Utilities look strong
Utilities could be one of the major beneficiaries if the Fed cuts the interest rates. The Fed kept the rates unchanged in June. The Fed indicated that it was open to rate cuts if the situation warrants. Looking at Treasury yields, you can see that the bond markets are already pricing in the Fed’s rate cut. Trade talk uncertainties could make broader markets anxious, which might send investors to defensive sectors like utilities.
On average, utility stocks (XLU) have risen ~16%, while broader markets have risen ~18% in 2019.
NextEra Energy and Southern Company outperform
Southern Company (SO) stock has been unstoppable in 2019. So far, the stock has risen almost 30%. Southern Company seems relatively better placed due to Plant Vogtle—compared to last year. NextEra Energy (NEE) has risen more than 22% YTD (year-to-date). Dominion Energy (D) and Duke Energy (DUK) have risen 5% and 9%, respectively, YTD. Dominion Energy and Duke Energy have underperformed their peers.
NextEra Energy continued to report above-average earnings growth in the first quarter. Most top utilities’ earnings fell in the first quarter due to milder weather. NextEra Energy has been consistent with its earnings growth due to the solid contribution from Florida Power and Light and NextEra Energy Resources in the last several quarters. NextEra Energy’s unmatchable renewables portfolio and large regulated operations in Florida had superior earnings growth compared to its peers. We’ll have to see how these utilities’ second-quarter numbers play out.
Utility stocks look expensive
Southern Company and NextEra Energy look expensive compared to their historical averages. They’re trading at multiples of 18x and 22x their earnings for the next 12 months. On average, utility stocks are trading at 19x their forward earnings. The multiple looks expensive for utilities due to their slower earnings growth. Even if utilities offer superior dividend yields compared to broader markets, the current valuation doesn’t appear to be justified. Broader markets are trading close to 17x. Dominion Energy and Duke Energy are trading at a forward PE ratio of ~19x.
NextEra Energy, the largest utility stock by market cap, has been consistent with its earnings growth for the last several years. The company’s market performance has also been consistent. NextEra Energy returned 25% in the last 12 months, while it returned 145% in the last five years. NextEra Energy has outperformed utilities at large and broader markets in all of the periods discussed above.
The Utilities Select Sector SPDR ETF (XLU), the representative of top utility stocks in the country, returned 19% in the last 12 months. We considered capital appreciation and dividends paid to calculate the total returns.
NextEra Energy managed to grow its adjusted EPS by close to 8% compounded annually for the last decade. On average, utilities increased their EPS by ~4%. NextEra Energy’s premium earnings growth fueled its higher dividend growth. The company’s dividends increased 10% compounded annually in the last five years—much higher than the peer average.
NextEra Energy aims to grow its EPS 6%–8% per year through 2021, which indicates that the higher dividend growth might continue. NextEra Energy yields 2.5%—one of the lowest yields among its peers.
Southern Company returned 25% in the last 12 months and 61% in the last five years. The company yields 4.4%—much higher than the peer average. Southern Company’s power plant issues, like cost overruns and delays, hit its earnings growth last year. Progress at Southern Company’s Plant Vogtle could have been one of the drivers behind the rally.
Duke Energy’s (DUK) total returns were 17% in the last year. The company returned 55% in the last five years. Dominion Energy underperformed its peers. The company returned 38% in the last few years. Dominion Energy completed the Dominion Midstream Partners acquisition, which could bode well for the company’s earnings growth in the medium to long term.
The S&P 500 returned 11% in the last 12 months and 65% in the last five years. “Widow-and-orphan” utility stocks outperformed the S&P 500 over the last five years.
The top utility stocks look strong based on their respective simple moving average levels. NextEra Energy stock is trading at $207.7, which is almost 4% and 12% above its 50-day and 200-day moving averages, respectively. The fair premium to both of these support levels suggests strength in the stock. NextEra Energy’s 50-day level close to $200 could act as a support for the stock in the short term. NextEra Energy stock is trading at an RSI (relative strength index) of 62, which implies that it isn’t in the overbought or the oversold zone.
Southern Company stock is also trading well above its support levels, which indicates strength. The company’ss RSI was 59 on July 2. NextEra Energy, Duke Energy, and Southern Company are trading close to their respective all-time highs.
Does Dominion Energy stock look weak?
Dominion Energy, the third-largest utility stock by market cap, is trading notably lower than its all-time high close at $85.0 in November 2017. Currently, Dominion Energy is trading at $77.4. The stock bounced from its 200-day levels close to $74.0 in the last few months.
Duke Energy, the biggest regulated utility stock, crossed above its 50-day moving average level. The levels close to $88.0 and $87.1 might act as support for Duke Energy stock in the short term.
Among the top utilities, the short interest in Dominion Energy stock increased substantially. The short interest in Dominion Energy stock increased 40% as of June 14. The short interest represents the number of a company’s shares that have been sold short and not covered back yet. An increase in the stock’s short interest might imply that more investors expect it to fall from the current price level. The short interest in Southern Company stock rose 14% on June 14. NextEra Energy and Duke Energy recorded a lower short interest.
Recently, the top utility stocks had an implied volatility of ~15%, while broader utilities’ implied volatility was ~12%. The implied volatility represents investors’ anxiety. Rising volatility is usually associated with a fall in the stock prices. Generally, utility stocks are considered to be slow and steadily moving. Utility stocks displayed higher volatility levels than broader markets.
Analysts expect a downside of more than 2% from NextEra Energy stock based on the mean target price of $212.8 and its current price of $207.7. Based on the estimates, analysts appear to be positive on NextEra Energy stock compared to its peers due to the flat “buy” recommendations. NextEra Energy hasn’t received a “sell” recommendation in more than a year. Analysts seem cautious about Dominion Energy, Duke Energy, and Southern Company.
Top utility stocks
Duke Energy stock has a mean target price of $92.6, which suggests a potential upside of ~4% from its current price of $89.1 over the next 12 months.
Analysts have given Dominion Energy stock a mean target price of $78.4—compared to its current price of $76.6, which implies a potential upside of 2.3%.
Southern Company stock is expected to have downside movement of more than 3% based on analysts’ target price of $54.0 for the next 12 months. The company’s current market price is $55.9.
All of the top utility stocks have a dull potential upside due to their recent strength. Fundamentally, utilities look strong at the moment. Their expected earnings growth for the next few years seems achievable, which could drive their dividends. Last month, the Fed indicated that it’s open to a rate cut if the conditions permit. A potential interest rate cut could make utility stocks even more attractive. Lower interest rates will save on debt servicing costs and improve utilities’ profitability. Utility stocks’ yield will probably look more alluring compared to bonds. Even though trade war tensions seem low after President Trump and President Jinping agreed not to impose any new tariffs last week, any concrete solution to the trade war might take a long time. Until then, volatility in broader markets could be a big positive for defensives like utilities (XLU).
To learn more, read Why Utilities Underperformed the Broader Market Last Week.