Utility Stocks Are About To Pull Back -- Get Ready To Buy

Adam Fischbaum's picture

Wednesday, August 24, 2016 - 12:30pm

by Adam Fischbaum

There's no arguing that utility stocks have knocked it out of the park this year. Year to date, the Dow Jones Utility Average is up better than 18%. Utility stocks are always attractive to income oriented investors because of their dividend yields. But is now the time to buy? 

Probably not. In fact, I recently recommend taking profits in utility bellwether Southern Company (NYSE: SO). But it looks like investors will get an opportunity relatively soon to pick up some high quality names in this dependable, dividend paying sector.

It's been quite a run for the average. Utility stocks have returned more than twice the S&P 500 year to date; 18.1% versus 8.29%. However, it looks as if the utility rally is running out of gas. The average is down 4.1% since its July peak.

Why?

Interest rates, maybe? Probably not. Typically, as rates rise, utility stock prices soften. Utility companies are heavily dependent on the debt markets for operational financing. Usually, utility stock holders become nervous when interest rates rise. Higher borrowing costs can put the squeeze on margins, earnings and eventually the beloved dividends utility companies are known for paying. But, right now, rising rates are not a problem. 

Dismally low yields are actually a shot in the arm for utility shares. Yield hungry investors will cling to utility stocks for the perceived safety of the income stream.

So who's the culprit for softening utility stock prices? It's possible to blame the presidential election. Markets and investors hate the unknown and, let's face it, this year's race is a case study in the unknown. Both sides have rolled out proposed tax policy with one side taking an unabashed confiscatory posture on the subject of capital gains and dividends. Regulatory fear also plays in. The United States has stumbled through nearly two decades without crafting a concrete energy policy. Power generation regulation will be a major component when, not if, it comes.

However, I think the real reason for utility stocks entering a noticeable downturn is much simpler: good old fashioned profit taking.  The sector has run like a thoroughbred this year. It's bound to at least take a little rest. When it does, here are two names to look at.

Southern Company (NYSE: SO) -- Considered the Coca Cola (NYSE: KO) of the regulated power industry, ironically, Southern Company is also headquartered in the soft drink giant's hometown of Atlanta, GA. Forecasts call for 8.6% revenue growth for this year, translating into $18.98 billion, compared to 2015's $17.48 billion. The 2017 outlook is even more optimistic, calling for revenue growth of 14%. The 2016 earnings per share (EPS) outlook is just as bright at $2.87 per share, versus 2015's result of $2.59, which is a bump of nearly 10%. 

Some of the growth can be attributed to SO's recent $7.9 billion acquisition of AGL Resources (NYSE: GAS), which is expected to boost the company's EPS growth by 4% to 5% over the long term. SO is also focusing on customer growth and higher industrial sales to add to revenue.

Entergy Corp. (NYSE: ETR) -- Serving 2.6 million customers throughout Arkansas, Louisiana, Mississippi, and Texas, Entergy's revenues are poised to grow at 3.4% this year and 1.9% for 2017, following a 7.9% slide in 2015. The revenue slump was attributed to a higher than expected number of customer outages on the industrial side of the business, resulting in a loss for 2015 of 99 cents per share.

But 2016 EPS are looking up, with 2016 estimates topping $7.05, a significant turnaround. Shares currently trade with an extremely cheap forward P/E of just 11.2, putting ETR at a 14% discount to its industry peer group. Analysts are also confident that the company is capable of maintaining its annual $3.40 per share common dividend for the next few years.

Risks To Consider: The obvious risk to this investment thesis is what seems like a sideways stock market. Investors on the sidelines aren't willing to commit to taking profits and rotating into new sectors, nor are they willing to commit additional cash to help grind the market higher. Gains in utility stocks may not continue to grow, with non-committal investors remaining content to sit back and collect the dividends. The risk of a Democratic victory at the top of and down the ballot will cast a regulatory shadow over the power generation industry, not only sending prices down (a good thing temporarily) but also putting pressure on margins and earnings for the foreseeable future (a bad thing).

Action To Take: SO shares currently trade around $52 with a 4.3% dividend yield. Shares are still a little pricey. $50 or better would be a decent entry point, bumping the yield closer to 4.5%. Upper to mid $40's would be even better. Be patient.

ETR trades at a discount to its peers. Shares are priced around $79 with a 4.3% yield. With a forward P/E of 11.8, it's probably okay to nibble. Use any weakness to add to the position.

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Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.