Utilities sector: Investing in basic services that make life better

What is the utilities sector?

• Electric utilities. These companies make up most of the utilities sector at 65.7%. They generate, transmit, and distribute electricity; among the biggest are American Electric Power Company, Inc. (AEP) and PG&E Corporation (PCG).
• Multi-utilities. At 26.7%, this is the second largest industry in the utilities sector. These firms provide a combination of utility services, such as electricity and gas or water and electricity, and offer integrated services to their customers. Examples include Eversource Energy (ES), which distributes electricity, natural gas, and water, and Consolidated Edison, Inc. (ED), a provider of electricity, steam, and natural gas.
• Independent power and renewable electricity producers. This segment makes up 3.3% of the sector. Independent power producers own or operate facilities that generate electricity but aren’t considered electric utilities. They often sell electricity on the open market. One of the biggest IPPs, as these companies are known, is NRG Energy Inc. (NRG). Renewable electricity producers are categorized within IPPs, and they are growing. This subindustry focuses on generating energy from renewable sources such as wind, solar, and hydroelectric power. The biggest is NextEra Energy, Inc. (NEE).
• Water utilities. As the name implies, companies in this industry provide water and wastewater services; they make up 2.6% of the sector. American Water Works Company, Inc. (AWK) is the largest and most geographically diverse company of its kind.
• Gas utilities. These companies are involved in the transmission and distribution of natural gas and make up the smallest part of the sector at 1.8%. (Many utilities offer natural gas distribution with other energy services, and thus are part of the energy sector.) Atmos Energy Corporation (ATO) is one of the largest natural-gas-only distributors in the U.S.

What makes the utilities sector unique

• Stable and consistent revenue. Many utility companies have been around for decades. These companies provide essential services, so demand is usually consistent (“inelastic” in economist-speak). With demand unlikely to change in the short term, returns are fairly predictable, which is appealing to investors who want steady returns.
• Considered a value play. On the growth-versus-value meter, the sector’s low growth and stability put it squarely in value territory. As of mid-2024, using three common metrics to measure value, utilities have a 1.9 price-to-book value, an 18.4 price-to-earnings (P/E) ratio, and a 2.4 price-to-sales ratio. Those results compare with the broader S&P 500, which has a 4.4 price-to-book value, a 21.1 P/E ratio, and a price-to-sales ratio of 2.6.
• Pay high dividends. When a company doesn’t offer strong growth, it often entices investors with fat dividends instead. Utilities are sometimes referred to as “bond proxies,” as their dividends can rival some bond yields. The S&P 500 Utilities index as a whole has an indicated dividend yield of 3.3% as of mid-2024, compared to the broader S&P 500 indicated dividend yield of 1.4%.
• Highly regulated. Utility companies operate in a highly regulated industry, so changing governmental regulations can have a significant impact on their profitability and operations. For example, the Inflation Reduction Act of 2022 pushed for increases in renewable energy consumption. As a result, many more electric utilities are adding solar, wind, and other clean energy that reduces carbon emissions. Investors need to be aware of changes in policy, especially as environmental standards tighten.

Key considerations for investors

• Subject to strict government oversight. Many utilities operate as a monopoly in their regions. This can give them certainty and pricing power, but the trade-off is often a high level of regulatory oversight, which may limit how often utilities can raise prices.
• High capital expenditures. As infrastructure investments, utilities must continually invest in upgrades for equipment and other large-scale projects such as pipelines, power plants, solar panels, or water-treatment facilities.
• Interest rate sensitivity. Changes in interest rates can affect utilities. Many carry debt because they are capital-intensive companies; high interest rates make it more costly to improve infrastructure. Plus, high interest rates can make the dividend payments offered by utilities less attractive if safer bond investments also offer high yields.
• Economic sensitivity. During recessions and market downturns, utilities can become attractive because of users’ consistent demand. During market rallies and strong economic times, utility stocks will lag growth stocks.
• Dividends aren’t guaranteed. A juicy dividend is attractive, but investors need to know if the payout is sustainable. Review the company’s payout ratio, cash-flow stability, and debt levels to get a clear picture of the utility’s overall health.

The bottom line

References

• S&P 500 Utilities | spglobal.com