Utilities – Running On Empty: Major Disruption Ahead by Horizon Kinetics
Electric Utilities – Perhaps Not The Investment One Expects
Overview
Shares of electric utility companies performed very well thus far in 20141. The $700 million iShares U.S. Utilities exchange-traded fund, or ETF (IDU), with a 70% exposure to electric utilities and 30% to “gas, water and multi-utilities,” returned 16% as of October 21st, and has a 5-year annualized total return of 12.6%. Similarly, the $2.2 billion Vanguard Utilities ETF (VPU), with a 52% weighting in electric utilities, gained 15% year-to-date and 12.7% annualized over the past five years. Utilities are widely owned as bond substitutes: there are roughly $10 billion of assets under management (AUM) in domestic utility ETFs2. This figure is dwarfed by utility mutual funds: by random selection, just five mutual fund managers (Gabelli, Prudential, Fidelity, Merrill Lynch, and Franklin) have well over $20 billion of AUM in this sector. Utilities are also trading at near record valuations: IDU’s distribution yield is approximately 3.0%, with a trailing price/earnings (P/E) ratio of 21.0x, and a price/book ratio of 1.9x, as of August 31st, which is considerably above historical valuations3 for electric utility companies. VPU yields 3.3%, with an average P/E ratio just over 20x, and a price/book ratio of 1.7x. At these valuations, it appears that a range of disruptive changes in the industry’s fundamentals are not being priced in and that investors who buy these securities seeking income during the current long yield crisis, expecting dividend increases and a “safe” investment, are vulnerable to a severe valuation contraction. These substantive systemic risks are separate from the significant interest rate risk posed by the historic low dividend yield; if re-priced from the current yield of 3% to merely 4% or 5%, utility investors would experience a principal loss on the order of 25% to 40%.
The electric utility sector has benefited from the dramatic and persistent decline in interest rates over the past 33 years, since the 10-year Treasury Note reached a yield of 15.3% in 1981, compared to today’s 2.2%. Consequently, their cost of capital (as for most debt-financed industries) has declined dramatically and created a benefit that is mathematically impossible to replicate. It is evident that historical returns cannot be used as a proxy for future returns—assuming that the future will repeat the past is not a sound investment strategy.
The electric utility sector used to be considerably more regulated than is currently the case. These companies were allowed to earn a guaranteed rate of return based on their capital investments, and were largely allowed to set rates accordingly. This is no longer true across the board. While some utilities continue to be regulated—with guaranteed returns on equity of perhaps 10-12%—others have become “merchant generators,” the term used for power producers that can charge market rates for their electricity and earn whatever rate of return the market allows. However, the tradeoff for that unbounded return possibility is the loss of the regulated guaranteed return on capital; therefore, those utilities are now subjecting themselves to the risk of losing money on their capital investments. While both groups are sensitive to rising interest rates—which would increase their cost of capital and potentially result in reduced share prices, given that utilities are often purchased as bond substitutes—the unregulated assets are the most at risk, since the demand for electricity seems to have decoupled from economic growth, as businesses and consumers have found ways to reduce their usage (both mandated and technological efficiencies). Here is the most critical such statistic: while the U.S. GDP has expanded during the last six years, electricity demand has actually contracted—a heretofore unknown occurrence in the history of the U.S. – basically, since Thomas Edison.
More important, still, the rapid expansion of solar panels as an alternative energy source for both consumers and businesses has finally begun to disrupt the electric utility industry—these panels not only displace demand from the grid, but may also be used to supply excess power back to the grid. The investing public, having been long accustomed to the failed promises and initiatives of the solar power industry, is hardly aware of the critical mass and economic tipping points that have only recently been reached. Perhaps the most startling statistic in this discussion: recent growth rates, both from lower unit cost and the development of effective financing solutions that free the retail customer from any capital investment, are such that 29% of the incremental electric power capacity additions in the U.S. in 2013 were from rooftop solar panel installations. Homebuilder Lennar Corp. now automatically installs, with arranged financing, rooftop panels in new subdivisions in California.
The impact could be particularly severe for those merchant generators operating what are known as ‘peaking plants’, those particularly profitable plants that operate primarily when power use is at its peak—as on hot summer days when air conditioning usage surges. This is also when electricity prices are the highest, and happens to coincide with the time when the sun is strongest and rooftop solar panels generate the most electricity. Consequently, if some modest share of those consumers with rooftop solar panels sell back to the utilities some of their mid-day power generation, the need for peaking plants would be reduced and potentially, in the not-too-distant future, eliminated. In nations with high renewable power capacity, some European and Australian utilities have recently faced true crisis days, when electricity prices were temporarily negative. In Germany, the most advanced European country in terms of alternative energy production capacity, and which is several years ahead of the U.S. in this respect, the two largest electric utility companies have declined by over 50% during the past five years, or by 15% or more on an annualized basis.
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