Utilities have been struggling this year as interest rates rise, making their dividends look less appealing next to government bonds. Now, some observers believe that the group faces challenging growth prospects as well.
Canadian utilities have slumped nearly 11 per cent this year, which is the second-worst return among the 11 sectors in the S&P/TSX Composite Index (behind telecom stocks). The past month has been particularly brutal, marked by a 10-per-cent decline.
U.S. utilities are suffering even more. They’re down 15.6 per cent this year, trailing every other sector.
“Clearly, momentum for the group is awful,” Andrew Weisel, an analyst at Scotia Capital, said in a note that made the case for lower stock valuations.
“We curb some enthusiasm on North American utilities, taking a more balanced view versus our previously bullish stance,” he said.
The downgrade follows an unusually tough period for dividend-paying stocks in general, as bond yields hover around multiyear highs.
The yield on the 10-year U.S. Treasury bond rose above 4.8 per cent earlier this month amid expectations that the Federal Reserve will keep its key interest rate higher for longer. That’s up from about 3.8 per cent in mid-July.
“U.S. inflation is proving to be frustratingly persistent,” Scott Anderson, chief U.S. economist at Bank of Montreal, said in a note Friday.
Many investors refer to utilities as so-called bond proxies because their reliable dividends and slow growth can make the stocks behave like bonds.
Bonds are in a world of pain right now as prices fall – sending yields, which move in the opposite direction to prices, soaring to their highest levels since 2007.
But Mr. Weisel outlined several other related headwinds facing the utilities sector, and investor sentiment.
For one, higher bond yields translate to rising borrowing costs for these companies, which traditionally rely on debt issuance to maintain and expand their electricity-generating operations.
Without new debt, utilities may struggle to make the capital investments needed to increase their profits. And with new debt, investors may grow concerned about stretched balance sheets.
“We’ve already seen some companies refer to balance sheet constraints limiting capital expenditure opportunities (American Electric Power Co. Inc. and Black Hills Corp. come to mind), and we expect we may see some more going forward,” Mr. Weisel said in his note.
He lowered his profit estimates for U.S. utilities in 2023-24 by an average of 1 per cent, which marks a stark contrast to expectations among analysts that the S&P 500 will see earnings rise 12 per cent next year.
What’s more, he believes investors are turning more cautious on utilities because of the increasing frequency of severe weather, including wildfires. Rising electricity bills – on average, up about 20 per cent since before the COVID-19 pandemic – are raising concerns about affordability and whether consumers could fall behind on bill payments.
Mr. Weisel now expects that utilities stocks will trade at about 15 times estimated earnings, on average. That’s down from a previous – and more bullish – expectation just one month ago that the stocks would trade at about 17 times earnings.
Among Canadian utilities, Scotia Capital now expects that Emera Inc. (EMA-T) will trade at $54 within 12 months, down from its previous target of $57. It reduced its target for Fortis Inc. (FTS-T) to $57 from $58.
Though Scotia maintained its $35 target on Hydro One Ltd. (H-T), the stock closed on Monday at $35.99, implying that the analyst expects the share price to decline slightly over the next year.
Still, Mr. Weisel is far from pessimistic. He pointed out that steady utilities offer a compelling refuge from wars, declining economic activity and political dysfunction in Washington. Longer-term, they remain intriguing bets on energy transformation, as electricity usage rises.
The stocks also look cheap when comparing share prices to estimated earnings. After the recent slump, Canadian utilities have swung to a 16-per-cent discount to the S&P 500, compared with a 25-per-cent premium last summer.
For a turnaround, though, bond yields may have to stabilize – and then decline.