Utilities may be steadier than tech or energy industry companies, but they're not where growth goes to die. In this week's Energy and Industrials episode of Industry Focus, market analysts Sarah Priestley and Jason Hall explain what investors should know about the utilities sector, and name a few companies that are on their radar for the long-term.

Find out how utilities can build some solid diversification into your portfolio, what investors need to know about yields before buying in, how the sector has been going through a bit of a renaissance lately, what the most important risks are with these kinds of companies, and more.

A full transcript follows the video.

This video was recorded on Nov. 9, 2017.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, Nov. 9, and we're going to be discussing utility companies. Joining me on Skype is Motley Fool contributor and all-around nice guy, Jason Hall. Jason, thank you for joining me!

Jason Hall: Hi, absolutely! Glad to be on!

Priestley: We're very glad to have you and your expertise on the topic. As I mentioned, we're going to be talking about utilities. Before listeners roll their eyes and turn us off, we know utilities have a reputation for being boring. But we're here today to prove, or at least try to prove, that they're worth a second look by some investors. Utilities are the foundation on which we go about our day to day life. When you got up this morning, your alarm woke you up, you probably turned on the light, you possibly had a shower, and all of these things we don't think twice about but they're fundamentally important to how we go about our lives. Utility companies provide these basic services like electricity and water. They're responsible for building and maintaining the vast infrastructure that gets these services to our houses, apartments, office buildings, etc. And they've experienced something of a renaissance lately in the period of low interest rates.

Hall: Absolutely.

Priestley: It's typically investors who might have been attracted to CDs and Treasuries, securities, have turned to utilities as an alternative to get good yields. Jason, what makes utilities slightly different from other stocks on the market?

Hall: I think there's a couple of things. You definitely nailed it when it comes to yield. Income investors typically might have money in bonds and bond markets. It's a lot larger than the equity market. That shifted a lot of cash into companies that can pay a steady, reliable dividend. And that's a big thing that historically has been a big focus for investors who have invested in utilities stocks, because they have these big cash flows, they're very predictable, they're often regulated. They're recession-resistant, which is important if you're looking for predictable income. They're really built to pay dividends in a lot of ways, because they have these big regulated businesses, it's very rare that you have a lot of competition for some of these types of utilities because it just doesn't make sense to build two competing power lines side by side to supply a town of a couple of hundred thousand people. There's no efficiency there. So, you get these regulated monopolies, and they produce tons of cash. Historically, that's what makes them good investments. There's some interesting things going on right now. There's some really interesting growth opportunities in some utilities right now.

Priestley: There's been a rise of deregulated utilities, what you were talking about in terms of stable government monopolies, they're allowed to operate solely in their respective municipalities without competition. And the way that that's orchestrated, for listeners, is that they're allowed to make enough money to cover their costs and make a small profit, but beyond that, they're sort of limited. But, in the deregulated environment, like you said, there's some opportunities, potentially.

Hall: Absolutely, there definitely is. We'll talk in a little bit about one of my very favorites, it's kind of a pseudo-utility. We'll talk about that one today.

Priestley: Excellent. We've touched on it a little bit, and people can probably guess. What investors do you think utilities are right for?

Hall: In general, we keep talking about the fixed-income part. There's a lot of interest for retirees or near-retirees that have a large enough portfolio that they can deal with some volatility of the actual value of their investments, so long as they can count on the income. So, that's good. But I think there are still some utilities that [are right for] somebody of any age that's looking for capital growth and also looking for dividend growth. I think there are a number of utilities that are ideal dividend growth stocks. If you're an investor looking to generate the best total returns over time, there's a lot of evidence that dividend growth stocks as a category can generate market-beating returns over time. So, I think even growth investors should be looking at certain utility stocks. Not every utility stock, but certain utility stocks.

Again, if investors are looking for kind of a defensive play in their portfolio, utilities can be nice, because in recessionary environments, the power doesn't go off. You keep paying your power bill, you keep paying your water bill when times are tough. You tighten your belt other ways. So, great investments for some defensive parts of your portfolio.

