By Serkan Unal
Dividend growth stocks tend to outperform other asset classes in the low- or no-growth environment, and are becoming increasingly touted as the markets start to factor in the threat of accelerating inflation. While the likelihood of high inflation in the near term is still remote, a dividend growth investing strategy is appropriate as it allows investors to generate increasing income streams over time and to offset inflation in the current environment in which real returns on fixed income instruments are negative. With these observations in mind, we look closely at dividend growth opportunities in the energy/utilities sectors, which, in aggregate, realized the lowest total returns last year. While the risk/reward opportunities in these sectors may have become less favorable amid valuation expansion and lower earnings growth, a selective approach should be taken when considering energy/utility stocks for dividend growth portfolios.
Our focus is the energy/utility dividend growth picks by the Gabelli Dividend Growth Fund (GABBX). The Fund, which seeks long-term capital growth, has realized a 1-year total return of 9.5% after taxes and redemptions. According to the Fund's portfolio holdings as of the end of the third quarter of 2012, the energy sector picks for dividend growth include the three U.S. energy behemoths, Exxon Mobil (XOM), Chevron Corporation (CVX) and ConocoPhillips (COP) and five other dividend stocks. Below is the overview of those five stocks. It should be noted that despite the overall sector's lackluster performance last year, some of the Fund's picks posted remarkable gains.
Great Plains Energy Inc. (GXP), an electric utility company servicing customers in western Missouri and eastern Kansas, pays a dividend yield of 4.2% on a payout ratio of 64%. While the company halved its payout in early 2009, it has resumed dividend growth since November 2011, with a cumulative increase to date of 4.3%. Analysts forecast the company's 5-year EPS CAGR at 7.7%, a reversal of negative average growth over the past five years. This month, the company is awaiting a decision on rate increases, which, along with its prudent cost management, could deliver the forecasted rebound in EPS of 20.6% for this year. This would provide more room for dividend growth. However, while the stock represents good value with a price-to-book of only 0.9 versus 1.3 for its industry, GXP seems unlikely to increase dividends at rapid rates, at least in the near term. Its free cash flow has been deep in the red since 2006, and has just turn positive on a trailing-twelve-month basis. The company also has a free cash flow conversion ratio of only 0.07. It is priced at below-industry 15.9x trailing and 13.6x forward earnings. Billionaires Israel Englander and D. E. Shaw trimmed their positions in GXP last quarter.
ONEOK Inc. (OKE) is a diversified energy company engaged in gathering, processing, storing and transporting natural gas and natural gas liquids ((NGL)). It pays a dividend yield of 2.9% on a payout ratio of 76%. OKE's dividend growth averaged 11% annually over the past five years. Its long-term annualized EPS growth is forecasted at 9.3%, based on a higher natural gas and NGL transportation capacity at its ONEOK Partners L.P. (OKS). OKE has expressed its intention to boost its dividends "by approximately 65 to 70 percent between 2012 and 2015, including dividend increases of 3 cents per share semiannually in 2013, subject to board approval." The company's targets its long-term payout ratio at between 60% and 70%. The sanguine outlook on natural gas consumption, bolstering transportation volumes and thus the profitability of its pipeline operations, bodes well for OKE in the long haul. However, the company's excessive ratio of long-term debt to equity is concerning. The energy company is trading at a 23.5x forward earnings versus 19.9x for the pipelines industry and 18.9x for the gas distribution industry. Last quarter, Israel Englander boosted his OKE stake by 190% to almost $30 million.
Phillips 66 (PSX), an independent downstream energy company, pays a dividend yield of 2.0% on a payout ratio of 11%. The company, a spin off from ConocoPhillips, started paying a dividend in the third quarter of 2012. The company has a high free cash flow yield of 14.3%. Its free cash flow conversion ratio is 0.83 and an annualized long-term EPS growth is 7.2%. In early December, the company's board approved a 25% increase in the company's dividend (effective in the first quarter of 2013), for the second time since the initiation of dividends. Furthermore, the company's board approved a supplemental $1 billion share repurchase to augment the $1 billion share repurchase plan authorized in the third quarter of 2012. Interestingly, PSX plans to boost its midstream and chemicals operations-increasing their shares in total revenue, while shrinking the share of refining revenues - and is likely to create an MLP whose IPO is planned for mid-2013. The stock is trading at 7.3x forward earnings, which still makes PSX more expensive than main competitors Valero (VLO), Tesoro (TSO), and Marathon Petroleum Corp. (MPC). The stock is one of Warren Buffett's holdings.
NextEra Energy Inc. (NEE), an electric utility company servicing customers in the United States and Canada, yields below-industry 3.3% on a payout ratio of 47%. The company has grown dividends at an average annual rate of 7.1% over the past five years. Its long-term annualized EPS growth is forecasted at 6.0%. The utility's large investments in infrastructure and new wind farms and power plants have been a drag on operating cash flow in the near term. However, lower capex and stronger growth from the new capacity, coupled with lower costs due to a greater utilization of inexpensive natural gas, will result in better profitability and free cash flows. This should bode well for dividend growth in the future. The company is also the largest U.S. renewable energy producer, and may benefit from supportive government policies regarding the sector. NextEra Energy is priced at below-industry 16.1x trailing and 14.7x forward earnings. However, its price-to-book of 1.9 is higher than the industry average of 1.3. The stock is popular with Polaris Capital. Last quarter, fund managers Phill Gross and Israel Englander both scaled down their investments in NEE.
Spectra Energy Corp. (SE), an owner and operator of natural gas-related energy assets, is a pure play on natural gas consumption growth. The stock pays a dividend yield of 4.4% on a payout ratio of 79%. The company has been making large investments in natural gas infrastructure, including pipelines and storage. It is also buying the Express-Platte pipeline system, running from Canada to Illinois, for $1.25 billion in cash to build its oil transportation network. (To fund the acquisition, the company recently issued common stock.) While the company's large investments are drags on liquidity in the near-term, they will substantially add to the company's capacity to transport increasing volumes of natural gas, bolstering profitability and free cash flow. SE grew its dividends, on average, by 5.6% annually over the past five years. The company hiked its quarterly dividend by a higher-than-average 9% in November 2012. The stock is trading at 18.3x forward earnings, slightly below the gas distribution industry average of 18.9x and the pipeline industry average of 19.9x. Last quarter, Arrowhead Capital and Citadel Investment Group significantly boosted their holdings in SE.