Why Utility Stocks Are No Longer the Easy AI Trade
What about customers? Will they pay more? Assume sales growth of 3% per year and the rate of inflation at 3%. Then divide expenses plus capital costs into two categories: those that will increase with sales and the rate of inflation (40%), and those that will move up with the investment base (60%). That calculation produces a 7.8% per year increase in revenue requirements, or 4.7% per KWH. Deflate that number by the rate of inflation to get the real price increase per KWH of 1.6% per year. Don’t get hung up on anything beyond the decimal point because this is a one significant figure calculation, but the message is clear. Prices of electricity will rise faster than the rate of inflation over the five year time period and could rise even faster in areas hosting AI centers.
The worksheet for the calculations (Table 1) follows:
The average utility stock, then, could show 6% (or more) growth annually in earnings per share, and that same stock now pays out a dividend that yields 3-4%, so, barring a major change in capital market conditions, investors might expect a total return (growth plus dividend) of at least 9%. As an alternative, they could get close to a 6% yield from an investment-grade corporate bond and over 4% from a ten-year Treasury. The present differential return over bonds is in line with historical norms. However, in the past, utilities tended to provide dividend yields no lower than two percentage points below bond yields, or three-quarters of the bond yield, and the average utility stock does not make that hurdle rate.
More than any other measure, investors check out the price/earnings ratio, which at 18-20x earnings looks expensive. A sign of overvaluation? Well, the stock market sells at 31x earnings, an extraordinarily high valuation, but utilities have historically sold at a price/earnings ratio roughly two-thirds that of the market, which is where they are now. However, that comparison may be misleading, because of the unusually high valuation of the Magnificent Seven AI-related stocks, which sell at high price/earnings ratios and make up over one third of the market’s value. Taking out those stocks, the rest of the market probably sells at closer to 22x, and in comparison, utilities would look less attractive. In other words, utility stocks sell where you might expect them to on a relative basis, only if you accept Magnificent Seven valuations as permanent. Before you dismiss this analysis by saying this time is different, remember the Nifty Fifty, the stocks like IBM that would never go out of fashion (but did), and the days when electricity sales were destined to rise forever. It has happened before.
In short, utility stocks don’t seem cheap relative to the market, although not notably overvalued either, so the big question for utility investors should be: where will the market go? Because, given that utilities don’t look like bargains, that is the direction we see them taking.
By Leonard Hyman and William Tilles for Oilprice.com
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