Background: Consolidated Edison, Inc. (NYSE:ED) has as its main subsidiary the wholly owned CECONY, Consolidated Edison Company of New York. CECONY is a powerful monopoly that also delivers natural gas and steam, as well as power. However, it's not so powerful that it cannot be beaten up in the political and real world arena. This has happened in recent times by the massive Hurricane Sandy in fall of 2012, and then by an explosion of a gas pipe in NYC in March, in which eight people died. ED also owns Orange & Rockland Utilities. ED has some operations in alternative energy. CECONY accounts for the great bulk of EPS, however.
ED no longer has any nuclear exposure.
Most investors have thought of ED as a bond substitute. In that role, I present the case here that ED is underpriced and that ownership of it could allow for both high current income and substantial stock price appreciation, though of course ED is not going to turn into the next hot stock by bull market standards.
Introduction: Plain vanilla electric and/or gas utilities have been looked at by stock market investors as relatively safe, low volatility, low beta types of investments that had stock prices that were anchored by high yields. In what is now an era of very low short-term interest rates and what is at least a prolonged period of low to extraordinarily low long-term rates, utilities have become stellar performers. At base, though, they are operating companies that provide essential services and have a value which according to basic financial theory should not be related to the degree to which earnings are paid out in cash dividends instead of being retained by the company.
In the real world, an aging investor base wants income. This has led to a variety of ways to stretch for yield. The Utilities Select Sector SPDR (NYSEARCA:XLU) has been a strong performer, outperforming the S&P 500 over the past six months:
The dividend yield on XLU is 3.4% (after modest fund expenses of 0.16%). Utility stocks may be very well suited for the current Goldilocks scenario of moderate economic growth, very low interest rates, and high prices for most growth stocks.
The question that investors may wish to answer is whether any individual utility stock is clearly more attractive enough to be a good purchase for new money, especially for a tax-deferred account where high current income has no current taxes applied. Often, these situations involve speculating on a turnaround, takeover, etc. However, typical utility stock investors are not so inclined. Safety and good total return are prized.
Enter Con Ed.
Con Ed as a bond substitute: ED is first and foremost a play on dividends. Per Con Ed's website, Con Edison has increased dividends for 40 consecutive years. Note the table linked to on ED's IR site shows two dividend reductions. Each was due to a 2:1 stock split, once in 1982 and once in 1989. Adjusted for splits, the dividend has risen from 12.5 quarterly to 63 cents in the last 37 years, a 4.5% annualized growth rate. The stock has appreciated from a split-adjusted $6.10 to the current $54.56, a rate of 6.1%. This produces a quite satisfactory about 10.6% total return per year over this long period of time.
Dividends have been paid uninterruptedly since the 1800s.
Before discussing how ED's dividends could and should be valued, let's just mention that EPS for 2014 and 2015 are expected to be in the $3.90 range, thus given an earnings yield over 7%, the dividend is well covered. This P/E under 14X is below the peer average. This is so even though Con Ed is one of the smallish number of utilities that retains a #1 ranking by Value Line (or, "VL") for safety, with an A+ financial strength rating and a 100th percentile ranking for price stability. Book value is expected by Value Line to end the year at $43/share.
In that context, the current dividend yield of 4.6% appears too high to me. The reasoning behind this ties to a long-term chart that Value Line presents, which I cannot present to you. Basically, treating ED as a bond alternative, VL presents the relationship of ED to the 10-year Treasury note (TNX). For each regulated utility stock, it looks at various factors and comes up with a "value line." This value line is normally a multiple of EPS for non-regulated companies, but is related to bond yields for most utilities. For ED, the trading history and Value Line's judgment is that the dividend yield for ED should be higher than the yield from the 10-year note, and that the relationship should be by a factor of 0.7. This means that if ED yields 5%, that should be associated with a yield on the 10 year of 3.5%. If ED yields 4%, the 10 year should yield 2.8%. With the 10 year around 2.45% recently, the yield of ED that by this formula would be expected to correlate with it is only 3.5%.
The following shows the degree of underperformance of ED versus XLU over the past two years:
If the price of ED were to rise so that the current yield on the shares were 3.5%, the share price should be in record territory over $70. If we "normalize" the 10 year to 3% (who knows what "normal" is anymore?), its approximate high yield since 2011, we still get a price of ED that is about 10% higher than it is today (May 29), as it should be priced to yield 4.23% by this formula and historical pattern.
It does appear that a case can surprisingly be made that ED has deviated from fair value, given the also surprising (to many) action of bond yields recently. (Note I authored two increasingly bullish articles on Seeking Alpha on bonds in the past half year, the more recent one being Turning Bullish On Bonds on March 17.)
While Con Ed has had some costs from the 2012 hurricane and the recent gas explosion, these sorts of things tend to even out over time. New York City is doing well economically these days. The IR section of Con Ed's website has a February presentation that reviews the company's operations; I see no red flags there and in fact like most of the trends that management presents.
Risks: Some of the risks to owning ED are as follows. ED has operational, market, inflation and interest rate risk. The pension plan is underfunded, and a renewed drop in both general stock market prices and in interest rates could be a material problem for the company's net worth. Also, no special relationship between ED's dividend yield and Treasury or other bond prices need to be re-established.
Summary: Con Ed is a well-known company that is the monopoly supplier of various essential energy services to New York City and several of its environs. The shares have underperformed their benchmark for reasons that I view as transitory. Even if the stock price never moves, the current dividend yield is attractive versus CPI inflation, short-term interest rates, and long-term rates. Dividends have been paid without interruption for well over a century, and have been increased annually for decades. While it may appear odd, ED has a chance to appreciate significantly simply on the basis that ED's yield may drop over time to "catch down" to prevailing Treasury bond rates.
Disclosure: I am long ED. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.