While energy utilities are in the early stages of a transformation wrought by regulatory demands and revolutionary technologies, we recognize that those who already depend on income investments can’t afford to stand by until clear winners emerge from the process of creative destruction.

It’s likely little comfort to income investors that many believe this transformation is a step toward a better future, particularly when the resulting disruptions are beginning to erode the earnings of once-reliable dividend payers.

Of course, for the last few years, it was thought US utilities would be largely immune to the losses their European counterparts suffered due to new market dynamics and the rising production of renewable energy. Policymakers believed renewables had been introduced in the US at a more measured pace (See Chart A), while the US economy had recovered more quickly than Europe’s since the global downturn.

But with the recent announcement that yet another US utility has declared a dividend cut (the third in a year) as a result of the same trends–renewables, market dynamics and low power demand–it’s clear that investors should look to Europe for insights on how to invest in this new environment.

 

Source: Energy Information Administration

Even as bad as demand and market dynamics are in the US for some companies, they are not yet nearly as bad as what European utilities have had to endure. But if Europe’s experience presages what could happen in the US, then investors will have to be significantly more proactive about monitoring their portfolios.

To that end, we’ve not only developed an early-warning system to help identify weakness in a company’s financials, we’re also rethinking what type of companies will be the safest income investments under these circumstances.

But before we delve into some income investments that might be better suited for this new environment, let’s examine what’s happened in Europe.

The Fall of Europe

Europe’s aggressive push for renewables has had a startling effect on the Continent’s utilities, largely because companies failed to respond to the competitive threat until it was too late. Subsidized renewables expanded quickly in the region and have become so pervasive that they’ve ultimately displaced a number of base-load generators, causing earnings declines, asset impairments and, as a result, steep declines in valuations.

According to The Economist, the top 20 European energy utilities were worth roughly EUR1 trillion at their peak in 2008. Now they’re worth less than half that amount. Since then, European utilities have been the worst-performing sector in Morgan Stanley’s index of global share prices. Furthermore, the magazine notes that back then the top 10 European utilities all had credit ratings of A or better, but now only five do.

Moreover, according to an Oxford University study, 10 of Europe’s biggest utilities mothballed 21.3 gigawatts of gas-powered stations last year, or 12 percent of the Continent’s generation fleet, as plants lost money.

Additionally, six of these firms, including French utility GDF Suez SA (OTC: GDSZF) and German utility RWE AG (OTC: RWEOY), reported impairment charges on their generation assets in 2013 equivalent to EUR6 billion, the study showed. In fact, gas-fired generation in Germany, Europe’s biggest power market, won’t be profitable before 2019, according to data compiled by Bloomberg. “Negative clean-spark spreads, a measure of plant profitability, falling power demand and an increase in renewable energy contributed to the closures,” the study said.

“Utilities have completely failed to anticipate changing carbon prices, coal prices, and the impact of renewables deployment and how these could affect the economics of gas investments,” observed Ben Caldecott, a director at Oxford University’s Smith School of Enterprise and the Environment, in a statement to Bloomberg News.

But perhaps what’s most disturbing is that as a result of all this, European utilities are no longer viable income investments. As The Economist puts it, “Once they were steady, reliable and inflation-resistant, the US Treasuries of the equity markets. Pension funds need such assets to balance their long-term liabilities. But [European] utilities no longer play this role, as evinced not just by collapsing share prices but by dividend policies.”

In fact, when prognosticators raise the concern that US utilities could be disrupted as income investments, the reason they say so with such alarm is due to what happened in Europe. Of course, US utilities have yet to lose half their value or take asset impairments. But Europe’s example should be sobering for US utility executives and investors alike, especially since the industry has moved slowly to respond to the threat.

Having followed these trends for some time, we’ve been advising investors to select only the highest quality utilities–those that boast strong balance sheets, whose service territories cover areas with rising populations and growing economies, and which operate in constructive regulatory climates. We’ve also focused on utilities that have embraced renewable technologies and are taking advantage of new market dynamics. This has proved to be a successful recipe for companies that have delivered shareholder value the past few years.

However, we’ve also seen a relatively new type of utility show extraordinary wherewithal during the severe crisis in Europe, as well as great promise in the US: the wires utility. These types of utilities don’t typically garner much attention from the media, as they’re seen as less glamorous than the companies that run generation or power plants.

Wire companies, or grid operators, were created during the process of deregulation in the US and Europe in the late 1990s and early 2000s. And in this period of industry upheaval, they could prove to be the ultimate investment for income investors who want a dependable payout amid all these changes.

In fact, investment opportunities in this niche could soon be on the rise. Several utilities have been considering creating standalone transmission companies this year, including Xcel Energy Inc (NYSE: XEL). But whether it’s a standalone company or the sale of transmission assets to a transmission company, regulatory approval will still be key. For instance, regulators declined Entergy Corp’s (NYSE: ETR) sale of its transmission assets to transmission company ITC Holdings Corp (NYSE: ITC) in 2013.

Wired for Safety

In this uncertain era, it’s difficult to know whether the executives who run energy utilities that own generation assets have the strategic competence to navigate these changes. While in previous columns, we’ve argued that utilities have been formidable in protecting their turf in the past during similar periods, we can’t assume this will always be the case.

And given what’s transpired in Europe, it’s quite possible utility executives will not know how to respond–or may not respond quickly enough before their business model gets disrupted. That’s why the best play may be to own a good number of wires-only utilities, which have high dividend yields and zero generation risk. Until utility-scale batteries become a reality, wires companies will be the backbone for all new generation technologies and earn income doing so.

There are a number of grid companies in Europe and the US that have been outperforming their peers on the generation side.

