Lights Out on Utility Stocks

Merrill Lynch's utility analyst Brian Chin was in town yesterday.  Brian has been following the utility space for 12 years, and in my opinion is one of the better ones on the Street.

I have been generally bearish on the utility group in recent months, but I thought I should go hear if there were any reasons that I should change my mind.

In a word:  No.

Utilities face a number of fundamental challenges.

Demand for power has been declining slightly despite an improved economy.  Alternative energy sources have played a role in supplementing traditional sources for power, and this trend seems likely to continue. 

Meanwhile, utilities are struggling to deal with new tougher environmental rules.

Utility commissions have been gradually reducing the allowed rates of return.  In a low interest rate environment, and with many Americans struggling with little or no real income growth, it is difficult to justify granting 10%+ returns to local utilities. 

Meanwhile, utility stocks are trading at the higher end of their historic valuation range; yield-hungry investors continue to favor the group almost regardless of price.  Brian's work indicates that most of the stocks are overvalued by at least 10% relative to a variety of different metrics.

In our meeting yesterday, I asked Brian if there was any real reason to get interested in the stocks he follows (fortunately he has a sense of humor).  While he favors a few companies in the group (he likes PPL; NextEra and Pinnacle), in general he would agree that the group needs a major re-rating before considering to add to positions.

Lights Out for Utility Stocks?

Yesterday I went to hear Brian Chin, utility analyst at Merrill Lynch. 

I have followed Brian's work for a number of years, first while he was at Citigroup and now at Merrill.  His analysis is always thoughtful, and he is not afraid to take a non-consensus stand.


Utility stocks were the rock stars of the stock market in 2011, returning nearly +20% while the S&P gave a meager +2%.  Investors flocked to utilities in search of high dividend yields, and drove valuations to historic highs.

Since then the group has struggled.  There are several reasons:

1. In a world of low interest rates, utility commissions are granting less generous rate increases.  Consolidated Edison, for example, recently filed for rate increases that would give the company a +10% rate of return.  Their regulators, however, have proposed a+8.7% allowed return for the company - a significant decrease from the +10% to +12% returns granted a few year ago.  Other regulators around the country are following suit;
2. Power usage remains low compared to the peaks of a few years ago.  Although the economy has gradually improved, industries that were heavy power users have not returned to peak production;
3. Power pricing has become more competitive.  With reserve margins remaining relatively wide, companies are demanding more pricing concessions;
4. Investor consensus remains almost uniformly bearish on the outlook for bonds.  Most believe that interest rates will continue the slow rise higher that began a year ago.  Higher interest rates nearly always lead to a period of poor performance for stocks that are bought primarily for their dividend yields, such as regulated utilities.

Although his livelihood is following the group, Brian is largely bearish on the stocks he follows.

He noted that while he was at Citi he rated only two of the 23 stocks he followed as "buys".  Under the Merrill system - which attempts to have a more normal distribution of buys/neutral/sell ratings - he has more buys, but only on a relative basis - he is essentially negative on the whole utility group.

What would cause him to change his views?

If the economy picked up steam, and growth rates surprise on the upside, Brian might be inclined to turn more positive.  Stronger growth could lead to more power usage, and mitigate some of the negative headwinds facing the group listed above.

But for now, at least, he would stay on the sidelines.