Understanding the Electric Utility Industry from the Investor’s Perspective

Investors should have signifiers for identifying recurring bear markets and investments historically deemed “safe.” This assessment, of course, should be given with a proviso of conditions that formulate volatility or stability. To aid in an investors’ search for the latter, the following overview details a category of stocks oft-ignored due to a lack of diversified options (i.e., there are considerably few stocks in this particular segment). However, the scope of these limited options is vast in terms of market capitalization and impact.

There are few verticals where investors repeatedly claim safety in regards to high or consistent yields. Investors aiming for stability have long flocked to electric utility stocks. The industry provides some degree of immunity from the economic cycles affecting many other industries. Utilities’ essential functions include providing the energy that households, businesses, and organizations need to both survive and expand. Investors are also drawn to these investments, in part, because utility companies return large portions of their income to investors in the form of dividends.

However, utilities are more than just the companies helping power lights or air conditioners; they encompass capital intensive industries involved in creating, transporting, and delivering electric power to end users, as well as the numerous investment vehicles that generally provide investors with both stability and above average returns.

The industry is split into four processes: power generation, transmission, distribution, and retailing. While competition often exists in distribution and retailing, power generation and transmission are considered natural monopolies. Natural monopolies form when the cost of building redundant power stations or transmission lines discourages competitors from entering the market. Hence, even with pricing controls and efficiency mandates imposed by regulators, utility stocks deliver relatively steady profits and can provide a reliable dividend.

Although these investments are regarded as safe, they are not without risk. One such risk is higher interest rates. High rates make it more expensive to upgrade critical infrastructure. Additionally, dividend-paying stocks guarantee neither dividends nor principal. Bonds protect principal, and interest rates are guaranteed, except in cases of bankruptcy. If bond interest rates match or exceed dividend yields, the appeal of dividend-paying utility stocks is reduced. Finally, the introduction of the Tesla Solar Roof shingles is potentially a disruptive force in the market. The future impact is unclear due to the lack of data on costs and reliability. However, if this product were to become a large source of residential electricity, it would introduce a competitor in many markets that were historically natural monopolies.

Investor-owned utilities serve the large majority of customers, which in 2015 accounted for only 143 out of over 2,000 utilities. NextEra Energy (NEE), Duke Energy (DUK), Southern Co. (SO), and Dominion Resources (D) are the four largest utilities in both the U.S. and the world at large. These companies are characterized by a reliable, slow-growth customer base, consistent profits and high, sustainable dividend payout ratios. However, there is some differentiation in the services in which each company specializes.

NextEra is the largest utility, serving 4.9 million customers in Florida through its subsidiary Florida Power & Light. The company produces energy from nuclear power facilities in four states. In 2016, NextEra generated profits of $6.25/share and paid $3.48/share of that profit in dividends, representing a payout ratio of 64%. Unlike NextEra, Duke Energy is more heavily involved in natural gas, distributing gas to 1.5 million customers in four states. The company also generates and distributes power to 7.4 million customers in Florida, the Carolinas, and the Midwest.

Like most other utility companies, Duke delivers steady revenues and profits. The company stands out with its unusually high dividend payout ratio, which stood at almost 84% in the 2016 calendar year and even exceeded 100% in fiscal 2016. Compared to NextEra and Duke, Southern Co. is more involved in transmission and distribution. Southern operates more than 200,000 miles of transmission and distribution lines and 80,000 miles of natural gas pipelines. The company serves 4.5 million customers in Alabama, Georgia, and Mississippi. The company also generates power in eleven states scattered across the country through its Southern Power and Southern Nuclear subsidiaries. Due to its substantial involvement in natural gas, the company diverged from the industry norm of consistent profitability. Southern suffered losses in 2015 and 2016 while still maintaining its $0.67/share dividend. In the first quarter of 2017, Southern posted its first profit since energy prices dropped dramatically in 2015.

Finally, Dominion Resources is different from the other three for its involvement in all four processes of the electric utility industry. It serves more than six million retail and energy customers and owns 6,600 miles of electric transmission lines, 15,000 miles of natural gas pipeline, and has one trillion cubic feet of natural gas storage capacity. Unlike Southern, Dominion maintained profitability through the slump in gas prices. Similar to Duke, Dominion Resources has a dividend payout ratio that occasionally exceeds 100%. This ratio was 83% in the 2016 calendar year.

While investors generally regard electric utility investments as low-risk, investors who prefer diversification have plenty of exchanged traded fund (ETF) options specializing in this industry. In the U.S., there are numerous utility-based ETFs actively traded. Like their corresponding individual stocks, these ETFs tend to be characterized by consistent profits and comparatively large dividend payouts. Of the ETFs that invest primarily in domestically-based companies, three stand out, both for their comparatively large investments in NextEra, Duke, Southern, and Dominion, and for comparatively higher rates of return.

The Utilities Select Sector SPDR (XLU) is the most popular electric utility ETF, with a 3.28% dividend yield and an expense ratio of only 0.14%. Though the dividend falls short of the category average yield of 3.87%, the expense ratio is well short of the 0.50% category average. Its 10-year return also exceeds averages, with an average appreciation of 6.75%, compared to a 5.20% category average for the same period. Another popular fund is the Vanguard Utilities ETF (VPU). Vanguard stands out with its low expense ratio at 0.10%, and its 10-year return was 7.08%. This sector attracts new ETFs as well. The Fidelity MSCI Utilities ETF (FUTY) was founded in 2013. Its 3-year returns are 9.26%, comparable to its larger counterparts in the same period. It also has an expense ratio of 0.08%, which helps to offset a somewhat smaller dividend yield of 3.19% in the previous twelve months.

Investors wanting to capitalize on the stable cash flow and higher than average dividends paid by electric utilities have many vehicles from which to choose. These investments cover production, transmission, distribution, and retailing. Utilities are varied geographically, with many operating internationally, others in the United States only. The American companies are often operating in multiple regions or throughout the country, and larger companies tend to be involved in most or all the processes of the electric utility industry. Though utilities tend to be regarded as conservative investments, financial and technological threats remain, so investors should remain vigilant. However, with opportunities in both individual companies and ETFs, investors can find cash flow returns that exceed the average dividend yield coupled with a comparatively low risk.

Authored by Dr. Brandon K. Chicotsky, Business Faculty Member at Johns Hopkins University