There was a particular and curious event that got me looking at utilities again, and that came from a chap investors should always watch; Warren Buffett. Always looking to put cash to good use, last May, Berkshire Hathaway (BRK.B) made a move that was a bit unexpected. It purchased Nevada 's NV Energy, another utility company to join currently-owned Mid American. Now at the time, utilities had come off a nice period of appreciation, and their minor drop didn't strike me, a value investor, as much of a buying opportunity. However, this deal gave me the idea to re-evaluate utility valuations since Warren Buffett is rarely wrong with his discounted stock selections.
I started doing some research and found a few possibilities, including Consolidated Edison (ED), Southern Company (SO) and Westar (WR). Since then, rising interest rates, stronger regulations on coal and even a few specific problems at some of the companies have made the valuations even more attractive, especially relative to the S&P 500. Here's a chart (from Google Finance) comparing the S&P 500, the SPDR Utility Index XLU and Consolidated Edison.
As you can see, Consolidated Edison has fared even less well than the utility benchmark, which hasn't exactly set the world on fire. Who is Consolidated Edison, you ask? It is the utility company seen in Ghostbusters, the ladies and gents who supply electricity and gas to good old New York City. Its business is almost exclusively regulated power and gas, meaning it has a license to make fair amounts of money.
Now why has it underperformed? Concerns about an upcoming rate decision with the NY State Regulators, which could weigh on revenue, as well as high capex spending from Hurricane Sandy have depressed its earnings and thus stock price. Now trading for 15X earnings, lower than the 16-17X valuation at which Berkshire bought NV, I believe ED has become a good total return value. Its yield is around 4.75%, with a payout ratio of only about 65%.
Here's a chart of some similar utilities' yields, payout ratios and earnings (from S&P Capital IQ, 2012 numbers)
|Company||Yield||Payout Ratio||Trailing Earnings Valuation|
|Portland General (POR)||3.7%||57%||26.6|
The history of its payout ratio is actually very revealing. If you look at it over the last ten years, it has steadily declined, going from the 90% range 10 years ago, to 70% by 2008, and now down to the mid-to-low 60s. That should be a very sustainable level of payouts, and shows smart money management from the board, as well as a commitment to keeping that dividend. Despite a high payout ratio, they didn't panic and cut dividends, rather they have even raised it, just slowly enough to bring down the ratio to a safer level.
Also, if you look at its earnings over the last ten years, they have risen about 50% going from $2.36/share to $3.86. Of course, earnings are what this game is all about, and more earnings equals more money to do all sorts of nifty things, including of course, raise the dividend. That brings up my biggest problem with Con Ed right now; the weenie dividend raises. The last few years have seen a princely 2 cents or so dividend raise per year, barely covering inflation. While this was advisable to bring down the payout ratio, it might be time to start beating inflation a little. I believe that would also help the stock price, as yield (and safety) determines a lot of the pricing of utility stocks.
What do the analysts think of Consolidate Edison? I have been reading a number of notes from Argus, S&P and Credit Suisse that draw a similar conclusion: once the uncertainty of the NY rate decision case is over, ED will return to the $60 range.
Now let's step back from the numbers for a second, and discuss. First, Con Ed provides an absolutely essential need for arguably the world's most important city. It's also a legal, if regulated, monopoly. It won't be going away and it'll be making money for a long time. Its payout ratio is not high at all by utility standards, so the dividend is safe, and has room for plenty of raises. Also, utilities often revert to the mean of the S&P 500 at various points, in which case you would be getting some stock price appreciation as well as the dividends. This scenario is what many of the various analysts believe as well.
Finally, if Con Ed seems safe but not very exciting, remember this: while things are still slowly grinding upwards in the US economy, there's always another recession coming at some time. We're on 5 years of a recovery, so one would assume a recession is getting closer. For instance, maybe Obamacare's attempt to cover the uninsured sick pushes up premiums for everyone? With more people required to buy insurance, this could drag on consumer spending. We've seen a lot of the industrials and materials shoot up over the last few years, so if a recession hits, those will take a much bigger drop than utilities. It might not be a bad idea to balance something aggressive, like Cummins, with something you can count on, like Con Ed.
You can see why Buffett made the move he did; there's nothing wrong with hitting singles all day. And that's what you get with Con Ed, no home runs but no strikeouts. You get a bunch of singles and if it is undervalued as Mr Buffett and some others surmise, a few doubles aren't out of the question either. It's a safe way to make a decent total return.
Additional disclosure: I may initiate a position in ED shortly.