specifically the sizable drop-off in economic activity immediately following the 9/11 attacks.

Moving forward, from 2008 to 2009, electricity consumption per capita dropped from 13,663kWh to 12,914. The effect was particularly harsh in the first quarter of 2009, when the economy and stock market were still heading downward. For that quarter, Power Magazine reported that residential electricity consumption was down 2.5%, commercial consumption was down 4.7%, and industrial consumption was down by fully 13.8%.

We should expect as much of a decline, and probably significantly more in the near-term, in 2020. Residential usage may actually go up a touch, as people spend far more time at home. That said, the marginal electricity use from staying at home probably isn't that high, many high-impact uses such as heating and appliances aren't going to change too much.

Meanwhile, commercial use is going to get pummeled. In 2009, stores had less activity, but there wasn't a mass government-ordered shutdown. You had malls with few shoppers, but not malls that were locked up with everything turned off inside as we have now. Similarly, industrial use will plummet for the length of the shutdown, as non-essential factories simply won't operate.

Longer-term, there's also the question of authorized returns on equity "ROE". Utilities tend to bargain with states and localities to earn a set rate on their capital investments. These ROE targets are a balance that should give utilities sufficient incentive to invest in needed services and provide safe and reliable operations for consumers. On the other hand, the locality has an obvious incentive to keep the utility from price gouging. These ROE targets are a well-known feature of the industry - here's a table by S&P from 2017, for example, showing this process in action:

There are now two factors working against utilities going forward. For one, with the economy hurting, look for states to be tougher at the negotiating table. When times are tough, there's less slack to be had overall. Second, the lower interest rates for longer environment is going to drag down the overall "fair" ROE target as time goes on. In a world where a utility's capital costs, say, 5%, a 10% ROE might make sense. But if the utility can now get capital at half that, the state or locality is likely to want a chunk of that savings as well. At the end of the day, utilities are regulated businesses, and as such, they aren't going to get the full benefits of favorable market-pricing developments.

As I showed above, historically utilities have been an average industry, doing no better or worse than the market as a whole. And after their recent sell-off, many individual utility stocks are back to more normal valuations, though they're by no means "cheap" yet.

Should you buy some? They're still one of the safest income sources around, no doubt, and the current yields have moved up nicely. For longer-term investors, however, you can surely find more attractive stocks that are much more deeply-discounted at the moment.

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