Four utility stocks to defend against yield inversion

The staggering 800 point plunge in the Dow Jones index last Wednesday marked the worst day of 2019. The recent spike in market volatility has been triggered by a bond market phenomenon called yield curve inversion, widely regarded as a precursor to an impending recession. This is yet another sign of the worrisome state of the U.S. economy, which has sparked a widespread sell-off, sending panicked investors running for safe-haven alternatives. 

Now’s the perfect time to look at boring but stable sectors such as the utilities. The sector remains relatively immune from economic shocks, utility companies offer relatively recession-proof products and their stocks pay healthy dividends. The inherently non-cyclical nature of the sector is underpinned by the fact that consumers can’t, or tend not to, cut back on essential products and services no matter the prevailing economic conditions.

Despite their defensive characteristics, though, these stocks can participate in stock market rallies. The sector has clocked more than 16% gains for the year to date, not far behind 18% returns for the S&P 500, as of August 14. As a result, these utility names are trading close to or above their fair value estimates. Investors looking for a defensive play may want to wait for a pullback to create some margin of safety and a better entry point.
 

Duke Energy (DUK) is one of the largest U.S. utilities that deliver electricity and gas to more than 7 million customers. The firm operates in electric utilities and infrastructure; gas utilities and infrastructure; and commercial renewable segments.

Duke’s long-term growth prospects are tied to successful completion of the Atlantic Coast Pipeline, or ACP. While the recent rulings will likely push back the completion date and raise costs, “we continue to believe that the economic benefits of bringing low cost natural gas will ultimately lead to completion of the pipeline,” says a Morningstar equity report.

Regulated utilities enjoy service territory monopolies and scale advantages, primary moat sources. “State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital they invest to build, operate, and maintain their distribution networks,” says Morningstar equity analyst, Andrew Bischof, who pegs the stock’s fair value at US$88, and forecasts 5% annual earnings growth. 

The second- largest utility in the U.S. by customer count, Southern Company (SO) distributes electricity and natural gas to approximately 9 million customers across nine states. Wholly owned unregulated Southern Power Company owns over 11 gigawatts of mostly renewable energy capacity and sells the electricity primarily under long-term agreements.

Southern Co. has been pivoting away from coal and towards green energy. “In 2000, almost 80% of electricity sold to customers was generated using coal,” says a Morningstar equity report. “By 2030, it will be less than 20% and the company recently announced a goal of low- and no-carbon generation by 2050 that will probably require the closure of the remaining coal plants.”

For that reason, nuclear, natural gas, and renewable energy are all growing as a share of overall energy generation, the report adds.

While the transformation has caused delays and cost overrun issues at some of its projects, “we don’t believe the financial impacts will derail our estimated long-term annual EPS growth rate of 5% or put the company’s growing dividend at risk,” says Morningstar equity analyst, Charles Fishman, who recently raised the stock’s fair value from US$50 to US$52, prompted by 2018 results and updated earnings guidance.

Sempra Energy (SRE) distributes natural gas and electricity in Southern California and owns 80% of Oncor, a transmission and distribution business in Texas. The company also owns and operates liquefied natural gas facilities in North America and infrastructure in Mexico through affiliates.

“Sempra Energy’s investment opportunities at its regulated California and Texas utilities [which constitute the lion’s share of margins and earnings] will remain the primary growth driver,” says a Morningstar equity report, noting that “those utilities will receive over 80% of the company’s capital investment during the next three years totaling US$15 billion.”

The firm’s safety and reliability infrastructure upgrades in California provide an attractive growth opportunity as they are perfectly aligned with the state regulator’s goals of risk mitigation across the utilities’ footprint. As well, Sempra’s Texas subsidiaries’ transmission assets should continue to benefit from Texas’ aggressive wind generation build out, says Bischof, who puts the stock’s fair value at US$125. The company is also in the process divesting its South American utilities and investing proceeds to pay down debt and invest in more profitable opportunities. 

A sustainable energy leader, NextEra Energy (NEE) distributes power to roughly 5 million customers in Florida through its regulated utility, Florida Power & Light (contributes 60% of total earnings). The renewable energy segment generates and sells power throughout the U.S. and Canada.

Through NextEra Energy, investors have exposure to Florida’s growing economy and U.S. renewable energy growth, says a Morningstar equity report.  “NextEra is the largest wind power producer in the United States, proving to be a best-in-class renewable energy operator and developer,” says the report, noting that the company enters into long-term purchasing arrangements which help mitigate cash flow volatility significantly.

Considering its full suite of businesses, NextEra Energy’s has a narrow moat, built on territory monopolies and scale advantages. Better yet, the utility giant’s renewable energy business has a sustainable competitive advantage, or wide moat. “This segment has secured some of the country’s most desirable wind and solar generation sites, locking in 20-year-plus purchase power agreements with escalator clauses protecting returns,” says Bischof, who appraises the stock’s fair value to be US$193.

The company recently divested most of its no-moat fossil-fuel generation fleet, further boosting its competitive strength, Bischof says, adding that “declining costs for wind and solar position Energy Resources unit [which has a sizeable backlog of renewable energy projects] favorably during the next decade.”