Dive Brief:

• Moody’s Investors Service on Monday lowered its outlook on the U.S. regulated utility sector to negative from stable for the first time since it began conducting sector outlooks. The lower outlook reflects what Moody’s sees as increased financial risk due to lower cash flow and holding company leverage for regulated utilities.

• Morgan Stanley upgraded the utilities sector to Outperform and said utility stocks are primed for defensive investments, according to a new note from Morgan Stanley analyst Michael Wilson, reported by Benzinga.

• Lower corporate taxes as a result of the federal tax law that took effect this year will result in lower cash flows for utilities and higher debt ratios, a critical component of credit quality and debt ratings.

Dive Insight:

For many companies, the tax bill that was signed into law just before Christmas was good news. It would lower their tax liability and boost earnings. But utilities are not like other companies.

Utilities have typically set aside payments from customers to pay for future taxes. Those deferred tax payments boosted utilities cash flow to the point where they accounted for about 14% of Funds From Operations, or FFO. With the cut in the corporate tax rate to 21% from 35%, utilities will collect less cash from customers and retain less cash for deferred taxes. Moody’s estimates those funds will shrink from 14% of FFO to 8%. In addition, as utilities refund excess funds collected for deferred taxes to customers, cash flow will be further reduced.

Lower cash levels also affect debt metrics that are a critical component of debt ratings. For regulated utilities, Moody’s sees FFO-to-debt levels falling to 15% from 17% over the next 12 to 18 months and for utility operating companies to 20% from 24%.

With roughly $600 billion of adjusted debt at year-end 2017, Moody’s peer group of 42 utility holding companies have a 10-year high ratio of debt-to-EBITDA and the highest consolidated debt to equity ratio since 2008, which was at the height of the financial crisis.

Moody’s expects those leverage ratios to remain elevated because of utility plans for higher capital spending in 2018 and 2019, rising dividend payments, and a continued heavy reliance on debt financing for negative free cash flow. The investor service's sector outlooks only covers 12 to 18 months into the future.

Moody’s acknowledged that many utility managers are seeking regulatory relief to address the effect of the tax changes but noted that will take longer than 12 to 18 months for those efforts to bear fruit.

Moody’s expects states such as Florida, Georgia and Alabama to continue with "very supportive regulatory outcomes" for their utilities while other states will likely have more moderate allowances for increased rates and cash flow recovery related to tax changes.

So far, Moody’s noted, many state commissions have provided for the 21% tax rate to be implemented into rates in 2018 but have said they will address the return of excess deferred tax liabilities to customers at a later date, adding to the uncertainty of the cash flow impact on the sector.

Utilities can also take internal measures to address rising financial risks related to tax reform. Those efforts could include cutting operating or capital costs, issuing equity, reducing debt, selling non-core assets or slowing dividend growth.

Morgan Stanley recommended the following utilities for Overweight-rated stocks: American Electric Power Company, FirstEnergy, NextEra Energy, NextEra Energy Partners, Pacific Gas & Electric (PG&E), Public Service Enterprise Group and Xcel Energy. PG&E has warned California lawmakers that it may consider bankruptcy or reorganization, depending on its liability for the state's devastating wildfires last fall.

And while many utilities are estimating a decline in capital spending after 2018, Moody’s expects that utility capital spending — for items such as smart grid deployments, resilience and renewable resource acquisitions — will continue to increase by about 5% annually compared with a 2012-2017 compound annual growth rate of 5.7%.

Moody’s noted that while utility companies often project a downward trajectory in capital spending, actual funds deployed frequently exceed projections by a wide margin. Moody’s data show that for 25 holding companies that have reported three-year capital expenditure projections since 2009, aggregate capital spending has always increased despite projections that usually predict a declining trend.