A couple of months ago I sold all my Entergy (NYSE:ETR) shares. I would like to share my reasons for doing so.
General utility risks, and how they manifest for Entergy
My general view of electric utilities is that they offer only limited upside and big downside, and thus are not very suitable for a long-term investment. Of course, money can be made if one buys very cheaply, or business economy of a particular utility improves unexpectedly, but I believe stocks from other sectors usually offer better opportunities. Although my suggestion is to avoid utilities, I would like to refer an interested reader to an article by Chuck Carnevale for a discussion of recent opportunities in the utility sector.
Decades ago, electric and gas utilities were among the most stable businesses, and wild swings in their stock prices were not common. Buying bonds and stock of a local utility were considered a prudent choice of saving for a retirement. Nowadays utility stocks are much more volatile. Although their beta is only about 0.5 on average, this reflects mostly lack of swift upside movements than an absence of severe price declines. For instance, Entergy lost about 45% of market value in 2008, with results very similar to various utility ETFs (IDU, XLU). There were also a few cases of utilities going bankrupt (e.g. PG&E) and many other utilities have cut their dividends.
There are two basic goals of utility regulation: keep electricity prices affordable for consumers, and give utilities a reasonable return on invested capital so they can maintain and build plants and infrastructure. While regulation almost never misses the first goal, it often fail to achieve the second, especially in an environment of rising costs which are often passed to consumers only partially and with a long delay. For an owner of a utility this means that any outsized profits will be cut down by regulators while losses will be for the most part left to him to deal with. Another similar risk comes from rising interest rates; most utilities are highly leveraged and increased interest payments can slash their profits close to zero even while earning reasonable operating return on invested capital. Depending on the country the utility is operating in, cheap electricity may be used by local politicians as a "bribery" to the public, and this adds additional risk.
Another unpleasing feature is that the potential for dividend increases is very limited in general. Utilities are very capital-intensive, and inflation we have lived with for the last decades means that their maintenance expenditures are often larger than depreciation which is derived from prices booked many years ago, and thus distributable cash flow is often smaller than earnings.
Present outlook is also not very favourable. Many utilities are burdened by old plants which are not cost-efficient, and I doubt the current limited demand for electricity will soon improve. This is particularly visible in Europe, where companies like E.ON (OTCQX:EONGY) are closing and mothballing plants to cut costs. In the U.S. it is not much different: nuclear plants suffer by increased costs due to security requirements after the Fukushima accident, and many are hardly competing with cheap natural gas plants (check the Vermont Yankee story for Entergy's share of it). Similarly, it does not pay off to invest into emission-reducing equipment in inefficient older coal plants and it is better to close them down.
Another aspect of electric utilities is governmental support for green generation, especially wind and solar. In Slovakia, there was a boom of little solar plants due to government subsidies, but the subsidies were cut after only two years which resulted in miserable returns on invested capital for many projects. There is a massive support for wind turbines in many countries around the world, but wind generation can neither stop global warming nor solve our dependency on fossil and nuclear sources, thus no one can be sure governments will not soon change their attitude towards wind power.
Nuclear plants (which Entergy uses for about one third of power generation) is in many places heavily opposed by the public and local officials. Although NRC seems willing to extend licenses on nuclear plants, local opposition may lead to a closure; an example is the case of Vermont Yankee. Of course, cheap natural gas does not help at all and Entergy's nuclear fleet is barely profitable: Entergy Wholesale Commodities booked only $11M of earnings in 2Q2013 compared to $71M in 2Q2012.
Why did I invest in Entergy then?
Had I understood all the stuff mentioned in the previous paragraphs, I would have avoided investing in ETR. I have lost only about 3% on my investment, and this is a cheap price for this experience clearly showing that I should avoid industries I do not really understand. (However, I am afraid this lesson will have to be repeated a few times, for I am enthusiastic and optimistic by nature.)
Entergy had a very capable CEO W. Leonard from 1998 to 2012. He took the helm at the company at a brink of bankruptcy and build it into a strong utility leading on many fronts, including speed of hurricane recoveries, being one of the top employers of choice, and bringing substantial returns to shareholders (the stock price increased from $30 in 1998 to $120 in 2008; in 2013 it moves in the range from $62 to $72). The dividends have increased every year from 2000 to 2011 (9.7% CAGR). This history was very appealing to me. Together with sustainable 5% yield and a hope for advantages of cheap nuclear power showing in the long-term, I found the stock attractive. Presently I view this as another lesson of history not necessarily repeating, no matter whether the new management is equally capable or not.
