Utilities are known for being low-growth, stable cash cows with predictable revenue streams. The business model is ideally suited for supporting dividend growth and recession resistance.
But utilities depend on debt financing to maintain existing assets and build new infrastructure projects. Debt has gotten more expensive as inflationary pressures are taking a particularly high toll on utility businesses.
The Utilities Select Sector SPDR Fund (XLU -1.09%) is down over 12% year to date versus an 18% gain for the S&P 500. However, it's up nearly 13% from its early October low. Here's why the exchange-traded fund (ETF) may have bottomed and could be worth buying now.
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A balanced way to invest in utility stocks
The Utilities Select Sector SPDR Fund is the largest utility ETF by net assets. It has a price-to-earnings (P/E) ratio of 21 and a 3.6% dividend yield, compared to a 24.6 P/E ratio and 1.6% dividend yield for the S&P 500. So it is a better value and produces more income.
The catch is that the S&P 500 has an overall higher growth rate than the utility sector. But for investors looking for value and income, the utility sector is starting to look very attractive.
Many top holdings in the fund are regulated electric utilities that work with agencies to set prices and secure steady growth. The sector may be dealing with headwinds, but these are stable businesses that should remain reliable dividend stocks for decades to come.
Many utilities have near-monopolies over a specific industry in a geographic region. And the Utilities Select Sector SPDR Fund is one of the simplest ways of achieving both firm diversification and geographic diversification in the sector. What's more, the fund has a mere 0.10% expense ratio -- meaning a $1,000 investment in the ETF would incur just a $1 annual fee.
The cost of capital problem
A growing population demands more resources. To meet the needs of their customers, utilities rely on equity and debt financing to support new projects.
When a stock price goes down, that makes it more expensive to tap into equity financing. And when interest rates are high, that makes it more expensive to use debt financing. The falling stock prices of many utility companies mean they are feeling the pain of both of these factors at the same time.
Stock prices can do all kinds of things over the short term. But when looking at the utility sector, there's reason to believe many of these stocks deserved to fall. It's for a simple reason, too: debt.
NEE Market Cap data by YCharts
The five largest holdings in the Utilities Select Sector SPDR Fund make up just shy of 40% of its holdings. For all five of those companies, total net long-term debt either exceeds the market cap of the company or is at least 64% of the market cap. For that to be sustainable, a company has to have either financed that debt inexpensively or has the earnings to support interest payments.
On the surface, all of these utilities are heavily leveraged -- which isn't necessarily a bad thing if equity financing is available for a good price or interest rates are low. The issue is that market dynamics have shifted. And now, these utilities find themselves in a much more precarious position, where funding their interest expense and their dividends, not to mention their capital expenditures, is becoming far more expensive.
The consequences of equity financing
Reliable dividend-paying companies, especially ones that sport a low growth rate, tend to reward shareholders mainly through dividend growth and share repurchases. Dividends provide an immediate benefit, while share repurchases reduce the outstanding share count -- thereby boosting earnings per share and making a stock a better value.
But in the case of top utilities, their shares outstanding have actually increased over the last five years, while many of their stock prices are either down or up modestly. Again, looking at the five largest holdings in the ETF, no single stock is up more than 10% over the last three years, and every single company has increased its share count.
This chart is a good example of how many utilities have relied on diluting their stock through equity financing to fund their growth. And now that their stock prices have come down, that lever is becoming increasingly harder to pull.
The buy case for utility stocks
Anytime you are looking at making a contrarian move in the stock market -- that is, buying a sector or stock that has been selling off -- it's important to understand the reasons behind the sell-off before impulsively smashing the buy button. There are very good reasons why the utility sector has sold off. But there are also now good reasons why may be a good time to buy into the sector.
There's a difference between a large debt position and an affordable large debt position. And in the case of many top utilities, the debt is affordable.
NEE Debt To Capital (Quarterly) data by YCharts
If we look back at those top five holdings in the ETF, each one has a reasonable debt-to-capital ratio. And what's more, the interest coverage ratio, which is just earnings before interest and taxes (EBIT) divided by the interest expense, is also more than manageable because all five top holdings have an EBIT that is at least double their interest expense.
NEE EBIT (TTM) data by YCharts
Now, I know what you're thinking: interest expense, leverage ratios, and all of these financial metrics are a bit much. What does it all mean?
Distilled down to the core, the metrics mean that these top utility stocks have a lot of debt and their stock prices have been falling, so it is getting more expensive to fund their growth projects. But at the same time, their debt is manageable, and the stock prices have come down a lot, which may present an opportunity, especially when we consider the valuations of many of these utility stocks.
A simple yet effective way to invest in utilities
The utility sector deserved to sell off. But the relatively high yield, paired with a reasonable valuation, makes the sector worth investing in for passive income-oriented investors.
The Utilities Select Sector SPDR Fund provides the perfect starting point for investors interested in utilities by giving them instant diversification for a negligible fee. The fund may not appeal to investors looking for growth. But for folks focused on capital preservation or supplementing income in retirement, buying utility stocks makes a lot of sense now.