Enter National Grid PLC (NYSE: NGG). Created in the mid-1990s when the UK unbundled its vertically integrated utilities to create electric competition, National Grid owns the high-voltage electricity transmission system in England and Wales and operates the system across Great Britain. It also owns transmission lines in parts of Europe.

Additionally, the network utility owns and operates the high-pressure gas transmission system in Britain, as well as electricity transmission systems in the northeastern US. With a USD48.4 billion market capitalization, National Grid is nearly the size of America’s biggest utility, Duke Energy Corp (NYSE: DUK). It’s also one of the world’s largest utility network firms, which bolsters the sustainability and dependability of the firm’s earnings. In fact, during this period of volatility in European markets, National Grid has preserved shareholder value.

Management has stated it aims “to grow the ordinary dividend at least in line with the rate of RPI (retail price index) inflation for the foreseeable future.” Further, with 65 percent of its operations in the UK and 35 percent in the US, based on 2012-13 operating profits, the firm offers economic diversification.

Moreover, the UK regulatory environment allows National Grid to earn in excess of its allowed return if the network utility meets certain performance benchmarks. The firm has received around USD40 billion in investment allowance for essential infrastructure over eight years.

Immune from Commodity Prices

National Grid does own some power generation in the US, in the form of 50 fossil fuel powered stations on Long Island and 4.6 megawatts of solar generation in Massachusetts, but it has a 100 percent commodity pass-through in all of its contracts.

What’s more, all of its network businesses are decoupled from the commodity. Decoupling refers to the disassociation of a utility’s profits from its sales of the energy commodity. Instead, a rate of return is aligned with meeting revenue targets, and rates are trued up or down to meet the target at the end of the adjustment period.

This makes the utility indifferent to selling less product and improves the ability of energy efficiency and distributed generation to operate within the utility environment.

The low price of natural gas in the US is a result of recent shale discoveries that have created an unprecedented supply. This trend is translating into growth for National Grid, as its network expands to meet new demand. If natural gas prices reversed as a result of inflation, National Grid’s management has stated this would not impact network expansion opportunities. Indeed, expansions have gone uninterrupted even when gas and oil prices were on par.

Chart B: National Grid Delivers Consistent Earnings

Source: Company filing

A Solid Growth Story

Earlier this year, the UK’s Labour Party threatened a windfall profits tax on generators in response to increasing energy prices, seemingly creating a headwind for what otherwise has been a stable company with a solid earnings growth profile. But as CEO Steve Holliday explained last year at a finance conference, National Grid has no generation that would be impacted by such a tax. Regardless, the transmission part of the bill is only 3 percent to 4 percent. Further, the UK has approved the firm’s rates for the next eight years.

To put investors at ease, National Grid hired a legal team to see how such a tax could be imposed. They found that this would necessitate a change to the firm’s charter, which would take nothing less than an act of Parliament.

In the last year, National Grid has generated a return on equity of 43.4 percent. The firm’s American depositary receipt (ADR) currently yields 4.9 percent, and management intends to continue increasing the dividend at a rate of 2 percent to 3 percent annually, in line with inflation, after receiving favorable regulatory outcomes in the US and UK. National Grid is a buy up to 64.

Similar to National Grid, Spain’s Red Eléctrica de España SA (Spain: REE, OTC: RDEIY) has been on a tear since the beginning of the year, with the stock gaining 11.2 percent (See Chart C). Red Eléctrica is a partly state-owned and public limited Spanish corporation that operates the national electricity grid in Spain. It also holds assets in Portugal, Peru and Bolivia.

A new Spanish government decree on remuneration to electricity transmission gives Red Eléctrica more opportunities to recapture capital expenditures if it meets certain performance targets. According to a J.P. Morgan Cazenove research note, “The government has provided a lot of visibility on the medium-term revenue outlook by publishing an estimated revenue profile for the transmission business.”

Based on the decree, management estimates revenues of EUR1.685 billion in 2015, with 3 percent annual growth through 2020. Furthermore, management confirmed that 2014 revenues would be EUR1.622 billion versus previous guidance of slightly more than EUR1.6 billion.

Finally, the J.P. Morgan analysts reported that management believes that through operating efficiencies, synergies in asset building, availability payments, and associated unregulated businesses, it can lift the headline 4.6 percent allowed post-tax internal rate of return (IRR) on new capital expenditure to a range of 6 percent to 6.5 percent.

Red Eléctrica’s American depositary receipt currently yields 3.2 percent. Red Eléctrica de España SA is a buy up to USD16.

Chart C: Wires Companies Holding Their Own Against Generation Companies

 

Source: YCharts

Michigan-based ITC Holdings Corp (NYSE: ITC) is the largest electric transmission company in the US. The company is in charge of the electric transmission system formerly owned by DTE Energy Holding Co (NYSE: DTE) and CMS Energy Corp (NYSE: CMS).

Its operations include asset planning; engineering, design, and construction; maintenance; and real-time operations. ITC Holdings serves investor-owned utilities, municipalities, cooperatives, power marketers, and alternative energy suppliers.

In late December, ITC provided initial operating earnings guidance for 2014 in the range of $5.50 per share to $5.70 per share. Operating earnings is a non-GAAP measure that ITC uses as its primary performance measurement for communicating its earning guidance and results of operations. ITC’s management believes that operating earnings provide a more meaningful representation of the earnings power and financial performance of the business.

ITC’s aggregate capital investments for 2014 are expected to be in the range of $730 million to $840 million.

Over the trailing 12 months, ITC’s stock has gained 24.1 percent on a price basis, and its shares currently yield 1.6 percent. ITC is a buy up to 86.