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Where were you when the lights went out?

On August 14, 2003, a 3,500 megawatt power surge created a domino effect, causing the second-widest blackout in North American history. More than 55 million people from New York to Toronto to Detroit lost power for almost two days. Police and public workers were on high alert, but most residents reacted with surprising calm. Municipalities and electric utilities used the episode as a call to arms to address aging and inefficient infrastructure.

Change is the result of hard work, debate, and compromise. Infrastructure has been rebuilt and upgraded. More efficient power generation has been integrated into the power base. More recently, unprofitable capacity power auctions have been restructured to provide proper incentives. Finally, technological innovation is allowing renewables to become increasingly economic compared to traditional hydrocarbon sources.

We believe equity investors will benefit from these secular shifts. Utility revenue growth improvement should support stronger earnings and dividend growth than has been evident over the past 10–15 years.

Growth potential charging up

As recently as two years ago, regulated electric utilities traded at a 35% premium to the S&P 500, according to RBC Capital Markets. Today they trade at a 2.6% discount after a third-quarter rally. Investor preference for growth stocks and the fear of rising interest rates have driven the underperformance. But these issues have opened a window of opportunity for investors seeking above-average return potential with below-market risk.

Regulated utilities hitting the sweet spot of earnings & dividend growth

GI_Nov_01

Source - Company reports, RBC Capital Markets estimates. Data is based on a weighted average of large-cap U.S.-based regulated electric utilities.

Stronger EPS growth combined with a return to normalized dividend payout ratios could result in faster dividend growth trends.

We believe investors may miss key trends that support an improved growth outlook. Stronger utility asset base growth combined with sustainable return on equity (ROE) means stronger revenue growth. With good cost controls and management of that asset base, RBC Capital Markets sees 4%–6% EPS growth that could accelerate to 5%–7% should current trends persist. In addition, the sector has been less sensitive to moves in interest rates than in past cycles (see chart).

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Debunking the Myth … Utilities Not Just Bond Equivalents Anymore

GI_Nov_02

Source - Company reports, RBC Capital Markets estimates. Data is based on a weighted average of large-cap U.S.-based regulated electric utilities.

Fast and more durable growth than in past periods has made utilities less sensitive to interest rates.

We also believe dividends, which are already twice that of the broader market, could grow more quickly. The percentage of earnings paid to investors in the form of a dividend is at 63% versus the 35-year average of 74%, leaving room to accelerate dividend growth.

Thus, we view the opportunity as twofold. First, we see potential for capital appreciation because the group is trading below what we view as “fair value,” due to better growth in assets and stable ROEs. Second, dividend growth could accelerate, rising to an average of 4%–4.5% from 3%–3.5%.

While utility growth may not be as high as other sectors (e.g., technology or biotechnology) it tends to be lower risk and more durable. The utilities sector is considered less risky than the market, carrying a “beta” of one-half to two-thirds that of the S&P 500.

How the System Works

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Source - Edison Electric Institute 

More importantly … How do utilities make money?

Regional public utility commissions (PUCs) have regulatory oversight for utility operations. This includes investment and investor return requests made by the utility. Utilities make money based on approved customer rates. Serving as virtual monopolies in geographic regions, utilities invest in capital projects to support customers’ needs. A basic formula is:

Total revenue requirement = Expenses + (Rate base x ROE)

The “rate base” is the firm’s capital assets minus accumulated depreciation. The allowed ROE helps ensure a reasonable level of profitability while expenses (fuel costs and support) are generally passed on to the consumer. Regulators set a utility’s allowed ROE at a level that allows the company to attract and service the capital it needs to maintain the operational integrity of its utility assets and to expand generating capacity as needed.

The combination of defensiveness and above average yield has made regulated electric utilities a steady partner in individual investor portfolios.

A “rate case” is submitted to the PUC to evaluate that the rate requested is reasonable and justified. Various regulatory mechanisms have been increasingly introduced to “tweak” this basic model, but in general, this formula applies. Rate cases in the current environment reflect significant increases in required capex, contributing to strong earnings growth potential.

Allowed ROEs are scrutinized by state PUCs. Despite a steady drop in long-term interest rates, ROEs have not declined as much as RBC Capital Markets expected. The primary drivers of this have been aging infrastructure and environmental mandates, which have necessitated a significant rise in rate case filings; spending hit $100B in 2014, up from $40B in 2005. RBC Capital Markets believes spending will moderate over the next few years to about $90B annually.

Need for efficient and reliable infrastructure drives investment

Stringent state and federal environmental guidelines have forced the retirement of inefficient power generation. As recently as 2000, coal-fired power represented around 52% of total power generation. Today, it is closer to 39% and on trend to reach 34% by 2040, according to the Energy Information Administration. These trends, combined with government incentives, have also driven the integration of renewables into the power generation base.

Reduced carbon emissions could be the next catalyst favorable to renewables development. Hawaii passed a bill calling for 100% renewables by 2045. California’s Governor Jerry Brown recently signed into law a bill calling for 50% renewables by 2030. Most states have taken measured approaches to integrating renewables, mindful of unintended costs.

In conclusion, the lasting impact of the 2003 blackout was not stories about where you were, but the resolve that cranked the wheels of the utility industry to meet the demands of the 21st century. The recent interest rate fears provide investors with a window of opportunity to do well and do good.


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