Priestley: Absolutely. I think growth stocks get so much press time, but really, [for] a good, diversified portfolio, it may not be a utility, but [including] a good, defensive income play is not a bad idea. We've talked about utilities having a reputation for being a bit of a snoozefest. But if I'm new to utilities, what would you recommend? How would I begin looking at utilities to assess them for investment?

Hall: I think there's a couple of things you have to understand about utilities, and really, any company that's involved in owning large infrastructure assets, which is really the key for utility businesses -- they tend to carry pretty large debt loads. So, there's a certain sensitivity they have to interest rates that's important to understand, especially if they have large planned investments for growth, or modernization of their infrastructure that they could be exposed to, higher interest rates could squeeze their cash flows, and that could affect their ability to grow the dividend. So that's a really important thing that you have to consider. The bottom line is, they're almost always going to have pretty significant debt loads.

But, again, because they have that predictable cash flows that those assets generate, they can have a relatively high amount of leverage and still be a lower-risk investment than companies in other industries, maybe a consumer-goods company or a tech company, just can't have that kind of leverage because they don't have that predictability of their cash flows.

Priestley: Yeah. So, potentially, risks to know about are, if interest rates rise, which they're expected to, it could lead to some investors moving their money into bonds, etc., and possibly them being squeezed a little bit on their cost of capital, too.

Hall: Right, absolutely. You brought up an important one to consider. It's tough to really know what's going to happen, say, over the next three to five years, as interest rates will continue to rise. As long as the economy is in relatively good shape, rates are going to continue to go up. At some point, there will be more money leaving equities, especially these dividend stalwart equities like utilities, and start shifting back into bonds. How is that going to affect how the market values utilities? Let's be honest: Right now, I think, as a general rule, most utilities are trading at a little bit higher multiple to their earnings than they historically have. So, that's a risk that investors should definitely consider.

Priestley: Absolutely. We're going to discuss a couple of specific options for investors. If you like the sound of utilities, there are lots of investment opportunities. We're going to be talking about a few individual stocks that have caught our attention, but there are a couple of ETFs, exchange-traded funds, to consider. The Utilities Select Sector SPDR ETF, the ticker is XLU, and the Vanguard Utilities ETF, VPU.

But, as I said, we're talking about a couple of stocks that pique your interest, Jason. First, NextEra Energy (NYSE:NEE). NextEra is a $73 billion market cap utility. Has a regulated arm, Florida Power and Light, which distributes power to 4.5 million customers in Florida. That arm contributed 60% of the group's operating earnings. The company also has natural gas, nuclear, and significant renewable assets, and its non-regulated aspect which, we kind of touched on that difference earlier. That business generates and sells power across the U.S. and Canada. So, what made you pick NextEra? I know you're generally bullish on the company.

Hall: One of the things I like about NextEra Energy -- probably the biggest thing that I like -- is the fact that there's a mix. They have a good regulated utility business in Florida, and that drives a little over 60% of their earnings, which is good, because you have that stable, relatively predictable cash flow that's kind of the base of the company's operations. The other thing that I really like about NextEra Energy is, they're really aggressively developing a lot of renewables, solar and wind both. The thing that I like about the focus on that is, obviously there's a lot of consumer-driven interest in renewables in terms of the environmental benefits, all of that aspects. But also, renewables are really dropping in price, and in terms of positioning the company with assets that can produce low cost energy -- and it's a commodity, the low-cost leader wins -- by focusing on developing those low-cost assets, it can sell electricity competitively to other utilities all across the U.S., and actually create a nice income stream. And it can sell the energy, in some cases, for less than a utility would be able to build a plant of its own, vs. just buying that power from NextEra, which can use its scale to build out these new assets on the unregulated side. So, I like that a lot.

