Here’s Why You Should Watch out for Coal-Reliant Utilities

Despite July's heat wave in the Northeast, summer temperatures in the majority of the United States have been cooler than last year's. For the entire year, U.S. retail sales of electricity to the residential sector during 2013 are forecasted to average 1.3% higher than in 2012, as lower summer consumption is offset by higher consumption during the non-summer months. President Barack Obama wants to reduce carbon dioxide emissions to 17% below 2005 levels by 2020, and in June instructed the EPA to write extra rules to make it happen. This has forced some of the largest utility companies to reevaluate their energy mix.

Southern Company  (NYSE: SO  ) is facing increasing scrutiny from state regulators who are frustrated about cost overruns at electric-power projects in Mississippi and Georgia. Problems with cost controls in Mississippi are focusing attention on an even larger project in Georgia, where Southern subsidiary Georgia Power Co. is building two nuclear reactors at its existing Vogtle power site.

The latest earnings for the Atlanta-based utility slumped 52% because of the cost overruns at the coal-fired power plant under construction in Mississippi. The plant uses an advanced gasification technology, which reduces the cost of producing electricity. Cost overruns close to $1 billion have now made the project unattractive for shareholders of Southern Co.

Duke Energy (NYSE: DUK  )  bought a San Francisco solar project from developer Recurrent Energy. The diversification into solar energy comes four months after the company bought Highlander solar power projects in Twentynine Palms. Duke Energy is the largest electric power company in the U.S. and is currently struggling with demand from its commercial customers and high restructuring expenses.

The company's latest earnings showed dwindling demand in Indiana, Florida, Ohio and Kentucky. With gas becoming increasingly expensive, Duke Energy's decision to stay with coal-fired power plants that meet the EPA's standards looks to be a wise move. Currently, Duke Energy's reliance on coal is only about 37%.

American Electric Power Company  (NYSE: AEP  ) showed signs of massive struggle in its latest earning release due to weak electricity demand, causing a drop in net income. The company had an increase in maintenance expenses in the quarter because of storms and power plant outages.

The company owns over 300 megawatts of wind generating capacity within Texas and 800 megawatts of hydroelectric power from its 17 hydroelectric facilities, but still has too much exposure to coal as it generated nearly 66% of its energy using coal power. It expects to retire 3,000 megawatts of coal power by 2016.

Financial Comparison

Indicator

Southern Co.

Duke Energy

American Electric Power

P/E TTM

22.0

24.7

17.8

Forward P/E

13.3

13.3

11.4

PEG Ratio

3.4

2.6

1.4

Operating Margin % TTM

20.8

16.0

16.2

Dividend Yield, %

4.57%

4.46%

4.33%

Return on Equity

9.6

6.4

7.9

Current Price

$43.29

$68.61

$44.15

Data from Morningstar and Financial Visualizations on August 16th, 2013

The industry has an average P/E ratio of 35, which leaves all three stocks undervalued. Relatively, American Electric Power is the most undervalued of the group. The company's largely coal-based portfolio helps to exploit the cheaper option of power production when gas prices are making gas-fired power plants increasingly expensive.

However, with stricter laws against coal expected to be in place by 2015, American Electric will need to change its coal-heavy portfolio sooner rather than later. The company's forward valuation also suggests that it is a cheap buy. The company's cash flow over the past three years has been going from strength to strength as well, boding positive free cash flow/net income ratios.

In the utilities segment, large yields make the comparison significant. American Electric power has been increasing its dividend for the last 10 consecutive years while maintaining a healthy payout ratio. Southern Co. has the largest yield of the three, and the company has also been increasing its dividends for the last 10 consecutive years. However, the company has a high valuation and volatile cash flow.

Verdict
Due the high amount of regulation in the utilities industry, the dividend payouts should be considered safe for the foreseeable future. What becomes important then is the earnings growth on offer – with 37% reliance on coal-fired power, Duke Energy looks to be in best shape for the impending environmental regulations.

American Electric Power presents a strong case for investment, but its heavy reliance on coal will cause uncertainty in a year's time when new rules are enforced. Furthermore, the reliance on coal is unsustainable in the long run even if the plants are installed with scrubbers, since nuclear and alternative power options offer a cheaper solution.

One home run investing opportunity has been slipping under Wall Street's radar for months. But it won't stay hidden much longer. Forward-thinking energy players like GE and Ford have already plowed sizable amounts of research capital into this little-known stock… because they know it holds the key to the explosive profit power of the coming "no choice fuel revolution." Luckily, there's still time for you to get on board if you act quickly. All the details are inside an exclusive report from The Motley Fool. Click here for the full story!


Read/Post Comments (1) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 27, 2013, at 4:30 PM, eddietheinvestor wrote:

    Southern Company (SO) has lost 7 points (from $48-$41 a share). The price is now very attractive for investors looking for an undervalued and safe energy stock with a solid and safe yield.

Add your comment.

DocumentId: 2609463, ~/Articles/ArticleHandler.aspx, 4/24/2014 7:18:40 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement