Watch for Entry Points in European Utilities

 | Mar 14, 2017 | 8:00 AM EDT
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With European Central Bank President Mario Draghi declaring victory in the war against deflation and the Fed universally expected to raise interest rates tomorrow, one sector in Europe that is suffering is utilities.

It's no surprise. Utilities are bond proxies, and now yields on various bonds are rising as investors sell off bonds to save themselves from the coming rate hikes. Analysts at Societe Generale noted that utilities were the fourth worst-performing sector in the Euro STOXX 600 last week.

The STOXX Europe 600 index includes large-, mid- and small-cap stocks in 17 European countries: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Following Draghi's remarks that deflation was no longer a worry, the yield on German 10-year bonds rose to 0.48%, the highest level since January last year. Italian 10-year bond yields were 2.36% and Spanish yields were 1.87%.

The present retreat of investors from safe havens such as utilities could prove to be a buying opportunity for the longer term. This is because utilities generally are quasi-monopolies and are largely insensitive to rising consumer price inflation. It's true that in Europe these companies are tightly regulated, but they do offer relatively stable cash flows, so they should be present in any well-diversified portfolio.

The analysts at Societe Generale favor utilities with clear individual catalysts. Drax (DRXGY) is a U.K.-based power company that supplies electricity to business customers and manufactures sustainable compressed wood pellets for use in electricity production. Its stock has fallen by more than 2% on its main London Stock Exchange listing since Draghi's news conference.

The analysts rate it a "key buy" as they like its high free cash flow yield, which was 6.31% last year, according to data from FactSet. Net operating cash flow at Drax jumped by 63.05% in 2015 and by 32.22% last year.

Spain's Endesa (ELEZY) is another European utility that has a "key buy" recommendation from Societe Generale. The company generates, distributes and sells gas and electricity as well as related services mainly in Spain and in Portugal. But it also supplies gas and electricity to clients in Germany, France, Belgium and the Netherlands. The Societe Generale analysts like its growth, dividends and strong balance sheet.

London-based United Utilities (UUGRY) is their third "key buy." The water company manages the water and wastewater network in the north-west of England, where it owns over 55,000 hectares of land around its reservoirs and serves around seven million people.

The Societe Generale analysts say United Utilities has an "attractive" regulatory asset base (RAB) premium. RABs were developed in England and Wales in the 1990s during the privatization of water companies as guarantees from the state that private investors in utilities will not be unfairly treated due to regulatory changes.

Unlike in the U.S., where RABs for investors in utilities are given explicit protection by law, in the U.K. RABs have been widely accepted as a useful protection device for private investors in regulated utilities without being explicitly written in law. Their strength consists in their reputational power -- much-needed investment would be withdrawn instantly if the RABs no longer were respected.

The Societe Generale analysts also say that United Utilities has merger-and-acquisition upside. Last year, United Utilities created a joint venture with Severn Trent (STRNY) for their non-household retail water business ahead of the opening of the market to competition this year. This opening could create more M&A activity in the field.

Weakness in the euro and the pound versus the U.S. dollar due to political turmoil could open interesting opportunities for U.S. investors. Utilities are a sector where it is a good idea to keep an eye right now.

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