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Change of Power

January 10, 2019

The electricity generation industry might not be as electrifying for investors as traditional growth sectors like technology or bioscience. And for the US market, electricity demand for the past 10 years has largely been flat, even as the economy has been growing and expanding since the 2008-2009 economic contraction.

That changed in 2018. Electricity demand rose by 2.30%, according to the US Energy Information Administration (EIA), making it one of the biggest years for growth in electric power demand. Industrial demand remained flat—consumers and households were responsible for the big gains in demand from the grid—even as more and more have been installing solar panels. This is projected to continue into 2019.

Moreover, more and more homes built after 2000 rely on electricity for heating—47.1% of all newer homes, compared to 19.5% of those built before 1970. Add in the rising number of gadgets in households, and power is more of a growth story than many investors expect.

Power utilities are among the more reliable sectors for both shorter-term and longer-term growth and regular to rising income. While many might think that they underperform the general stock market, over the past 20 years, US utility stocks as tracked by the S&P Utilities Total Return Index have outperformed the general stock market as tracked by the S&P 500 Index, 255.74% to 197.30%.

The market for utilities isn’t about sacrificing return for dividend income—rather it can be a potent rival in the market for general stocks.

Utilities can also make for a great defensive part of your portfolio during very tough times for the general stock market. For example, in the fourth quarter of 2008, the S&P 500 index was down very heavily in short order. But during that same quarter, utilities managed to outperform by more than 50% thanks to the combination of reliable core business assets and higher dividend payments.

Two-Sided Market

Now, not all utilities are the same, of course. They can include a host of essential services, including electricity, natural gas and water. And they are comprised of both regulated and unregulated businesses.

Regulated business means that the companies have contracts set with specific rates for gas, electricity and water by local public utility commissions (PUCs). This means that the companies with regulated markets must lobby local PUC officials for acceptable rates that take into consideration the cost of providing the services as well as the capital costs of the operations for the services.

In addition, PUCs, along with other regulatory bodies, must approve any expansion of regulated services, including new plants and transmission or other conveyance lines. And they also need to gain approvals for payments for upkeep and repairs.

All of this takes a range of skillsets by management to make the most for shareholders while keeping customers and their PUCs content. This includes negotiating and lobbying as well as budgeting and supply-and-demand forecasting.

Yet, at the same time, regulated business means that companies can conduct longer-term budgeting for capital expenditures as well as forecast revenues and profitability more reliably.

This means that companies can provide smoother performance for shareholders, especially in challenging economic or market times. That adds to the longer-term stability for investors’ portfolios.

Then there is the unregulated part of the utility market. This can include wholesale provision of essential services for industries as well as for other local utility companies that will contract for gas, power or water.

This is where some companies can provide larger scale across local markets and even across the country. And this means that the companies in this space can provide the opportunity for investors to cash in on their success with less regulatory oversight on rates.

The Powerhouse

One of the best electric power utilities in the market is NextEra Energy (NEE). The company is primarily comprised of two operating units that take advantage of the regulated and unregulated power utility market.

Based in Florida, NextEra has its primarily regulated power company in Florida Power & Light. The operation provides power through a variety of generating sources including natural gas, coal, oil as well as nuclear power plants. Its customers number in the millions and are primarily residential customers, with some commercial customers.

In addition to its own power generation, it also contracts with external power generators that transmits power via the power grid to supplement its own power generation.

The other side of the company is Next Era Energy Resources. This division of NextEra provides unregulated wholesale power around the US, with some additional assets in Canada and Spain. It does operate many traditional power plants, but increasingly its power comes from wind and solar generating assets. It has quickly become one of the largest renewable power generation companies.

In addition, NEER also has some petroleum and natural gas pipeline assets that take advantage of the company’s reach across the US.

Revenues from the regulated FPL side of the company represent the larger sum of revenues, which continue to expand at a reliable three-year average of 1.58%. This makes for a steady cash flow for the company.

The company continues to focus more on the NEER division, which provides the namesake for the overall company. The idea is that the next era in power generation will be increasingly focused on renewable energy sources. This is supported in that the revenues for the NEER unit have expanded to become 28.55% of overall revenue of the company.

The industry is benefiting from state and local legislation around the nation requiring that a portion of power be generated by renewable sources. In addition, NextEra’s renewable power expansion takes advantage of Federal tax credits for renewable energy facilities. These come based on capacity and not just the amount of power generated. This means that the company can operate wind and solar facilities around the nation, and not just in areas that are particularly sunny or windy.

The company is a stronger performer for investors. The return on its capital is running at 12.80%, while the return on investors’ equity is a whopping 27.7%. The shares have delivered a total return over the past five years of 132.77%, which is more than double the return of the S&P 500 Utility Index.

While the stock continues to perform, its value is still there. The price to book is at 2.4 times, making for value to buy right now. And while the dividend could be higher, it’s still market attractive, at 2.60%, and the payout has been on the rise over the past five years by 10.68%. There is ample cash generation to further expand that dividend, with a cash coverage rate of 2.9 times the dividend.