Why Wall Street Keeps Getting It Wrong With Utilities

And I’m betting on a massive re-rating to much higher ground.

Most of us have a hard time resisting the allure of the hottest stocks. And after almost 40 years as an investment advisor, the one thing I can say with 100 percent assurance is sales of our services are always highest when the sectors we cover are sizzling.

That’s never been something I’ve been comfortable with for two main reasons. First, we’re in this business to help investors buy low and sell high. And chasing already hot stocks is no way to accomplish either.

Second, our knowledge and experience in the sectors we cover is always most valuable at the lows. That’s when investors are most prone to confusing temporary unpopularity with real business weakness—and are therefore at greatest risk to both stepping on landmines and missing generational opportunities to build wealth.

Utility stocks could hardly be less popular now. The Dow Jones Utility Average is underwater by -13.3 percent year-to-date, including dividends. That’s 22 points behind the S&P 500 and trails the Nasdaq 100 by 44 points.

As for valuations, the DJUA yields 4.26 percent compared to 1.68 percent for the S&P 500 and just 0.91 percent for the Nasdaq. The DJUA also trades at 13.4 times expected 2024 earnings, versus 18.1 times for the S&P and 23.3 times for the Nasdaq. And earnings projections for the Big Tech companies dominating both of those averages are arguably based on far more aggressive assumptions for profit growth.

Why are investors shunning utilities? It all boils down to expectations for interest rates, and especially their potential impact on companies’ CAPEX-led growth rates.

Just prior to the first utility Q3 earnings release last week—NextEra Energy’s (NYSE: NEE)—a prominent investment bank published a report titled “Q3 Preview: Will Rates Dethrone Rate Base Growth?”

The question is a valid one. Utilities needing to issue stock in the near future will be doing so with the DJUA down roughly -20 percent from its all-time high of April 2022. And yields to maturity for investment grade utilities’ longest maturity debt is 1 to 1.5 percentage points higher than at the beginning of 2023.

That means raising capital to fund growth—however needed—is meaningfully more expensive now that it was just a few years ago for these high quality companies operating in a recession resistant industry. Even asset sales are increasingly off the table for many, as higher interest rates have limited the pool of would-be acquirers.

When affordable capital is unavailable, companies have no choice but to reduce investment and therefore growth. That’s the lesson from NextEra Energy’s cancelled asset sale/drop down to its affiliate NextEra Energy Partners (NYSE: NEP) a month ago.

The energy midstream business has operated under these restrictive conditions since the middle of the previous decade. And we’ve seen a sharp reduction of investment in new pipelines and other vital infrastructure, which is has tightened supply.

Curbing growth has also made midstream companies far more resilient than in the past, with operating cash flow fully funding CAPEX, dividends and debt reduction. In fact, former dividend cutters like Energy Transfer LP (NYSE: ET) are now positively utility-like in terms of being able to weather a future recession unscathed.

Cutting CAPEX plans would no doubt strengthen utilities’ balance sheets and further safeguard dividends. And after the DJUA’s decline, sector stocks are now priced for them. Industry leader NextEra, for example, is down nearly -33 percent year to date, trading at its lowest P/E and highest dividend yield in a decade. That’s after nearly tripling earnings per share and dividends since 2013.

But at least so far there’s been no reckoning. The bulk of utility companies will release Q3 results and update guidance in the next two weeks. But the half dozen reporting so far have either met or increased guidance for this year. And they’ve affirmed longer-term projections for CAPEX-led earnings and dividend growth as well.

NextEra Energy was first, reporting a record 3,245 megawatts of new contracts for wind, solar and energy storage signed in Q3. Management affirmed “it would be disappointed” if it did not hit “the high end” of earnings guidance ranges for 2023-26. It provided unprecedented color on funding growth, including $1.6 to $1.8 billion in sales of renewable energy tax credits made possible under the Inflation Reduction Act. And it guaranteed the health of its yieldco funding affiliate NextEra Energy Partners (NYSE: NEP), which increased its November payout in line with 6 percent annual growth guidance.

Next up was Iberdrola SA’s (Spain: IBE, OTC: IBDRY) 81.61-percent owned US affiliate Avangrid Inc (NYSE: AGR). And despite several key contingencies—including opening this country’s first commercial scale offshore wind facility next year—management affirmed its projected 6 to 7 percent long-term growth rate. A day later, Centerpoint Energy (NYSE: CNP), CMS Energy (NYSE: CMS) and FirstEnergy Corp (NYSE: FE) all repeated 6 to 8 percent earnings growth guidance, fueled purely with regulator approved, utility rate-based investment.

All of these companies acknowledged the negative impact of higher interest rates. And as readers well know, I think the Federal Reserve will keep pushing benchmark rates higher until it’s painfully obvious the US economy is in recession—even while sowing the seeds of future inflation by squeezing investment.

But these results show they’re not sitting ducks either. Regulatory support, the fact that most targeted investments cut costs and therefore customer rates, two decades of prudently laddering debt maturities, ability to sell low cost green bonds, Inflation Reduction Act tax credits and conservative planning when credit was cheaper have all contributed to resilience.

Also, unlike during the 1970s cycle of heavy CAPEX—when inflation and higher interest rates triggered billions of cost overruns—most projects now are short-term where expenses can be locked in. That applies to the largest and longest-term utility project still under construction—Southern Company’s (NYSE: SO) two new nuclear reactors at the Vogtle site—with the final unit on track for startup next year with a rate settlement in hand.

Offshore wind development costs have increased 50 percent since latge 2021. But even that’s not a substantial risk to utilities’ CAPEX-led growth. Few utilities have ever had direct exposure. And those that do have either cut their losses or locked in costs, including Dominion Energy’s (NYSE: D) Coastal Virginia Offshore Wind facility.

That’s why I think Wall Street will keep getting it wrong with utilities. And so long as those growth rates hold, the sector is headed for a massive re-rating to higher ground, once investors are less worried about interest rates.