Many dividend growth investors have capital invested in steady-eddy utilities firms, and there is nothing wrong with that. In fact, we also have exposure to the Utilities Select SPDR ETF (NYSEARCA:XLU) in the Best Ideas portfolio and to PPL (NYSE:PPL) in the Dividend Growth portfolio. Though the regulated 'returns' and steady performance of utility-entities are quite attractive, especially when they pay annual dividend yields of 3%-4% per annum or more, we think it is very important for investors of all types to understand that the dividends of utilities are not without risks. In fact, the nature of their capital structure sometimes exposes utilities to more risks than other entities, especially with respect to the dividend.
Before we get started, it's very important to reiterate that we're not saying utilities are poor investments. The truth is quite the contrary, in fact. For many different types of investors, equity exposure to the utilities industry is an important avenue to meet financial goals while staying within appropriate risk thresholds. But while the stable operations of a utility may imply that its dividend payments are also safe, the Valuentum Dividend Cushion ratios of most utilities tell a very different story. But why? How could there be a perceived inconsistency? It seems to run counter to conventional market wisdom and everything you may have been told or learned about utilities. Utilities, by definition, have to be low-risk investments, right?
Well, yes and no. A utility's operational risk, regulatory risk, and overall default risks (as measured by its credit rating) are generally low, but the dividend growth investor is interested in analysis that goes beyond these assessments. In particular, the safety of a firm's dividend is based primarily on the free cash flow capacity (cash from operations less capital expenditures) the firm has to allocate to future cash dividend increases (after considering support from its balance sheet). In the context of dividend growth analysis and as it relates to the balance sheet, we're most interested in the company's excess cash position-i.e. its balance-sheet net cash position (net cash is a firm's cash and cash equivalents less its total debt load). Just like an individual has more flexibility to pay himself/herself a personal dividend such as a vacation, for example, when there is significant savings in the bank, the same is true for a company, which has more flexibility to pay shareholders a growing dividend when there is more net cash on its balance sheet.
The larger the excess cash capacity that a firm has (balance sheet net cash and future free cash flow relative to future cash dividends), the more secure existing dividend payments are, and the more capacity a firm has for future dividend growth. 'Dividend Safety' scores that are poor in Valuentum parlance reveal that the board of directors of a company has essentially maxed out the firm's annual payout (on an inflation-adjusted basis) and has little room for operating error. Said differently, the firm can't easily handle negative events that impact the income statement and cash flow statement--think primarily revenue, operating income and working capital. A poor 'Dividend Safety' assessment doesn't mean, however, the board can't keep raising the dividend in the face of such risks.
As you may have gathered, a number of steady-eddy utility firms in our coverage universe receive poor 'Dividend Safety' ratings. The Dividend Cushion ratio considers the stability of utilities' business models, but it also reveals that, in a scenario where an exogenous event may impact a utility's performance, the utility simply doesn't have much excess cash capacity on the balance sheet to absorb a shock. This hidden risk may be a way of life for the sector, but it is a key risk for dividend growth investors. The Dividend Cushion is completely objective.
Let's examine two recent examples of Exelon (NYSE:EXC) and First Energy (NYSE:FE) to further illustrate the importance of balance-sheet net cash. Both of these utilities' dividends were thought to be safe by the general market, but yet, both had poor Valuentum Dividend Cushion ratios (below 1) before each firm eventually slashed its respective payout. The primary driver for the poor Dividend Cushion ratios rested in each firm's massive debt positions. Let's have a look.
Exelon ended 2013 with $17.3 billion in long-term debt and only $1.6 billion in cash and cash equivalents. When the utility's performance suffered last year, the company had no choice but to slash its payout in order to preserve its investment-grade credit rating. The utility's dividend track record and payout ratio revealed nothing about the forward-looking risk to Exelon's dividend, but the Dividend Cushion highlighted the very real risks of a hefty net debt position. Unlike firms in other industries where one year of declining earnings may just be a short-term setback (and can be supported by the balance sheet), Exelon's lack of a balance-sheet cushion cost income investors dearly Click to enlarge
Image Source: Exelon
First Energy's excessive leverage resulted in a similar sad story for income investors. The firm ended 2013 with $15.8 billion in long-term debt and only $218 million in cash and cash equivalents. When it issued disappointing 2014 guidance in January of this year, the firm didn't have a cash-rich balance sheet to draw from in order to sustain the dividend. As with Exelon, First Energy had no choice but to cut its dividend.
Wrapping It Up
The goal of this article is not to scare you away from the utilities sector, but to highlight the importance of also evaluating the balance sheet when assessing a company's dividend safety and dividend growth potential. The Dividend Cushion ratio is the only analytical instrument that performs a comprehensive analysis of the dividend and captures the key risks to the dividend inherent to a company that holds outsize debt obligations on the balance sheet. Read more about the Dividend Cushion here.
Dividend cuts may be rare in the utility sector, but it's important that investors understand that not all utilities' dividends are safe, and even well-known utilities with excellent dividend growth track records can be forced to cut their dividend - mostly due to a lack of support from their debt-heavy balance sheets. Most do not have net cash positions to support the dividend under adverse scenarios.
For this reason, we prefer to hold a broad swath of utilities via the Utilities Select SPDR ETF, as such diversified exposure shields us from firm-specific dividend risks. The ETF has a meager 0.16% gross expense ratio and a relatively attractive dividend yield of ~3.4% at present. We think it's worth a look for investors seeking exposure to the utilities sector. Our best ideas are always included in the Best Ideas portfolio and Dividend Growth portfolio.
Disclosure: XLU is included in the Best Ideas portfolio and PPL is included in the Dividend Growth portfolio. The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.