Utilities are one of the smallest sectors in the S&P 500 (2-3% weight), but they can still play an important role in a portfolio. Electricity demand is expected to grow over the next decade due to artificial-intelligence-driven data center expansion, electric vehicles becoming more prevalent, and manufacturing being brought onshore via the CHIPS Act and other factors. At the same time, the United States grid reached 94% capacity in 2023.

The answer to more demand and not enough supply is to increase the supply, i.e. utilities need to build out capacity. In addition to building out added capacity, utilities are transitioning away from coal to cleaner energy sources such as wind, solar and nuclear in some cases. While this does not always add capacity it does require that utilities invest in their infrastructure.

This spending increases a utility’s rate base – the value of property on which a public utility is permitted to earn a specific rate of return. All utility spending must be pre-approved by state regulatory bodies (for generating power), or the Federal Energy Regulatory Commission (for transmission of power). The utility is then allowed to earn a rate of return on the spending, generally around 10%. In summary, a utility grows it rate base, earns a return on the increased rate base, and that increased return leads to earnings growth.

Most utilities in the U.S. are projecting 5%-7% earnings per share (EPS) growth over the next 5 years. In addition, most pay out a high percentage of their earnings in the form of dividends resulting in yields of 3% to 4%. If valuations (i.e. earnings multiples) remain relatively consistent, a utility could return 7% to 10% annually over the next few years. For example, a utility earning $10 per share and trading at 18X earnings with a yield of 3.5% is priced at $180 with a $6.30 in annual dividends. If earnings grow 6% per year and the utility continues to trade at 18X earnings, in 5 years the price will be $241. In addition, the investor will have earned $32 in dividends for a total annualized return of about 9%.

As with all investing, this return is not guaranteed. EPS growth could be lower than expected if spending is not approved, or if the utility does not reach its goal return on that spending. Natural disasters, such as wildfires, could result in unexpected expenses for a utility. In addition, the valuation for utilities could contract. Utilities are sometimes considered a bond substitute and valuations are sensitive to interest rates. If interest rates increase, investors may pay less for utilities as the returns on bonds are more appealing.

Utilities provide strong potential upside in the current market. Eagle Ridge added Alliant Energy Corp (LNT) to portfolios. Alliant supplies electricity, natural gas and water to residential and commercial customers in Iowa and Wisconsin. LNT has historically grown EPS and its dividend by over 5% with a return on equity of over 11%. LNT has relatively low debt levels at 140% debt to equity and a high credit rating of A-. LNT generates about 35% of its power from wind and solar. While this provides less opportunity for upgrades from coal, it shows LNT can successfully transition to clean energy. Iowa and Wisconsin regulators have approved reasonable returns on LNT’s investment, evidenced by the 11% returns on equity. Both states are attractive to businesses- Iowa is expected to drop its tax rate to 5.5% and Wisconsin put through sales & use tax exemption for data centers, which should promote electricity demand.

Overall, utilities represent a good potential investment and LNT has the fundamentals to deliver.