Why Utilities Stocks Look Risky Today

The following is an excerpt from the video series Dividend-Stock Deep Dive, hosted by Morningstar DividendInvestor editor David Harrell. Watch the full interview.

Harrell: In the headlines today, we've seen a lot of about inflation, and obviously, in addition to the humanitarian crisis that Russia's invasion of Ukraine has caused, we're seeing economic fallout with higher commodity prices and supply chain disruptions that could potentially push inflation rates, which are already quite high, even higher. Now, you and your colleague Andrew recently published a report on utilities and inflation. Can you explain why this sector is particularly vulnerable to higher inflation rates?

Miller: Sure. Yeah. We've had, like you say, a confluence of events here that really nothing good comes of it when you're a utility--inflation, higher interest rates. Even the defensive nature of utilities, when you have a situation like Ukraine and Russia where it's hitting energy prices, that also is not good for utilities. So, we've got really, really a tough situation, both fundamentally and for investors right now in utilities.

For inflation, in particular, a couple of key reasons why utilities are really at a disadvantage when you have high levels of inflation. One is energy costs are a huge portion of the utility bill for all customers. As we've seen, one of the biggest drivers of inflation here in the last three months has been energy prices. To the extent that energy prices are flowing through customer bills, customer bills are higher because of energy prices, utilities make less money on the portion of the bill that covers their capital and operating costs. So, that's one primary disadvantage.

The second on a more fundamental basis is operating and capital costs are huge for utilities. It takes a lot of capital and a lot of people and a lot of materials to run the electricity, gas, and water networks in the U.S. and really worldwide. When we looked at the data, the average utility spends 70% of net revenue, so this is sundry gross margin, after accounting for energy costs. Seventy percent of their costs are either maintenance capital or operating costs--materials, labor, and just keeping the system operating. So, a huge amount of capital and operating costs--when materials prices go up, when labor costs go up, that hits a huge portion of the cost structure for utilities and, obviously, hits earnings and ultimately the dividends.

Harrell: And as you wrote about in the report, it's difficult for utilities relative to other industries to pass those increased costs on to their customers.

Miller: Yeah. The structure of driving revenue for utilities is essentially customer rates runs through state and sometimes federal regulators. The utility has to petition regulators, either at the state or federal level, to raise those rates. That becomes a much more political process when customers are seeing their utility bills rise because of energy prices or when utilities face higher costs because of higher material prices or labor costs. It becomes a very political situation when you have customer bills going up, and that's essentially what happens for utilities when you have high inflation rates.

Harrell: And even if they're able to raise their prices, it's going to take months to do so.

Miller: Yeah, these are long, drawn out, and again, political, contentious types of, really, almost legal types of events that they go through when they're trying to request rate increases. That's a key part of the utility analysis that we look at is how constructive is the regulatory environment in a given state where a utility operates.

Harrell: But just in general they don't have the pricing power that you're going to see ...

Miller: You can think about it as fixed revenues essentially.

Harrell: OK.

Miller: It's not necessarily the exact case, but think about it that way relative to certainly many other companies.