Ouch! Bear-ish Utility Investors Just Got Trapped

And how you can avoid the pain

This fall, utility stocks faced their worst selling pressure in years. 

That’s now eased up for one major reason: The much predicted and feared sector-wide earnings Armageddon never happened.

Rather, Q3 results and guidance show plainly that companies are adapting successfully to everything from rising labor costs and pressure on customers’ finances to the likelihood of higher for longer interest rates.

Utilities’ resilience obviously surprised most of Wall Street. Just before NextEra Energy (NYSE: NEE) kicked off earnings reporting in late October, a prominent research house asked the question many had already answered for themselves in the affirmative: “Will Rates Dethrone Rate Base Growth?”

 So the theory goes, utilities’ earnings and dividend growth depend on the ability to invest at a fair return. Companies finance capital spending (CAPEX) by issuing new debt and equity. Higher interest rates and lower stock prices have raised that cost of capital. So therefore, utilities’ returns on investment are getting squeezed.

So why isn’t the theory panning out?

Interest expense has risen dramatically over the past 18 months, particularly for borrowers with heavy refinancing needs and that rely heavily on floating rate debt. But dig a little deeper and you’ll see the impact on the bottom line has been far less than meets the eye.

Thanks to years of staggering debt maturities at generation-low rates, most utilities have only modest refinancing needs in any given year. And monthly billing makes utilities a cash business, with large cash balances now earning several times the returns they did 18 months ago.

Utilities have also increasingly been able to offset higher interest costs elsewhere in the business. That includes sharply lowering fuel costs passed onto consumers from earlier this year. And we’re also seeing substantial and systematic cuts in operating and maintenance costs, which as a line item expense are several times larger than debt costs.

Utilities have increasingly targeted capital spending on measures that reduce costs. That starts with O&M by increasing efficiency. And it includes cutting fuel usage by replacing aging coal, gas and oil with wind and solar, which the Inflation Reduction Act has made even cheaper to deploy.

Since NextEra Energy highlighted $1.8 billion of potential tax credit sales as a major source of low cost finance for its CAPEX plans through 2026, we’ve seen several peers announce similar plans. That includes AES Corp (NYSE: AES), which like NextEra is also enjoying accelerating demand for new renewable energy generation from corporations.

Those are all major positives. But the single most important reason for utilities’ earnings and CAPEX resilience—and why sector bears keep getting it wrong—is simply supportive, constructive regulation.

 The consensus expectation has been state officials would force utilities to cut CAPEX plans as inflation and higher interest rates increased costs, so as to avoid rate increases. That hasn’t happened. In fact, regulators in most places appear to be doubling down their support, allowing companies faster recovery of costs and even adjusting utility ROE—return on equity—to higher levels in a timely way.

That support appears even more entrenched following the results of November elections, which despite the lack of major national contests nonetheless featured major challenges for the sector. 

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This has been a sneak peek of my analysis from the forthcoming issue of Conrad’s Utility Investor, hot off the presses tomorrow. 

If you would like to read the rest of this story, my rundown of what’s important for investors about the state of regulation, and see which utility investments I consider profitable for you at this time, then a subscription to Conrad’s Utility Investor would be just the thing. 

Just like that free trial you started just so you could watch one new TV show, feel free to subscribe only to finish this story and then cancel if need be. Of course, like thousands of others, you might find the analysis truly helpful for your financial future…

To your wealth!

Roger S. Conrad