Has the Evergreen Utilities Sector Lived Up to its Expectations?

Summary

• Utilities sector players are considered as blue-chip stocks with companies providing essential services such as electricity and water, whose demand is expected to remain strong despite economic turmoil.
• Utility companies are usually cash rich and provide high dividend yields to attract investors.
• Investors with a preference for obtaining long-term benefits prefer companies with stable operations and a history of pay-outs.
• S&P/ASX 200 Utilities has delivered an annual negative return ofs 4.89%, as of 17 August 2020.

Utilities sector generally includes companies providing essential services such as electricity, water and waste services to the general public, commercial sector and government. As these companies provide essential services to the public, the sector is regulated, which forces them to keep their tariffs within a limit.

The sector also requires heavy equipment and is capital intensive. To purchase these heavy machineries, companies most of the times procure them through financing. Given that the revenue margin is low, and are required to undertake maintenance capex, it becomes necessary for these utility companies to provide higher yields to investors for the debts floated.

As the utilities sector provides essential services, the demand did not falter during the pandemic-driven lockdowns. However, the sector faced supply chain disruption as the materials and equipment are mostly shipped from abroad.

Must Read: Is there Resilience in the Utilities Sector?

On that backdrop, let us look at few factors that could influence the revenue and liquidity of a utility company.

High debt load: Utilities sector players use heavy equipment, which are primarily procured through heavy financing, adding considerable debt to the balance sheet. Higher the debt load, higher the debt to equity ratio, which can impact the credit rating of the company, as most of the times the companies have to float the debt in the market. With a negative rating, there might be challenges for the company to seek further funding from its investors or borrowers.

Customer Churn: The market also has many service providers, and thus the companies experience a high customer churn rate with people switching to services that are cheaper.

Power Purchase Agreement: As a customer retaining technique, sector players many times offer long-term contracts to customers at competitive rates that with time leads to less profit, as costs keep changing.

As we now have acquainted ourselves with the factors that might impact the utilities sector, let us understand the demand for utility services such as electricity.

Australian Electricity Market

In 2019, Australia generated a total of 265.1K Gigawatt hours (GWh) of electricity, according to a report released by the Department of Industry, Science, Energy and Resources in May 2020. 79% of the electricity was generated through fossil fuel, which was 209.6K GWh in 2019. Coal was the primary contributor among fossil fuels and accounted for 56% of the total 2019 electricity generation.

Contribution from renewable sources towards electricity generation increased by 12% (YOY) with renewable sources accounting for 21% of the total electricity generation at 55.5K GWh.

Source: Department of Industry, Science, Energy and Resources

Impact of the Pandemic on the Electricity Sector

• With the onset of the pandemic, demand for electricity for commercial uses has decreased, owing to several businesses shutting down their operations. However, demand for residential electricity has gone up, as people are working remotely or staying at home.
• Wholesale prices of electricity have also declined because of the economic downturn. According to the National Electricity Market, a decline of 48% to 68% has been recorded in the average spot wholesale prices with prices hovering between ~$32 and $43 per megawatt-hour in the second quarter of 2020.

Let’s glance through the utilities sector performance on ASX

Stocks from the utilities sector generally fall in the blue-chip category. Owing to the nature of the services offered, demand in the sector is usually immune to economic fluctuations. Sector players usually offer dividends consistently and high dividend yields to attract investors as they are always in the need of liquidity to purchase and maintain the heavy infrastructure required for daily operations. For garnering dividend income and beefing up portfolio’s income stream, investors often consider utilities space as one of the lucrative sectors.

A glance at the annual performance of S&P/ASX 200 Utilities highlights a negative return of 4.89%, as of 17 August 2020, demonstrating that the sector is currently undervalued.

On 17 August 2020 (AEST 02:20 PM), S&P/ASX 200 Utilities was trading upward by 0.2% to 7,493.8.

Good Read: 5 ASX Utilities Stocks under Spotlight: SKI, AST, MCY, MEZ and CEN

Bottomline

The utilities sector is generally less sensitive to economic downturns, as the sector players are engaged in offering essential services such as electricity and water. This creates a steady topline for the long-term. The utility companies also provide high dividend yields to their investors. As the business environment and general economy is expected to remain uncertain, current low in the utility stock trajectory seems to prevail in the near term.