Priestley: Yeah. I think their Florida-based business, that's obviously quite a fast-growing area, and I think a percentage of their contribution from that region is a particularly strong captive and price insensitive user base. So, that's great to know. But, obviously, because it's 60% Florida-based, investors need to be comfortable with Florida regulation, too. The company is also an MLP, is that correct?

Hall: They sponsor a master limited partnership, NextEra Energy Partners (NYSE:NEP). It's two separate stocks, two separate tickers. NEE is the corporation, and then they have a master limited partnership. Here's the difference, and here's something that two different kinds of investors should consider.

NextEra Energy pays a dividend yield, I don't have it right in front of me but it's around 2.5% [at] current prices. Now, NextEra Energy Partners, its master limited partner, yields closer to 4%. Now, the difference is, NextEra Energy is using its master limited partnership as a way to develop a lot of its renewable projects, a really good mechanism in terms of cash flow efficiency to do that with. It's also going to be a pretty accelerated dividend growth investment. Now, there's a difference investors need to understand. There's a catch with that nearly 4% yield. As a master limited partnership, it's not the kind of investment you would want to own inside your retirement account. Because there's some tax complications. You could actually end up paying taxes on your dividends inside of a 401(k). So, that's an important thing, if you're investing in a taxable account, you may want to consider looking into NextEra Energy Partners for that higher yield, just understand there are some tax consequences, there are some differences there.

Priestley: Thank you for explaining that.

Hall: Absolutely.

Priestley: Interesting company. They're up 30% year to date. So, I guess a lot of people are seeing the opportunity here. The next company that we have that you recommended to me was Pattern Energy Group (NASDAQ:PEGI). Pattern is an independent power company focused on wind energy. This is a long way from the fuddy-duddy traditional utilities that people think about. It's very attention-grabbing. What drew you to the company?

Hall: The first thing that jumped out at me, frankly, is the dividend yield. Its yield is, at today's price, 7.3% or 7.4%. It's actually almost 7.5% at today's trading prices. So, that's a red flag. What's going on with a yield this big? Is the dividend about to get cut? What's happening? As I started doing some research into the company, what I discovered is, there is a privately held development company that the CEO of Pattern Energy was one of the founders of that develops huge numbers of renewable projects. And Pattern Energy Group, the publicly traded company, is essentially a mechanism to be able to find the cheapest cost of capital, through either issuing equity or using that corporate entity to raise debt to fund these projects. It's a really symbiotic relationship. Pattern Energy Group, the publicly traded company, they have a right of first offer for these projects that the privately held development company is developing. So, they have this huge pipeline of wind. It's not just wind. They're actually starting to invest in solar projects, as well.

What management is saying is, in terms of costs, it gets back to the cheap cost of producing the power, they're in a position to develop these projects, sign these 15- to 20-year power-purchase agreements with utilities, and be able to make a nice, incremental return over their cost of development and producing energy versus what they could sell the energy for. So it's a really interesting opportunity.

One of the challenges with valuing the company is, you have to look at cash flows. This is a company that, in the first six months of the year, had almost $100 million in depreciation and amortization. Those are non-cash expenses that actually help drive more cash flow to the bottom line by reducing taxes. Because the company is in such an accelerated growth mode, those really big non-cash depreciation and amortization expenses, the company reported a GAAP (generally accepted accounting practices) loss last quarter, largely because of its accelerated non-cash expenses tied to its investments. So, if you look at it from a cash flow basis, it's reasonably well valued right now, especially when you factor in the strong yield it's definitely maintained. The average contract for its power production right now is 15 years. 

Priestley: That's incredible.

Hall: So, you have that predictability that you get with regulated utilities, in a non-regulated business.

Priestley: Yeah. I think 89% of the electricity is under these power sale agreements. You don't get that very often, I don't think.

