Shedding Light on the Utilities Sector

US tax reform legislation dampened investor enthusiasm for utilities stocks in the last four months of 2017. Here, Franklin Equity Group’s John Kohli says that view may be creating opportunities for long-term investors. He digs deeper into industry fundamentals that he thinks make for an attractive longer-term investment case for the sector.In September 2017, US President Donald Trump unveiled his tax reform plan, and then signed it into law in December. During that time, the US utilities sector lagged the broader US equity market.

In our view, there are likely two reasons for this underperformance, both related to the tax proposals. First, utilities likely won’t enjoy the immediate earnings boost from the tax reforms that other sectors expect. Second, some investors think tax reform could lead to higher long-term interest rates and negatively affect utilities companies.

As a result, many investors have felt they should sell utilities stocks. However, this view may be creating an opportunity for long-term investors. We believe the industry remains in a good place from a fundamental perspective, and long-term earnings and dividend growth prospects have good visibility.

How Lower Corporate Taxes May Boost Clean Energy

The new tax law reduces the US corporate tax rate to 21% from 35%. While the lower tax rate is likely to boost earnings in many sectors, we don’t see benefits to the utilities sector in the short term. For utilities, corporate tax expense is a pass-through cost in customer rates. So, a lower tax rate would likely lead to lower prices that benefit customers, not the bottom line of utilities companies.

That said, lower pass-through costs will likely free up capital for utilities to continue to invest in infrastructure without raising prices. We see utilities continuing to replace coal-fired power plants with investments in alternative sources such as natural gas, wind and solar.