4 Utilities Stocks Powered by Solid Fundamentals

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The Dow Jones Industrial Average hit its tenth record closing high of the year — and fifth in a row — while the S&P 500 ventured into uncharted territory when it hit new highs on June 5 that were above its record close. Looks like records were made to be broken.

It will seemingly take a lot to break the current rally, as the market only bent under the weight of political unrest in Iraq and the resulting higher oil prices yesterday. And stocks also largely shook off the disappointment of weaker-than-expected May retail sales.

But even with the market continuing to hit new highs, I believe there are still plenty of buying opportunities just waiting to be scooped up in the midst of any weakness. And some of the best opportunities out there are in the utility sector.

We’ve seen a lot of sector rotation amid the market volatility, as investors run to “safer” names that offer some downside protection. One industry that benefits from this is utilities, which are generally known for its defensive characteristics because their businesses will be necessary no matter the economic climate.

I have four picks in this space that I want to share with you now that offer solid fundamentals and attractive valuations. Let's take a closer look:

Consolidated Water (CWCO)

Consolidated Water (CWCO) is a utility with some innovative technology in its pursuit to treat and provide water in parched areas.

CWCO is not your typical water utility. While its peers simply process and transport fresh water to customers, and collect the waste water that results post-use (and treats it), CWCO is in the business of desalination — converting unusable salt water into fresh water, and transporting it to some of the most underserved areas globally.

The company uses a process known as reverse osmosis, which implements a pressurized system to separate saline from fresh water and passing the water through a semi-permeable membrane that keeps the salt out. The process is used at CWCO’s 13 plants located throughout the Caribbean. The bulk of its 26 million gallons per day of capacity is located in the Cayman Islands and the Bahamas, with 92% of capacity located there.

CWCO fell after reporting disappointing first-quarter earnings of 4 cents per share and revenues of $16.3 million. Both numbers were shy of expectations — 9 cents per share and $17 million. The miss was largely due to a drop in profit-sharing from one of its affiliates in the BVI, as well as increased costs from the ongoing Baja, Calif. water desalination project.

However, it has since made a significant turnaround since its post-earnings low, rebounding nicely. As the company continues to broaden its geographic footprint, especially into important water-starved Mexico and California regions, revenues should strengthen and I expect the Street to take notice.

NRG Energy (NRG)

NRG Energy (NRG) is the second-largest independent retail energy provider in the United States. The company boasts more than 2 million customers thanks to some recent acquisitions.

Management has been snapping up solar projects around the country, and its new capacity for business has caught my eye. A recent purchase of Dominion Resources’ (D) retail business added half a million customers, while Edison Mission’s renewable assets also helped extend its reach. An agreement to buy residential solar company Rooftop Diagnostics has further cemented NRG’s foray into new markets.

The company posted first-quarter earnings that underscored the momentum NRG has going for it. For the March period, NRG reported a loss of $56 million, or 18 cents per share, which is a vast improvement over the loss of $332 million, or $1.03 pershare, from a year ago. Revenues jumped nearly 70% to $3.5 billion — far better than the $2 billion anticipated by the Street.

On the conference call, management mentioned a “drop down” of new projects in the renewables portfolio to NRG Yield, for $349 million in cash. These include two solar facilities and a gas-fired plant in California. Most importantly for the near-term outlook, management raised its 2014 guidance and now expects adjusted EBITDA of $3.2-$3.4 billion — up from its previous estimate of $2.7-$2.9 billion.

NRG could see strong upside from current prices within a year as it continues to execute on its long-term plan of moving beyond its traditional energy base. Rising electricity prices should also benefit unregulated utilities such as NRG, and we’re headed into the summer months when demand for electricity demand should be strong. That means that these utilities have some leeway in pricing, which should help margins going forward.

Covanta (CVA)

Covanta (CVA) is not tied to any of the instantly recognizable areas of greentech, such as solar or wind, but it still operates right in that niche. The company quite literally turns trash into treasure — or in this case, energy.

The company operates 45 facilities throughout the northeastern United States that convert garbage into steam, which is then used to power electricity at the utility level.

Having emerged from the bankruptcy of a previous incarnation in 2004, Covanta is the biggest company in its industry. Of its $1.6 billion in annual revenue, 63% comes from long-term contracts with municipalities (where it picks up trash) and another 26% is tied to energy revenues from utilities (where the steam generated from burning waste is used to create electricity). The remainder of its sales comes from a metals recycling business.

Management is currently in the midst of building out a few projects and generators, which is gaining Covanta more attention from the Street (it was initiated with a buy rating with a $23 target by an analyst at BB&T earlier this month).

CVA’s financials have improved with the project expansion, as operating cash flow in the latest quarter rose from $64 million to $102 million. The top line has been growing faster than expenses, at nearly 8% revenue growth last quarter with comparable growth expenses of a little more than 3%.

As new projects and operations come online, free cash flow could see a boost. According to management, if you exclude the working capital tied to those projects, the midpoint of its range moves to $230 million, or 10% yield. Assuming a meaningful compression of that yield, the shares are well positioned to move into the mid-$20s range. That’s in addition to a healthy 3.9% dividend yield, which puts cash in our pockets as we wait for new business streams to come online.

Plus, we’re in good company investing in Covanta. It’s no secret that I like to see noted investors with strong positions, and CVA has a heavy hitter holding a sizable stake in the company. Sam Zell, who you may be familiar with as the billionaire who built up and sold a commercial real estate empire several years ago, owns 11% of CVA stock and also serves as chairman.

With improving financials and future growth already well on its way, Covanta offers an attractive opportunity in this niche area of the greentech revolution, especially as electricity demand rises as we head into the summer months.

EnerNOC (ENOC)

EnerNOC (ENOC) is a play on the intersection between technology and energy. ENOC is a relatively small tech firm ($560 million market cap), and it operates in two revenue segments, providing what is known as “demand response” services to utilities and “energy management” services to enterprises. The biggest segment by far is utilities, which brings in 90% of revenue, while the remaining 10% comes from enterprises.

Key customers are found within the commercial and industrial segments, and all told the company helps manage more than 8,600 megawatts (MW) at nearly 13,700 sites across the U.S., the UK, Australia and New Zealand.

EnerNOC’s utility model connects electric utilities with commercial and industrial power consumers and helps to reduce the need to rely on peak power plants (which are expensive to build and operate). The company does this through software as a service (SaaS) offerings that help utilities track, manage and regulate demand response. Management estimates such energy intelligence software represents a $5 billion market. ENOC’s revenues last year were $383 million, so you can see the growth potential.

EnerNOC has been growing at a good clip over the past several years, and that trend is likely to continue, given energy demand and the need for regulation. ENOC will also benefit over the longer term from recent EPA proposals that would cut carbon pollution from the nation’s power plants. Though the details have yet to be finalized, and there will be at least a year before final rules take shape, it’s likely that any net impact to the “smart meter” and “smart grid” industries will be positive, as utilities will look for additional ways to cut power usage.

EBITDA margins are strong at mid-teen levels. Should the top line be able to grow at double-digit rates through 2015, pro forma earnings should be able to touch $1.80 per share by 2015, and current free cash flow yields at around 10% should also lend some support to ENOC. With a mid-teens forward multiple, ENOC stock could reach $27.

The stock hit its 52-week high of $24 in May, and it has since pulled back in the wake of the PJM 2016/17 capacity market auction, which saw a drop in demand response clearing as gas fired plants have come on line. However, pricing has remained stable, and as demand continues to rise, additional, incremental auctions would bring more revenues to ENOC.

Hilary Kramer is the editor of GameChangers.