The third-quarter earnings season is nearing to a close with nearly 90% of S&P 500 members having already revealed their earnings numbers. Before we say adieu to this earnings season with all its highs and lows, we would like to draw investor attention to the highly regulated and defensive utility sector.

Utilities are a mature sector contributing nearly 2.9% of the S&P 500 market cap. The capital intensive sector particularly benefited from the U.S. economic recovery and low interest rates.

Per a release from the U.S. Bureau of Labor Statistics, Gross Domestic Product (GDP) of the country has increased by 1.5% year over year in the third quarter of 2015. The GDP rate is however sharply lower than 3.9% registered in the second quarter.The unemployment rate across the country has also seen a gradual improvement. A U.S. Bureau of Labor Statistics report indicates that the unemployment rate has come down to 5.1% in Sep 2015 from 5.9% in Sep 2014.

Strength in the economy calls for an upward revision in the interest rate from the current near-zero level, which will inevitably have a negative impact on the capital intensive utility operators. The bond markets might start appearing more lucrative, but amid the market turbulence utilities continue to perform steadily without failing to enrich their shareholders through share repurchases and dividend payouts.

The possibility of rising rates and the new Climate Action Plan, which calls for lowering emission levels substantially from 2005 levels by 32% by 2030, could stretch the margins of the utilities. Though the Federal Reserve kept the key interest rates unchanged during the October meet, a December rate hike is not ruled out. However, the utilities have long started to proactively lower exposure to polluting power generation units.

Per a release from the U.S. government’s Energy Information Administration (EIA), the electricity industry retired nearly 9,800 megawatts (MW) of conventional steam coal-fired generating capacity during the first half of this year. More is being earmarked to be taken out of service in the second half of 2015.The utilities are resorting to mergers and acquisitions to strengthen their operations and expand service territories. In Jun 2015, Wisconsin Energy Corporation completed the acquisition of Integrys Energy, forming WEC Energy Group (WEC – Analyst Report). The Exelon Corporation (EXC) and Pepco Holdings (POM) merger is finally on course for completion in the first half of 2016. 

If good earnings are the primary indicator of performance, the utility sector has proven its merits, outperforming the S&P 500 in the first two quarters of 2015. This may be attributed to their predominantly domestic focus which makes utilities immune to global downturns and the pitfalls of a strong dollar.

Weather does play a key role in their earnings. Per a release from the U.S. Energy Information Administration (EIA), the upcoming winter electricity bills are expected to be lower than last winter in regions east of the Rocky Mountains. For the third quarter, warmer-than-normal temperatures must have given electricity sales a boost.
Utility operators like Xcel Energy (XEL), DTE Energy Company (DTE) and American Electric Power Co. (AEP) came out with positive earnings surprises this season. Currently, the quarterly margin in this sector is higher at 11.2% than the S&P 500’s margin of 10.3%. We have more players in the utility space who have the capability to surpass earnings estimates this season.
 
Way to Pick Right Utilities for your Portfolio

Picking the right stock for your portfolio from so many operators in the space could be difficult. But an easy way to narrow down the list of choices is to look at the stocks that have a favorable Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold) – and a positive Earnings ESP.