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WHY HAVE
UTILITY STOCKS SUDDENLY STARTED TO DECLINE?
Market Comment, 1/25/2008
Last week, clients inundated us looking for answers to
the sudden collapse of the Dow Jones Utility Average on Thursday,
January 24, apparently on no significant news developments or change in
the fundamental outlook (relative to the previous day). While the
broader Dow indices managed to close the turbulent trading week with
nominal highs, the Utility Average closed down 19.78 points at 484.14,
its weekly low and well under its 552.74 12-month high reached a few
weeks earlier (mid-December 2007). Meanwhile the Dow Industrial Average
ended the week up 107.87 points and the Transportation Average posted a
295.12 point gain. Suddenly, however, as the stock market made a
significant intraday break on Thursday, the Dow Utilities
uncharacteristically followed. What happened?
Despite the general market volatility since the beginning
of 2008, utilities have not moved in lockstep with the rest of the
market and had been holding up well – we suspect dividend yields
provided a very short window of opportunity for investors seeking
yields, unavailable in Treasuries or other sectors having the
potential to post earning surprises. We feel that utilities may gain on
an interim basis as the Fed cuts rates and investors reach for yield but
we caution investors not to ignore the stronger, secular trend that is
operating on the entire market, including utilities. That is the short
answer.
Longer-term, the answer is one which investors may not
necessarily be pleased with. Utilities have traditionally been viewed
as defensive stocks, particularly during periods of easing interest
rates – but only “to a point.” That point was reached Thursday. An
argument can be made that the broader market has been trading at an
overly-inflated valuation when measured by P/E multiples for perhaps as
long as a decade – or longer and the entire market may be reverting to
historically lower valuations (i.e. P/Es). Utilities are not immune from
what might be a secular retrenchment in risk/reward relations. In short,
investors may have begun to realize that multiples have been inflated
for too long and, ultimately, a run-up in interest rates would not bode
well for utilities. The bull market has stampeded for too long,
distorting appropriate risk premiums in all sectors. A readjustment to
lower historical levels across the broad equity spectrum may be
underway. January 24 may prove to have been that “random” day when
utilities joined the real world and its harsher realities
The Dow Utility Average was recently trading at 18x to
22x earnings. Historically the Dow Utility P/E has traded at in the
upper 12x range. Recently, utility multiplies have shared the lofty
levels enjoyed by all stocks. Utility P/Es have remained above the 12x
mark for the past eight years and even longer if we discount the
industry specific turmoil with which the sector began the decade.
Much like the entire market, all stocks are struggling to
find a fresh level of equilibrium; accordingly, utilities cannot buck
the trend indefinitely. Nevertheless, there are six general points
observable about the utility reversal right now:
1. VALUE Point 1: P/E multiples and their
attendant overall stock/risk valuations are moving downward in
conjunction with the market which again brings to mind the old adage, "a
falling tide takes down all ships." The electric utility sector, whether
measured by the Dow Index or others, had been a laggard but with its
recent lofty valuations had reached the breaking point that I noted
previously. It will probably now drift downward towards its bear market
valuations which in recent years have been 12x earnings. In more
distressed periods of the past it has in fact fallen into single-digit
territory of about 8x earnings.
2. VALUE Point 2: After past interest rate cuts
utilities have proven to be safe havens. However, the recent deviation
from that pattern indicates that the market is not accepting the
precipitous decline as a "mere correction" or "short-term" downward
adjustment, especially over the last few weeks. And the unexpected
precipitous drop in the Electric Utility Indices marks yet another
breaking point for the markets, suggesting that a bear market is
underway.
3. FUNDAMENTAL Point 1: Fundamentally, a decline
in economic activity (i.e. recession or whatever label you chose to give
it) could result in lower electricity usage, especially since weakness
in manufacturing activity, which comprises nearly 40% of sales, dwarfs
residential and commercial sales (individually). Kilowatt sales growth
for 2008 is estimated to be 2.5%.
However, as various sectors of the economy weaken, especially for
commercial and industrial users, sales to these heavy users can be
expected to ease by 1.5% to 2.0%, thus depressing top-line growth. The
latest available statistics place composite sales by customer
classification for U.S. electric utilities as:
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Residential 36.8%
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Commercial 35.4%
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Industrial & Other 39.6%
4. FUNDAMENTAL Point 2: Evidence of an economic
slowdown began to show up in annual 2006 statistics, with residential
growth up only 0.8%, commercial up 1.8% and industrial down 3.3%.
Composite statistics for 2007 will not be released for several months,
making it difficult to gauge the impact of the 2007 third and fourth
quarters. I suspect first-quarter sales results will highlight
weaknesses across all customer classifications.
5. FUNDAMENTAL Point 3: In addition to the
fundamental front, about 50% of the United States is deregulated while
the regulated companies still need to seek rate recovery of operating
costs from regulatory bodies. These politically-sensitive agencies are
less inclined to grant rate increases during times of economic weakness
which raises the concern in the market that the ability to secure
adequate cost recovery will not be forthcoming, thereby leading
utilities to anticipate a recession.
6. FUNDAMENTAL Point 4: For those utilities which
operate as deregulated entities (a.k.a. Independent Power Producers,
Merchant Power Producers and the like), the slackening in sales will
force them to absorb any reductions in revenue, lowering their
profitability. With no recourse for revenue recovery from any mechanism
or body other than pure market forces lower retail prices might be in
the offing, again adversely affecting profitability for these
non-regulated companies.
Many financial commentators and their guests have only
tangentially touched upon the dynamics of the very large and important
sector. Our reaction is that the unique characteristics of utilities do
not seem to have taken into account the full ramifications of how the
weakening utilities’ valuations seem to be ingrained with that of the
broader shift in the stock market.n
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