A combination of steady electricity price gains and stable-to-improving demand are helping the utility sector’s earnings power. The favorable demand backdrop is a function of the improving outlook for the U.S. economy, with recent readings confirming that growth has resumed in the current period following the weather-induced sub-par showing in Q1. Measures of labor market, housing and other areas have started showing strong momentum lately.

Utility companies are steadily improving the environmental impact of their operations by investing in more environment-friendly power generation facilities. Per a recent release from the U.S. government’s Energy Information Administration (EIA), 31 gigawatts (GW) of coal-fired generating capacity is projected to be retired and 4 GW converted to natural gas facilities between 2014 and 2016. The phasing out of coal-fired plants will largely be influenced by the need to comply with Mercury and Air Toxics Standards and exploit low natural gas prices.

The EIA also projects that the share of renewables to total electricity generation will rise from 13% in 2013 to 18% in 2040.

We believe a constructive rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will definitely enable the utilities to efficiently serve a larger customer base.

In the segments below, we discuss the basic strengths of the utility sector:

Stable & Growing Demand

The biggest positive as well as the fundamental strength of the utilities sector is that there is basically no viable substitute for their services. The endless need for electricity and utility services are driving the sector. This gives the revenues and cash flows a high level of certainty and visibility.

Regular Dividend & Share Buybacks

Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008–2009 when utilities continued to pay dividends without fail.

Focused on R&D

In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, transmission and distribution lines, and gas pipelines into operation to meet the rising demand for power without compromising on energy efficiency.

Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.

Barriers to Entry

Utility businesses are by their very nature monopolistic. In fact, that’s the primary reason why they are so heavily regulated in the first place. But flip side of this heavy regulation is that they don’t have to worry about new entrants in their area of operations as companies in other industries have to do. The need for greater capital investments also creates a big hurdle for new operators in the space.

Mergers and Acquisitions

Utility sector operators don’t shy away from relying on M&A activities to supplement their organic growth measures. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources.

We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way to enhance market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio of the companies and also lowers operating costs through the usage of common back office space to control the expanded operation.

Two utility majors, Exelon Corporation (EXC - Analyst Report) and Wisconsin Energy Corporation (WEC - Analyst Report), are currently working on their respective acquisition deals. Exelon expects to close the acquisition of Pepco Holdings (POM - Analyst Report) in second half of 2015 and Wisconsin Energy Corp. expects to close the acquisition of Integrys Energy Group, Inc. (TEG - Analyst Report) by 2015, subject to all necessary approvals.

In Dec 2014, NextEra Energy Inc. (NEE - Analyst Report) announced that it has entered into a definitive agreement to acquire the utility wing of Hawaiian Electric Industries, Inc. (HE - Analyst Report) for a total consideration of $4.3 billion.

Utility Services Have No Alternative

We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but do not have any alternative to electricity. Similarly, clean water does not have any substitute. This is perhaps the most vital driving factor for the industry.

To Sum Up

Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features. That’s why this sector has historically provided investors a safe refuge in times of market turbulence and uncertainty.

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