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When the Music Stops: Utilities with Enduring Value

By Richard Stavros on August 19, 2016

With utility stocks starting to correct after hitting all-time highs during this year’s mass investor flight to safety, it’s time to ask which utilities will hold their value best when the music stops.

One possible answer: productivity.

In the upcoming issue of Utility Forecaster, we’ll be taking a look at which utilities are being managed best from a productivity standpoint, since we believe this will likely be a key differentiator of enduring value in the sector.

Productivity has become a central issue for most U.S. businesses, as many firms are failing to fully utilize their resources, which has led to disturbing declines in revenues and profitability in various sectors over the past few quarters.

According to the U.S. Labor Department, non-farm business productivity—the goods and services produced each hour by American workers—decreased at a 0.5% seasonally adjusted annual rate in the second quarter, as hours worked increased faster than output. This was the third consecutive quarter of falling productivity, the longest streak since 1979.

And long before this latest losing streak, productivity growth was already tepid, averaging just 1.3% annually from 2007 through 2015, according to The Wall Street Journal.

At the same time, there has never been a perfect correlation between business investment and future returns, as corporate managers don’t always identify the most productive areas in which to expand their businesses.

Although regulated utilities have guaranteed returns on their investment, which provide for steady earnings, there have certainly been times when utilities mismanaged their businesses.

For example, some analysts argue that the reason for weak electricity demand in many service territories is that some utilities overbuilt during the housing bubble, which provided a demand signal that was ultimately illusory.

Nevertheless, companies that fail to reinvest in their businesses will find themselves at a disadvantage when the business cycle turns, while those that continue to effectively allocate capital typically have a competitive advantage.

From this standpoint, utilities are way ahead of other sectors in pursuing this fundamental business operation that helps grow future earnings.

From Macro to Micro

For the past few years, we’ve used big-picture trends to help identify which utilities are the best investments in the sector.

But with valuations still near all-time highs, and utilities issuing more debt and equity to support acquisitions and upgrades, the growth picture has clouded. And there is a real risk that credit quality could decline or growth in earnings per share could flatline.

That’s why we also look at companies from a fundamental perspective, particularly when it comes to financial stewardship. To that end, those utilities with the greatest productivity are best positioned to deliver a strong return on their investments.

Right now, our proprietary models still show most utilities trading near full value.

But as the broad market exits the fear trade, the divergence between how companies are managing their balance sheets and investing for future growth could prompt investors to re-rate each firm accordingly.

For subscribers, we highlight one utility that is showing superior productivity compared to its peers.

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