Biggest risk to utility stocks: You going solar

Wilson Magee picked the right time to start buying and selling utility stocks. The lead manager on Franklin Templeton Investments' Global Listed Infrastructure Fund started looking at the sector 18 months ago, and in that time, he's already seen some big changes.

Since he started following the industry, renewable energy generation has climbed by about 16 percent. "The changes are significant from a long-term perspective," he said.

Renewable energy is powering more and more homes in the U.S. and elsewhere, and it's likely that trend will continue well into the future.

Source: Recurrent Energy

Since 2004, power generation from renewable sources has increased by about 50 percent in the U.S., and it accounts for 13 percent of all energy produced in the country, according to the U.S. Energy Information Administration. By 2050, renewables could account for 80 percent of all energy sources, according to the National Renewable Energy Lab.

It's not yet clear what that will mean for traditional utilities, but one thing's for certain: The utility sector will look a lot different in the future than it does today.

While it may be years before we see dramatic changes, it's never too early for investors to start looking at their utility exposure and figuring out who will emerge as the new utility sector threat, who will adapt and which legacy companies will be caught napping.

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Magee isn't yet ready to say that a company such as SolarCity—which serves as a solar project installer and financier—will be the utility of the future, but he is keeping an eye on the transition to renewables.

"As an investor, it's intriguing any time you see changes under way," he said. "The question is, How do you profit as an investor?"

As you move to solar, the traditional utilities model is breaking down. There’s potential for one or more of these companies to emerge as a national utility.
Paul Coster
alternative energy analyst with JPMorgan

Decades ago, utility companies were responsible for generating power and delivering it to consumers.

In 1978, though, states began deregulating the industry, which allowed for more competition in the power generation space.

Today, 18 states have a deregulated utility sector, though many still regulate the businesses that actually get that power to the end user.

There are two parts of the electricity model where new companies can have an impact: power generation and power delivery, said Sonia Aggarwal, director of strategy at Energy Innovation, a think tank focused on the evolution of the U.S. power generation market.

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In the areas that are deregulated, any power producer can generate electricity and then sell it to a utility that would then deliver it to customers. It's here that renewable-focused operations—and especially solar, which is growing the fastest of any renewable—could make inroads, Aggarwal said.

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There are many companies with large solar fields already operating in this space, such as NextEra Energy and Duke Energy, but more could materialize as solar prices decline, Aggarwal said.

Today the price per kilowatt hour (kWh) for solar is about 11 cents for utility-scale solar projects, according to the Department of Energy. It's still more expensive than using natural gas, which sells for about 6 cents/kWh, but the price has come down from 21 cents/kWh in just three years. The Department of Energy's "SunShot" program predicts the 6-cent goal will be reached by 2020. That would allow 14 percent of all U.S. electricity generation to be provided by solar.

Wind and hydroelectric power are almost as cheap as natural gas—both cost about 8 cents/kWh—but it's solar that offers the best opportunity to deploy new power generation: You can't put a windmill in someone's backyard, so it's limited to large, open spaces. Hydroelectric power, meanwhile, is limited to where there's water, and most of those places are already being used. The amount of hydropower generated in the U.S. today is almost the same as it was in 2004.

The new utilities

You have a changing landscape, and it's critical to be on top of it and understand which companies will flourish and which ones won't do as well.
Wilson Magee
lead manager on Franklin Templeton Investments' Global Listed Infrastructure Fund

One example of these "new utilities" is Recurrent Energy, a private San Francisco-based solar company that has large-scale solar projects in California and Ontario, Canada. CEO Arno Harris thinks of his company and its peers as traditional electric operations, despite producing a non-traditional type of power.

"We develop power plants first and foremost," said Harris. "Look at all the different power industries and you'll find developers that do essentially what we do—find land, find connections and market power."

Traditional utility companies, including NextEra, the largest producer of wind and solar power in the U.S., are also diversifying their power bases. NextEra gets 56 percent of its energy from wind, 22 percent from natural gas, 15 percent from nuclear, 4 percent from oil and 3 percent from solar. Five years ago, gas accounted for 37 percent of its power, while wind made up 41 percent and solar less than 1 percent.

Many people think of solar companies that cater to the small-scale commercial and residential markets, including SolarCity and Sungevity, as solar panel sellers and not utility companies. SolarCity now has sales representatives in Home Depot and Best Buy locations, allowing residential customers to shop for a solar rooftop or backyard project just like they would a home improvement or electronics product. But in effect, they operate more like utilities, allowing their customers to lease the solar projects on their property. Any excess power that's created from a project is fed back into the neighborhood electric grid, and the user may then be given a discount on their electrical bill.

The fact that end user is generating power—rather than getting it from a utility company—is a major change.

"As you move to solar, the traditional utilities model is breaking down," said Paul Coster, an alternative energy analyst with JPMorgan. "There's potential for one or more of these companies to emerge as a national utility."

People who have solar panels on their roofs still depend on their local utility to supply electricity when solar power runs low, but there could come a time when people disconnect from the power grid all together, Aggarwal said.

At some point, energy-storage batteries will be able to store enough power to keep homes running when the sun isn't shining—it's no coincidence that Elon Musk is founder of both Tesla Motors and SolarCity, two companies that are already working together on ways to store solar power in lithium-ion battery units inside Tesla electric vehicles. When that happens, individual homeowners will have the power to become utilities themselves, Aggarwal said.

How to invest

Investors don't need to make any drastic moves yet, but they do need to pay attention, because companies that aren't embracing this shift from natural gas and coal to solar, wind and water will be left behind, Coster said. "There's something inevitable about renewables. They're going to be huge, and they are challenging the traditional business models, and those models have to change in advance," he explained.

The companies that have been around for decades are often large-cap businesses that pay solid dividends of between 3 percent and 5 percent and generate slow but steady returns. This includes operations that are adding renewables into the mix. For instance, NextEra, a $41 billion market-cap company, saw revenue and earnings per share grow by about 12 percent year-over-year in the first quarter. It also has a 3 percent yield, and its stock price has climbed by 20 percent over the last 12 months.

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SolarCity, which has a $5 billion market cap, doesn't have a yield, and its earnings are negative, but it's growing revenue rapidly—its first-quarter revenue doubled year-over-year, up from $30 million to $63 million. Its stock price, which has been volatile, has still generated a very healthy return of 330 percent since its IPO in late 2012.

Worst-performing utility stocks in S&P 500

TickerSecurity NameYTD % Chg
AESAES Corporation-5.20%
EDConsolidated Edison-1.90%
TETECO Energy-1.00%
DUKDuke Energy Corporation2.10%

How to play the ongoing transition in the utility sector depends on two factors: the type of investor you are, and where you think this space is headed. The former is easier to define than the latter. Magee remains a cautious buyer. He likes the large utilities with stable long-term cash flows, profits, dividends and some growth. Companies like SolarCity remain a growth stock bet in Magee's view, similar to a rapidly growing technology stock.

"Most of these types of businesses are priced for extraordinary growth," he said. "So it's a bit of a different investment strategy."

Coster said with the "new utilities," investors need to see a growing customer base and a clear path toward positive earnings. For the more cautious investor sticking with traditional utilities, be sure to look for companies that are diversifying their power mix.

"Renewables have the potential to grow significantly and rapidly," Magee said. "You have a changing landscape, and it's critical to be on top of it and understand which companies will flourish and which ones won't do as well."