Utility stocks have remained popular due to their attractive dividend yields in a low yield environment. Lately, the Fed’s QE tapering signal and rising treasury yields have resulted in a pullback for utilities, to keep their yield competitive to treasury yields. However, QE tapering is conditional to an improvement in the economy, that’s why volatility is likely to prevail in the utility sector as investors fear the Fed’s measures.
Utilities outperformed the broad market in 2011. Utilities SPDR (ETF) (NYSEARCA:XLU), an ETF, returned 14.8% in contrast to a flat return for the broad market in 2011. However, since May this year, Utilities SPDR (ETF) (NYSEARCA:XLU) has underperformed the market by 9%, the primary reason has been fear of Fed’s QE tapering.
Independent power producers (IPPs) are attractive
IPPs offer lower dividend yields and are not subjected to high degree of regulations when compared to regulated and diversified electric utilities. Due to lower dividend yield on average offered by IPP’s, I believe Utilities SPDR (ETF) (NYSEARCA:XLU) will underperform the IPP’s in a current rising treasury yield environment. Currently, it offers a dividend yield of 3.7% and the 10-year Treasury yield is 2.48%.
Also, after the recent PJM auction pricing announcement, uncertainty has been addressed that is expected to be positive for the IPPs. Moreover, IPPs generate healthy free cash flow that can be used to boost EPS through share repurchase program. Therefore, I remain bullish on IPPs.
Two IPPs with potential of superior returns
Together with its subsidiaries, NRG Energy Inc (NYSE:NRG) operates as an integrated wholesale power generator and retailer. Following the PJM auction results announcement, NRG’s stock was price down 5%, as the company’s margins might be affected in the future due to lower than anticipated long-term capacity pricing. However, NRG offers investors a good investment opportunity and potential for price appreciation.
I am bullish on NRG Energy Inc (NYSE:NRG) because of a possible increase in margins from import of capacity into the PJM market, realization of expected synergies from GenOn acquisition, and conversion of coal plants into gas fired units. Also, NRG Energy Inc (NYSE:NRG)’s significant exposure to the Texas market, rising natural gas prices, and possible monetization of contracted assets bode well for the company.
NRG Energy Inc (NYSE:NRG) has strong cash flow, evident from its current operating cash flow yield of 13%, and is expected to generate healthy cash flow in the future, which could be used to repurchase common shares and boost EPS. Given its strong cash flow position, the company can repay its debt, which will further strengthen its balance sheet and eventually lead to multiple expansion.
Changes in regulations currently faced by NRG Energy Inc (NYSE:NRG) in Texas and weak natural gas prices are important sources of risk for NRG and can adversely impact financial performance in the future.