Hall: No, you really don't. One other thing that I like, really quickly, is, you have a founder of the company that's running it. The CEO has about a 7% stake. You like to see a CEO with skin in the game, and you certainly have that. So, that's just another thing that I really like about this company. You have leadership that's involved in founding the company, and has completely bought in and has a major stake in the success of this company.

Priestley: Yeah. That's something we often like to look for here at The Fool. And I will say to listeners, too, Jason has some incredible insights into particularly the renewable energy future, and one of his recent articles, "What Investors Need to Know About Our Solar-Powered Future," is particularly good. He has a lot of good primers, too. So, if anybody's interested, please feel free to reach out, and we can send you those links.

The last company that I wanted to mention very briefly is a complete wild card, but they've had such crazy goings on recently that I thought we couldn't not mention SCANA (NYSE:SCG). SCANA is a $6 billion market cap South Carolina holding company primarily engaged in electric and gas. It supplies energy to half a million electric customers and about a million gas customers. So, they have somewhat a balanced portfolio between nuclear and natural gas, hydroelectric, solar and coal. The reason that we're mentioning them is, unlike a lot of steady-Eddie utilities, they've had a lot of upheaval of late. They decided in 2008 to take a 55% stake in the first new nuclear project in the U.S. in 30 years. This project was supposed to usher in a new era of nuclear energy in the U.S.

Hall: Talk about bad timing.

Priestley: [laughs] Yeah, I know. Costs completely spiraled. It pushed the price tag for SCANA's portion -- they split the project up, too -- I think the estimate was $10 billion. The delays mounted, it got basically untenable. And the final straw was the contractor, Westinghouse, filed for bankruptcy. It ultimately led to SCANA abandoning their plans, and it's had huge repercussions for the company. They're still paying: $0.18 of every dollar they make goes toward its failed stake in the project. They've had a subpoena from the U.S. SEC. They've got a shareholder lawsuit possibly pending, their credit was dinged, and most recently...

Hall: The CEO is stepping down.

Priestley: Yeah, basically, there were calls for the CEO, Kevin Marsh, to resign. He'll be going in January. Anyway, you might be thinking, why on Earth am I even bringing it up? It's just interesting because, in the utility world, it's not often that you get a bit of a value play, but the stock is down 40% year to date, has a current P/E of 13.9 times compared to the industry average of 21 times, and a 5.5% yield. So, potentially, if you look at the fundamentals of the company, which, over the long term, I don't believe are going to be impacted too severely by this, there could be potential here. Do you think I'm crazy for bringing that up?

Hall: I don't know if I would necessarily call it a value play. I think it's more of a turnaround play. And even not necessarily where the business truly has to turn around from the brink of serious troubles. But there's a lot of perception at play here. There's also some risk. I think, at this point, I don't have it right in front of me, I think a couple of billion dollars is what they're looking at being able to recoup from Toshiba, now the owner of Westinghouse. So, I think the market is sitting back and watching and waiting to see what happens. I think it's a great, minimal risk, some good reward, and I think the dividend is probably relatively secure. So 5.5% yield right now is not too bad.

Priestley: Yeah. Obviously, there's a ton of caveats to anything around this company right now, and any position in a company like this would probably be a very small one. But I just thought it was an interesting narrative in an otherwise regulated industry and boring sector. But, thank you very much, Jason! Do you have any final thoughts for us?

Hall: No, I think we covered it pretty well. I will add one thing. Historically, this is kind of a boring little sector. But if you think about the dollars -- we're talking trillions and trillions of dollars over the next several decades that are going to need to be invested in modernizing these global assets and expanding them. Utilities may seem boring, but they're actually a great way to get wealthy. It's a good sector to look in, for any investor of any stripe.

Priestley: Well, if that doesn't make people look into it, I don't know what will. Thank you very much, Jason. You're awesome, as always. That's it for us today. If you would like to get in touch, please feel free to email us at industryfocus@fool.com, or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Jason, I'm Sarah Priestley. Thanks for listening and Fool on!

Jason Hall owns shares of Pattern Energy Group. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.