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This is the part 6 in the latest Desperately Seeking Yield series. Part 1 dealt with BDCs; Part 2 with agency mortgage REITs; Part 3 with non-agency mortgage REITs; Part 4 with Telecom Stocks; and Part 5 with equity REITs. This part deals with utility stocks.

Once again, we have a sector with some peculiarities which make initial comparisons between sectors based upon financial data potentially misleading. Utilities are, at least partially, regulated and subject to a variety of forms of regulatory oversight. They tend to make large capital investments to carry a lot of debt. Regulators provide franchise utilities with at least some protection from competition but limit earnings to a reasonable return on investment. There is also oversight of takeovers which generally have to be approved by regulatory authorities. Some utilities also engage in activities sometimes called "merchant power production" in which they produce power which is sold competitively.

Utility stocks have certain "bond-like" characteristics. They are frequently priced based largely upon dividend yield. Dividends tend to be very stable and to grow steadily but very slowly. I have argued in another article that the entire stock market is starting to trade in a "bond-like" manner and given the fixation on yield, utilities have done reasonably well. Investors should be aware that utilities can reduce and even omit dividends and that this has happened from time to time in the past. It is interesting that almost every utility website has an extensive dividend history section.

The table below gives the closing price and quarterly dividend on June 27, 2011, the date of the article in the original series as well as the Wednesday's closing price and the current dividend for Consolidated Edison (NYSE:ED), American Electric Power (NYSE:AEP), Exelon (NYSE:EXC), Duke Power (NYSE:DUK), Entergy (NYSE:ETR), Constellation Energy (NYSE:CEG), Dominion Resources (NYSE:D), Edison International (NYSE:EIX), Southern Company (NYSE:SO), and PEPCO (NYSE:POM). Prices are based on data from Yahoo Financial; dividend data is derived from information on each company's website. CEG and EXC merged in 2012 with each share of CEG converting into .93 shares of EXC; I have carried forward CEG's per share price based on an assumption that a shareholder received .93 shares of EXC for each share of CEG and then held onto the shares; I have not presented CEG dividend data as CEG no longer exists. DUK had a 1 for 3 reverse split and I have split adjusted the 2011 data.

Price 6/27/11Dividend 6/27/11Price 3/13/13Dividend 3/13/13
ED$52.40$.60$58.77$.615
AEP$37.10$.46$47.44$.47
DUK$55.53$.735$69.91$.765
EXC$42.02$.525$32.20$.525
ETR$68.17$.83$63.68$.83
CEG$37.14 $29.94
D$47.25$.49$56.34$.5625
EIX$38.70$.32$51.00$.3375
SO$39.43$.4725$45.29$.49
POM$19.18$.27$20.75$.27

A couple of points jump out. The sector has done pretty well with some significant gains. It has certainly been a better place to be than cash and it beats many fixed income alternatives. The slow but steady dividend growth pattern has continued and increases an investor's yield on original cost over time. There are some losers and this suggests the wisdom of diversification for investors in the sector and in dividend stocks in general. You can never be sure in advance which electric utility may experience a nuclear plant problem which regulators blame on management and, therefore, the costs of which are not fully recoverable. The sector has seen an overall pattern of slow but steady dividend increases; those companies which have not increased dividends have tended to trade down. I may try to do a more detailed comparative analysis later in the year. Financial numbers do provide insight into the sustainability of dividends but a very important intangible called "regulatory climate" can be even more important.

Cheap natural gas is a double edged sword for this industry. On one hand it may permit many utilities to hold rates down by creating a relatively cheap source of generation. But there are circumstances in which the dramatic change in the United States energy market can create at least temporarily higher costs for some utilities. Utilities that are faced with nasty cost increases will always face resistance when they try to raise electric rates and I think investors should be careful of utilities stuck with old coal plants because the Obama administration is likely to tighten emission requirements leading to either substantial compliance costs of plant closures. I also think that utilities that are in the process of planning or actually building nuclear plants could be forced to cancel such plans because natural gas has become a less expensive alternative. In this event, there may be some question about the recovery of the money spent on a plant never put into service.

My advice to investors is to kick the tires on individual stocks and to be sure to diversify. I still like D, DUK, ED, SO, POM and AEP. D and POM benefit from the strong economy in the DC and Virginia area. ED should do well as New York prospers. DUK has become diversified and is generally viewed as having strong management. SO operates in a region which should see some growth. AEP covers a broad area which provides some diversity protection; it is also in an excellent position to benefit from growth in the American "heart land" as heavy industry recovers. I think that the sector will continue to do well as long as interest rates are low but that this is a sector which could take a hit as rates go up. Because I think that rates will stay low for quite a while, I am generally long and consider the sector a good source of stability in a collateralized account (see this article for a description).

Source: Desperately Seeking Yield Redux: Part 6 - Utility Stocks