Utilities Race Ahead of Earnings

Utilities have had an enviable run since the start of the year, rising 15.7% compared to just 0.8% for the broad market. That means they must have had an incredible earnings season, right?

Well, not exactly. In fact, as a group, the 15 utilities in the Dow Jones Utilities Average saw sales decline by 9.9%, while earnings per share fell 7.7%.

Some of that is likely due to a warmer-than-average winter, so we shouldn’t judge utilities too harshly.

After all, it’s not like the rest of the market distinguished itself. Indeed, a majority of the 10 sectors that comprise the S&P 500 posted earnings declines for the fourth quarter.

And utilities were far from being the worst performer. That distinction goes to the energy sector.

So a stock’s performance won’t always correlate with earnings, at least in the short term. In the case of utilities, the sector has clearly benefited from the fear trade: The market’s earlier tumult along with continuing uncertainty prompted fearful investors to seek out safe havens.

No other sector of the stock market boasts the perceived safety that regulated utilities do. And in addition to safety, utilities offer investors the additional enticement of a high and rising dividend.

The other factor at play is the mergers-and-acquisitions spree currently underway in the industry. That’s given an additional inducement for investors to pile into smaller utilities, with the hope of catching a windfall from an acquisition premium.

Eventually, there will be a reversion to the mean, and the market will start to differentiate between utilities of varying quality.

To that end, let’s take another look at the utilities that performed best during the fourth quarter.

American Water Works Co. Inc. (NYSE: AWK) continues to grind out steady gains, with earnings climbing 5.8% during the fourth quarter on revenue growth of 7.1%.

The firm’s growth continues to be driven by a consolidation strategy coupled with infrastructure upgrades to the country’s aging water systems.

In 2015, American Water’s capital spending totaled $1.4 billion, with $1.2 billion allocated toward the replacement and upgrade of infrastructure, while $64 million was spent on acquisitions of regulated water utilities. The company spent another $133 million to acquire a 95% equity interest in Keystone Clearwater Solutions, a company that provides water-management solutions to the oil and gas industry.

American Water plans to invest another $1.3 billion in 2016, with almost $1.2 billion of this total allocated toward improving water and wastewater systems.

Analysts forecast earnings per share will rise 7% this year, to $2.82, on revenue growth of 6%, to $3.4 billion. The company is targeting long-term EPS growth of 7% to 10% annually, which should flow through to the dividend.

American Water has grown its dividend 9.4% annually over the past five years. The annualized payout is $1.36, for a current yield of 2%.

Unfortunately, shares of American Water are rather expensive at the moment. The stock trades at a price-to-earnings ratio (P/E) of 26.6, compared to 18.8 for the broad market.

Wisconsin-based WEC Energy Group Inc.’s (NYSE: WEC) shrewd acquisition of Integrys last summer is expected to give it above-average earnings growth for at least the next few years.

During the fourth quarter, earnings rose 12%, while revenue jumped 51%. Obviously, the addition of Integrys played a big role in that performance, especially considering a winter that was 26% warmer than average in WEC’s service territories.

When looking at the performance of continuing operations alone, therefore, we see the effect of seasonality, including a 2% drop in residential use of electricity and a 0.4% decline in industrial demand for power.

Looking ahead, analysts forecast WEC’s earnings per share will rise 7%, to $2.92, for full-year 2016, while consolidated revenue is expected to jump 46%, to $8.7 billion, again thanks to the acquisition.

Management is targeting long-term EPS growth of 5% to 7% annually, with dividend growth projected to be in line with earnings growth.

WEC’s quarterly dividend is $1.98 annualized, for a forward yield of 3.3%.

Getting back to the sector as a whole, the 29 utilities in the S&P 500 are forecast to grow earnings per share by nearly 3% this year on revenue growth of 2.4%. Meanwhile, dividends are expected to grow another 4.1%. Yes, please!

Of course, we wouldn’t mind another buying opportunity, especially since the sector’s valuation is approaching parity with the broad market.

Over the long term, utilities typically trade at a moderate discount to the overall stock market. And as we’ve seen in the past, this relationship will eventually reassert itself, and we’ll be able to buy some of our favorite names at a more reasonable price.

Our Super-Secret Stock Pick

In May, we’re holding our annual Wealth Summit–this year in Las Vegas. It’s a great way for us to meet you, our subscribers, one-on-one, and there are still spaces open if you’re interested.

Also this year, we’ll be making a special recommendation to those who attend the Summit, and to those who are part of our Wealth Society, whose members receive all the Investing Daily newsletters and other premium services.

It’s a fun exercise for us because there are no rules. We don’t have to pick a utility stock. In fact, our pick doesn’t even need to be a stock: It could be an alternative investment that isn’t traded on a public market.

Our publisher says we can’t reveal the pick in Utility Forecaster, or even to him before the Summit. But in the weeks ahead, we’ll let you in on some of the research we’re doing to identify this exclusive pick.