These Heavily Indebted Utilities Offer Risk and Growth
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The debt to equity ratio is an important metric that every investor needs to watch. Debt allows for the financing of growth, but at the same time it can place a serious drag on earnings. These utilities all have debt to equity ratios over 1.6, but different regulatory environments will make or break these stocks. ITC Holdings (NYSE: ITC) is a special opportunity in the power transmission market which allows it to produce very strong returns and margins relative to other electrical utilities. Debt levels ought to be given special attention, but they should not blind investors of unique opportunities in niche markets.
AES Return on Invested Capital data by YCharts
AES Return on Equity data by YCharts
AES Debt to Equity Ratio data by YCharts
Among these companies, ITC has the highest ROIC at 4.6% and the highest ROE of 13%. This firm operates in the electrical transmission market and the U.S. Federal Energy Regulatory Commission (FERC) is the major regulatory body. The FERC has specifically stated that they are offering high returns on equity in order to spur new investment in transmission assets. As the blackout throughout the North Eastern U.S. and Eastern Canada in 2003 demonstrated, North America's power grid is in desperate need of upgrades. The PE ratio of 22.7 and yield of 1.9% makes ITC rather expensive right now. However, considering the high quality of the underlying business and the future growth prospects, this is definitely a company to put on the watch list.
The AES Corporation (NYSE: AES) is a large utility with assets in North America, Europe, Latin America, and Asia. In the utility sector, governments are heavily involved in shaping the market. Developing nations can view western corporations as an arm of U.S. imperialism which makes rate increases during times of slow growth very difficult. In addition to these broad geopolitical risks, AES has a high total debt to equity ratio of 3.55. Their low yield of 1.5% only gives more reason for the market to view the firm as risky and discount it with a low 1.28 price to book ratio.
CMS Energy (NYSE: CMS) is a Michigan based utility with a yield of 4.0% and an ROE around 11.2%. Like ITC, the need for new infrastructure is a top priority of the firm. In the latest earnings call transcript executives mention that over the coming years an energy shortfall will start to develop. Their total debt to equity ratio of 2.26 is not cause to rejoice but their ROIC of 3.7% is higher than that of AES. If Michigan voters approve increased renewable energy goals then CMS will need to increase their capital investments over the coming decade while having to deal with a greater amount of volatility on a daily basis due to more renewable energy sources. Their focus on U.S. assets and higher yield makes them more attractive than AES but their underlying business is not as attractive as that of ITC.
Unisource Energy Corp (NYSE: UNS) is based in Arizona, and with a debt to equity ratio of 1.7, they have the lowest debt to equity ratio of any of the firms mentioned above. Normally climate change is discussed in a negative light, but in the South Western U.S. it can be viewed as a positive long term trend. As the summers get hotter, the need for air conditioning will only increase. The winters are already mild relative to Northern states, so utilities should not see a very sharp decrease in demand from warmer winters. Though the firm has a relatively low amount of debt, their current ROE comes in at 9.7% and their ROA of 2.5% is not exceptional. Currently they are petitioning for a rate increase due to non-fuel related increased costs. The rate increase is expected to pass and should help to bring their ROE and ROA numbers closer to industry norms. Regardless, the importance of coal in their generation portfolio is a downside as it limits their ability to switch to cheaper and cleaner natural gas. Although they have a low debt to equity ratio, UNS does not benefit from the regulated market and high ROE of ITC.
Conclusion
Investing in utilities offers yields and stability to a portfolio. High debt loads places a serious damper on some of these utilities. ITC is a special case as its position in the unique transmission market will offer higher ROE along with new capital expenditure. As America grows and rebuilds its infrastructure ITC is position to profit and support the nation.
MrCanadian1 has no positions in the stocks mentioned above. The Motley Fool owns shares of ITC. Motley Fool newsletter services recommend ITC and UniSource Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
