Utility stocks have made up one of the market’s top-performing sectors over the past year. The Utilities SPDR ETF (NYSEArca: XLU) is up 20% in the past one year, trouncing the 2% return for the S&P 500 in that time. And, this is just price return—adding in the hefty dividends that utilities are renowned for, and it is clear that the utility sector is on fire.
But the question for investors now is whether the rally has further room to run. Utility stocks are typically more defensive names, not accustomed to high growth. As their stock prices increase, so do their valuations, and valuations across the sector look stretched.
The path for utility stocks gets even more difficult next year, when it is widely believed the Federal Reserve will raise interest rates again. With higher interest rates in the mix, now might be a good time to take profits off the table.
Valuations Look Lofty
Utility stocks have, on average, increased 20% in the past one year. But the earnings generated by the utility sector have not increased 20%. Earnings growth per year is typically in the 3%-5% range for most utilities. This means the bigger driver of stock price increases over the past 12 months has been expansion of the valuation multiples.
For example, take three of the biggest utility stocks—Duke Energy (NYSE: DUK), Southern Company (NYSE: SO), and Exelon (NYSE: EXC)—which have seen their stock prices rally considerably in the past one year, and now trade for price-to-earnings (or PE) multiples of 18-22. That is a significant level because the S&P 500 Index as a whole only trades for about 20 times earnings.
This means utilities are valued roughly evenly with, or in some cases above, the stock market on average. Expanding valuations mean expectations are rising. But since the utilities operate in such a stable, defensive industry, growth is limited.
These valuation levels are also notable because they are elevated in historical standards. Five years ago, Duke Energy, Southern and Exelon all traded for P/E ratios in the high single digits or low double digits.
Therefore, it could only be a matter of time before reality catches up to the expectations, and investors rotate out of the utility sector in favor of more attractive opportunities elsewhere. Investors should be especially wary of utilities if interest rates are set to rise.
Impact of Higher Interest Rates
Higher interest rates raise a utility’s cost of capital. With significant assets to finance, utilities frequently utilize debt within their capital structures. When interest rates go up, it will be more difficult to raise debt at attractive rates. The historically low rate environment over the past few years was a great time for rate-sensitive companies such as REITs and utilities, but the opposite will be true as well.
With higher costs of capital, future earnings growth could be negatively impacted. Higher interest expense could reduce earnings, and lower valuation multiples across the sector could soon follow. The utilities were already seeing difficulties to start 2016, even without the pressure from rising interest rates.
Duke Energy’s earnings per share fell 9% last quarter, while Southern Company posted a 5% drop in profit last quarter. Meanwhile, Exelon’s operating profit fell 4% last quarter. Things will only get more difficult if higher interest rates are on the way, and the with U.S. economy strengthening, the Federal Reserve may hike rates this year and next.
Utility Stocks: Slow Earnings Growth
Utilities trade for above-average valuations, but sentiment could change. Investors should only expect utility stocks to grow earnings per share each year in the low single-digit range. And, if interest rates are poised to go higher, utilities may have trouble growing earnings at all.
Investors have earned remarkable profits from utility stocks over the past year, but it may be time to take some of those profits off the table.