Utility stocks have weathered the market selloff better than many others, but the broad coronavirus-induced collapse in equity prices could carry some consequences for the sector, according to UBS analysts.
Customer growth and capital spending drive earnings for the utilities sector, along with regulator-determined return on equity and a company's capital structure, the bank's analysts said. It is the last metric, the companies' use of debt and equity to finance growth projects and operations, that could raise concerns for some gas utilities and make certain stocks in the space more attractive than others, in UBS's view.
"We don't expect any direct impact form the COVID-19 on revenues as it will likely not impact the customer growth," UBS analysts Aga Zmigrodzka and Shneur Gershuni said in a March 10 research note. "That said, many [local distribution companies] accelerated capital spend and their equity needs increased and were magnified by the recent tax reform."
That means many gas utilities will have to issue equity in 2020 just as the market selloff has left publicly traded companies with lower stock prices. Companies like CenterPoint Energy Inc. and Southwest Gas Holdings Inc. have high equity needs as a percentage of their market capitalization, compared to other gas utility operators, according to UBS analysis.
Of the seven gas utilities UBS covers, the analysts determined Northwest Natural Holding Co. and ONE Gas Inc., which have low equity requirements, could face the least earnings dilution at lower stock prices. They also said UGI Corp. does not need to issue equity in 2020 and Atmos Energy Corp. also faces lower near-term risk because it has agreements in place for much of its equity needs.
UBS expects investors to rotate back into utilities stocks, reversing the shift in fall 2019 to equities more likely to rise with the business cycle. That is because utilities are reasserting their historic role as bond proxies.
At the start of 2020, equity analysts were recommending stocks with unregulated, non-utility businesses that might benefit from solid economic growth and the easing of U.S. trade tensions. But with the coronavirus spread casting a pall over the global economy and central banks cutting rates to prevent or mitigate a recession, utility stocks are once again positioned as dividend-paying alternatives to bonds and often outperforming the market.
The U.S. 10-year Treasury yield fell below 0.6% following the Federal Reserve's emergency interest rate cut, expanding the spread between the 10-year yield and return on equity for gas utilities to a record 9.2% by March 10, UBS said. Low rates have the added benefit of allowing companies like CenterPoint, Northwest Natural and Southwest Gas to refinance debt that is coming due in 2020 and 2021.
UBS believes investors will be on the hunt for defensive stocks that offer a safe haven from market volatility like One Gas. In addition to its low equity needs, One Gas operates regulated gas utilities in three states, has a solid credit rating and boasts regulatory mechanisms to recover 90% of its capital expenditures annually. It also has a 20-year inventory of vintage pipe to replace, which underpins its 7% rate base growth, the bank said.
However, the bank cautioned lower interest rates could weigh on return on equity, warning investors to monitor how lower interest rates influence utility rate cases.
Strategic traders are already piling into utility sector for short-term protection. U.S. utilities have outperformed the S&P 500 in 12 of the last 13 Friday trading sessions, Scotiabank analyst Andrew Weisel observed in a March 12 research note. He attributed the trend to investors seeking protection from Monday morning trading driven by weekend news updates about the coronavirus pandemic.
"In other words, investors (more likely traders) want to remove risk exposure given the potential for negative updates between Friday afternoons and Monday mornings," he said. "We note that we have seen no comparable patterns emerge for other days of the week."
Across its coverage universe, UBS observed a slowdown in rate base growth in the fourth quarter of 2019. It forecasts weaker earnings growth in 2020 due to asset sales at CenterPoint and NiSource Inc. and higher operations and management spending at Northwest Natural.