Utilities to protect from virus volatility

Utility companies provide a defensive play at times of market downturn. The rationale is that people tend not to cut spending on gas and electricity, thus keeping utility companies relatively immune from the vagaries of stock markets. In fact, the sector has jumped more than 5% in the S&P 500 in January, as of Jan 29. Not surprisingly, the following names are trading above their fair values. However, a pullback could create an attractive entry point.

The largest investor-owned U.S. utility, American Water Works (AWK) provides water and wastewater services to approximately 3.5 million customers, including military bases, municipalities, oil and gas exploration, across 16 states. Regulated markets account for more than 90% of earnings.

The pure-play water utility has increased earnings at a low-double-digit pace since its IPO in 2008, surpassing most of its peers. “The earnings growth has rewarded investors with a total return of over 500% in the 11 and a half years since the spin-IPO by German utility RWE,” says a Morningstar equity report.

Improving regulatory frameworks, increasing operations and maintenance efficiency and acquisitions have underpinned the firm’s earnings growth. American Water recently reported adjusted quarterly earnings of US$1.33 per share versus US$1.20 in the same period last year, boosted “entirely due to strong regulated results,” says Morningstar equity analyst Charles Fishman, who recently raised the stock’s fair value from US$93 to US$96, and projected EPS growth of 9.4% over the next five years, topping most regulated utilities.

Utilities are trading at multi-decade high price/earnings multiples, but American Water trades roughly 50% higher than the average P/E of regulated electric utilities, cautions Fishman. On the bright side, though, the utility has been accelerating its dividend increases, averaging over 10% per year for the past few years. “We expect an annual dividend-growth rate of 10% for the next five years,” says Fishman, noting that “there is room to increase the dividend modestly faster than earnings growth.”

A public utility company, Ameren (AEE) delivers electricity to nearly 2.5 million customers, and natural gas to roughly 1.0 million customers, in Missouri and Illinois.

After operating for years in one of the most difficult regulatory environments, the company is benefitting from improved and constructive utility legislation in both its regulatory jurisdictions. “Management’s patient, yet persistent years-long efforts resulted in increased investment opportunities across the territory, a stark change from just one year ago,” says a Morningstar equity report, noting that continued execution and support from regulators could add to the firm’s competitive strength.

As a result of more favourable regulatory framework in Missouri, management is keeping its promise of capital investment in supportive jurisdictions. “Ameren is allocating US$6.8 billion of its US$13.3 billion five-year investment program in Missouri, long the recipient of minimal investment,” says Morningstar equity analyst Andrew Bischof.

The utility is committed to upgrading aging and underperforming assets, employing smart grids and connected grid services, and improving its focus on renewable energy. Ameren is pushing to meet its goal of 700 megawatts of wind energy generation this year in Missouri, with an investment of approximately US$1.2 billion. “Ameren has received regulatory approvals for the full investment, as well as executed interconnection agreements,” says Bischof, adding that the company is also looking to install 100 MW of solar by 2027.

While the utility lacks an overall economic moat, “Ameren’s transmission assets are moaty,” as capital costs for new transmission lines are too high and Ameren benefits from regulatory protection, asserts Bischof, who recently upped the stock’s fair value from US$62 to US$66.

Virginia-based Dominion Energy (D) produces and transports natural gas and electricity. The integrated energy company generates 31,000 megawatts of electricity and operates one of the nation’s largest natural gas storage systems.

Dominion’s offshore and onshore wind projects and proposed solar projects appear to have strong policy support from Virginia state that has set a goal of 30% renewable and nuclear energy by 2030 and 100% by 2050.  “In our opinion, Dominion’s offshore wind project has some advantages compared with the difficulties offshore wind developers are having in New England,” says a Morningstar equity report, pointing out the firm’s offshore project is located on federal land entirely locked up in leases by Dominion, as well as the construction site doesn’t interfere with fishing.

Further, Dominion has accelerated its capital expenditures with growth investments expected to be roughly US$26 billion over the next five years, about two-thirds of those tied to its regulated utility in Virginia. “Including maintenance capital expenditures, we expect total capital expenditures and equity investments in Atlantic Coast Pipeline [of which it owns 48%] to reach US$35.5 billion from 2019-2023,” says Fishman, adding “this should drive EPS growth over 5% annually.”

The wide-moat firm reported solid third-quarter earnings and made a strong argument for the potential of its offshore wind project proposal, prompting Fishman to raise the stock’s fair value from US$84 to US$86. Dominion’s sustainable competitive advantage stems from the fact that its regulated gas and electric utilities enjoy some of the most constructive regulation and attractive growth potential in the country.