Avoid These 2 Utilities

Faizan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Utilities are generally considered to be low-risk businesses, providing investors decent risk-adjusted returns. Utilities are also favored by investors during uncertain and tough economic conditions, as they can offer attractive dividend yields even in a low-yield environment.

Following the financial crisis of 2007 through 2008, investors' risk appetite decreased and utility stocks were in demand as they offered stable and consistent income stream. The Utilities SPDR (NYSEMKT: XLU) ETF has been a good investment option for investors who want exposure to utilities, as it replicates performance of the sector. The following table shows the yearly performance comparison of utilities and the broad market from 2008 until 2012.

<table> <thead></thead> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>2008</strong><strong></strong></p> </th><th> <p><strong>2009</strong><strong></strong></p> </th><th> <p><strong>2010</strong><strong></strong></p> </th><th> <p><strong>2011</strong><strong></strong></p> </th><th> <p><strong>2012</strong><strong></strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Utilities SPDR </strong></p> </td> <td> <p>-30%</p> </td> <td> <p>4.5%</p> </td> <td> <p>0.05%</p> </td> <td> <p>15%</p> </td> <td> <p>-3%</p> </td> </tr> <tr> <td> <p><strong>S&P 500 Index</strong></p> </td> <td> <p>-39%</p> </td> <td> <p>23%</p> </td> <td> <p>13%</p> </td> <td> <p>0%</p> </td> <td> <p>13%</p> </td> </tr> </tbody> </table>

The Utilities SPDR ETF has an expense ratio of approximately 0.2% and a manager's fee of approximately 0.1%; moreover, it has a dividend yield of 3.9%. The top-three component holdings for the Utilities SPDR ETF are Duke Energy at 9.4%, Southern Company at 8.1% and NextEra Energy at 7.2%. 

The fundamental outlook for the utility sector remains healthy. However, the poor performance of utilities in the last couple of months can be mainly attributed to a rise in the long-term Treasury yields and increasing investor risk appetite. In the upcoming months, if the Treasury yields rise further and the Fed tapers the ongoing quantitative easing, the Utilities SPDR ETF will under-perform the broad market. Rising Treasury yields do not bode well for the utility sector. 

The least favorite

Pinnacle West Capital (NYSE: PNW) remains the least favorite company among regulated utilities, perhaps because the company is facing regulatory uncertainties. A couple of months back, the Arizona Corporation Commission opened a docket exploring the possibility of retail competition in the state. Given the regulatory uncertainties, last month Pinnacle announced that it is not in a position to complete and close the Four Corners deal, which will adversely impact the company’s financial performance.

Earlier, Pinnacle announced it would acquire Southern California Edison’s interest in the Four Corners coal-fired plant in Northwestern New Mexico. It was expected to issue debt to fund the acquisition if the transaction was consummated. Failure to complete the acquisition is likely to reduce Pinnacle EPS by $0.12  per year in 2014 and 2015.

Regulatory uncertainties remain as overhang on Pinnacle's stock price and translate into lower earnings and dividend growth for the company. Also, there are no important and significant rate cases pending that can drive up earnings growth in the near future.

Furthermore, the rising Treasury yields are and will continue to put pressure on Pinnacle's stock price; currently it offers a dividend yield of 3.9%. Dividends offered do not seem to be in jeopardy and are likely to be maintained in the future; the company has a healthy operating cash flow yield of 18% and a moderate payout ratio of 57%.

Due to the tough business conditions, cost-cutting initiatives and renewable investments remain important growth drivers for Pinnacle. Potential cost-cutting initiatives include reducing operational and maintenance expenditures (O&M) by improving operational efficiency. Management has a good track record of improving cost efficiency, and in order to realize target ROE of 9.5%, cost-cutting discipline should be maintained.

Other than cost-discipline efforts, renewable energy investments are another growth driver for Pinnacle. In a settlement with the commission, the company is permitted to own 200 MW solar projects through the state program. As the company is surrounded by regulatory uncertainties, Pinnacle is expected to under-perform its peers. 

Moreover, Pinnacle has a high forward P/E of 16x as compared to utility sector forward P/E of 15.3x, which makes the stock unattractive at the current valuation.

Foolish diversified utility

FirstEnergy (NYSE: FE) is a diversified electric utility. It faced several issues in both the regulated and unregulated business segments over the past year that led to its under-performance relative to its peers. Due to the weak nature of JCP&L’s (a FirstEnergy subsidiary) rate case, an adverse outcome is likely, which will impact the stock price negatively.

Another factor that has remained a headwind for the company is its highly levered deregulated business. In order to maintain an investment-grade credit rating, the company needs to lower its debt level. Maintaining an investment-grade credit rating is very important for FirstEnergy because a lower rating would lead to a rise in collateral requirements.

In an effort to maintain its credit rating, the company may have to sell its non-core merchant hydro assets. Also, the PJM capacity prices announced in May were disappointing for FirstEnergy, as they were lower compared to last year's prices. Moreover, PJM prices were below analysts’ consensus. (Each year, the Pennsylvania - New Jersey - Maryland Interconnection conducts an auction to acquire supply for the planning period that is three years ahead. Revenue determined by the auction drives profitability of the utility companies operating in the PJM region.) FirstEnergy's stock is surrounded by various factors that pose potential risks to the company. 

FirstEnergy registered total revenue of $3.7 billion in the 1Q 2013, as compared to nearly $4.0 billion in the corresponding period last year. The decrease in the total revenue was mainly due to lower electricity sales in the quarter. EPS for 1Q 2013 was $0.76; marking an earnings surprise of 11%. FirstEnergy also reaffirmed its operating EPS guidance range of $2.85 to $3.15 for the full-year 2013. 

Final words
Utilities have delivered a healthy performance in the last decade and also have been favored by income-seeking investors in the low-yield environment. Utilities are expected to remain attractive for income-seeking investors until the Fed comes up with something decisive to taper the quantitative easing (which is conditional to economic health).

However, Pinnacle West and FirstEnergy are currently surrounded by some regulatory issues that can adversely affect their stock prices. Therefore, investors must remain cautious regarding the aforementioned factors for both companies. 

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Faizan Chudhry has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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