Infrastructure
Trend Watch After EPA Rules: Time to Rethink Utilities? (AEP, XLU, IDU, RYU, UPW, ETR, ITRI)
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The utilities sector had been performing incredibly. We recently highlighted the strong performance seen this year and over the last year with many of these names up 20% to 30% along with the allure of the high-yield dividends. The problem is that the valuations on many names were getting high even if these are somewhat defensive for investors, and now the real costs of new Environmental Protection Agency rule proposals may further weigh on the sector. There are caveats here, but at least some investors may start to reconsider their positions and we wanted to dig down to filter out the noise from the risks in the sector.
American Electric Power Co., Inc. (NYSE: AEP) has outlined the charges, the impact on jobs and prices, and more for the new EPA rules being proposed. It is asking for relief, and what the company is giving for projections may only add pressure on the entire sector of utilities. The ETFs include Utilities Select Sector SPDR (NYSE: XLU), iShares Dow Jones US Utilities (NYSE: IDU), Rydex S&P Equal Weight Utilities (NYSE: RYU). Those three ETFs are all down 3% to 4% from their very recent highs. The ProShares Ultra Utilities (NYSE: UPW) uses leverage, so it is down more from highs than peers with a drop of more than 5.5%; it is also up almost 50% from its year lows.
Entergy Corporation (NYSE: ETR) has been the dog of the utility and power generation sector. At $67.60, its shares are down more than 16% from the peak and are only up about 4.5% from its 52-week low. Thomson Reuters has a consensus price target of only $73.96.
American Electric Power Co., Inc. (NYSE: AEP) is down about 4% from its recent highs, but many peers are now down over 5% from highs and some of the weaker utilities are approaching the double-digit drop level now. AEP outlined the billions of dollars that the plan will cost ahead. Before wondering just how much they tacked on for a total cost, the skeptics need to look at a fresh report that recently came out from the Electric Power Research Institute just for a smart grid being some $500 billion. This will be a boom for companies like Itron, Inc. (NASDAQ: ITRI) for its smart meters, but the valuation has been high there and its shares have been challenging 52-week lows of late.
American Electric Power’s figures, pleads, and complaints comes to rather long list that we chopped down so you wouldn’t have to read a tome. The notations about the new proposed EPA rules are as follows:
So, as you probably deduced… this matters. Environmentalists and capitalists will argue over AEP’s claims and figures. It doesn’t really matter. This is now the new risk profile and is likely a new starting point. Our take is that AEP is still one of our top stocks to own for the next decade. We always maintained that these shares should be bought on a pullback rather than chased. AEP shares are only about 3.8% off the 52-week highs. If more weakness comes in on the shares, that is when long-term opportunists should really consider positions. Analysts from Thomson Reuters show a consensus price target of $39.69 and the stock trades now at just under 12-times a blended forward earnings estimate.
With consolidation opportunities ahead in the world of adjacent utilities, we have scribbled out that the long-term opportunity for AEP could theoretically reach $5.00 in earnings per share over the next decade. Our own multiple is a fair 10-times earnings and that generates a raw price target of about $50.00 at some point, discounted two or three years out. That gives a five-year to seven-year parameter, but remember that AEP pays almost a 5% dividend yield as well and it has a history of dividend hikes.
Today’s news is something we are merely looking at as a starting point rather than as gospel. The risks are many, but the reality is that electric power demand is likely to only rise over the next decade. AEP can navigate this storm, but the real impact that investors need to consider is more of a sector risk rather than just one company’s projection of $6 to $8 billion spent over the coming decade.
JON C. OGG
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