ITC Holdings merger
Entergy is currently busy with the pending disposal of certain parts of their transmission assets which are being merged with ITC Holdings (ITC). This obfuscates quantitative details of both companies; it is not clear whether "future" Entergy free of transmission will be able to maintain the current dividend rate or how much dividends to expect from the new ITC. The management shows firm belief in benefits of this transaction for all the participants: customers, shareholders and regulators. As an Entergy shareholder, I was not very happy with getting shares of ITC for the current market price, because ITC trades for about 3.3x book value and with P/E about 24, and although its profits have grown by more than 10% a year in the last few years, I do not view it as undervalued. Although I believe the management that the merger is a good thing to happen, and it will certainly help both companies to focus on their core business, I do not expect a significant value creation for ETR shareholders, so it has not affected my decision to sell ETR.
Considering ITC as a stand-alone investment, it is worth a look, but carries some risks too. Transmission companies' maximum return on equity is determined by FERC and is currently about 12-13% for ITC. The company has opportunities to invest large sums of capital and get nice returns on all of it; however, increasing interest rates may lead to a diminished supply of capital compared to the past few years. Moreover, FERC-allowed rates of return are in a legal dispute in certain states, and might decline based on a court decision. You can find more details on regulatory issues of ITC in an article by Jon Parepoynt. Although I like ITC as a society-enhancing business, I do not have a strong opinion on ITC as an investment and will stay away because I do not understand electricity transmission regulatory frameworks in detail and cannot judge what will happen in long-term. Still, my feeling is that it is better to be in transmission than in generation and distribution in the present situation.
How I invest in utilities now
The above-mentioned general utility risks make me stay away from individual utilities now. It is not a simple case of blood in the street which one should exploit as a big opportunity; economics and risk profiles of utilities are unfavourable in general and one has to be very selective to find an attractive one. Nevertheless, I have found two ways of participating in utilities indirectly.
The first way is buying Berkshire Hathaway (BRK.A, BRK.B) which owns about 90% of MidAmerican Energy (the initial 76% stake was bought in 2000). I consider their management best-in-class; apart from the investment results speaking for themselves, there are some other proofs for it, e.g. top ratings of their pipelines. In addition, Berkshire is known for great capital allocation skill, so I believe they will invest additional capital only when expected long-term returns make it rational to do so. In the last three years, earnings of MidAmerican increased from 1.2B in 2009 to 1.5B in 2012 and shareholder equity increased from 12.6B to 15.7B. The return on equity is 9.5%. Earnings were 1.8B in 2008; this illustrates that the US economy has still not fully recovered and life is not rosy for companies in the utility sector. On the other hand, 1H2013 results are encouraging: net income increased by 15% year-on-year.
MidAmerican is opportunistically acquiring smaller local electric utilities. Currently, they have capitalized on depressed utility prices and bought NV Energy for about $5.6 billion. I believe they have done their due diligence on the deal and surely they can do it better than me -- I see no reason to try to analyze tens of publicly-traded utilities instead of earning additional money to invest and let Buffett and his team do the dirty work for me. I think that MidAmerican benefits from Berskhire's strong cash position in two ways. In case of a steep rise in interest rates, Berkshire can help with financing and MidAmerican avoids a squeeze; thus the risk is partially mitigated. In addition, MidAmerican has obviously a much better potential to profitably grow by acquisitions; they have money to buy even when others are cutting dividends to save every penny.
The second way is buying a partnership associated with Brookfield Asset Management (NYSE:BAM). For the utility sector, there is Brookfield Renewable Partners (NYSE:BEP) focusing on renewable power generation, and Brookfield Infrastructure Partners (NYSE:BIP) focusing partially on transmission of electricity and marginally on distribution of electricity and gas. BIP appears attractive now -- see my recent analysis.
I think that the current Entergy's 5.33% yield may still be appealing to some shareholders; moreover, I believe that the dividend is sustainable. However, I doubt it has any room to grow in the short- and mid-term (except by an increase of the payout ratio to levels unsustainable long-term). This 5.33% return (maybe enhanced by a 1-2% growth) is not enough for me; I would rather buy a dividend index ETF or a diversified portfolio of selected dividend growth stocks yielding about 3.5-4%, but with a much larger dividend growth potential and a chance for capital appreciation.
Disclosure: I am long BIP, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.