By Travis Miller
Grannies, hold onto your hats: Utilities are on fire. But does that mean it's time to cash out? Or do utilities still represent the best investment option for yield and growth? If you pick carefully, we think there are still some attractive total-return opportunities left in the sector, along with some areas where we think the fundamentals do not justify investors' enthusiasm.
Utilities Leading the Pack
Investors have plowed into utilities during the past three years trying to capture their recession-resistant cash flow and attractive dividend yields. A market-capitalization-weighted group of the 34 largest fully-regulated U.S. utilities has outperformed every other sector since October 2007, with an 18% total return through September. Consumer goods, the second-best-performing sector, has produced just 7% total returns, and the S&P 500 has lost 20% during the same period. This year alone through September, these 34 utilities have generated 12% total returns, while the total return for the S&P 500 is just 4%.
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Yet utilities still offer a 4.4% average dividend yield. Compared with the 2.5% current yield on 10-year U.S. Treasury bonds, utility dividends are the most attractive on a relative basis they have been in at least two decades. Since the early 1990s, this spread between utility dividend yields and U.S. Treasury yields has been a good leading indicator of relative returns for utility investors. Utilities produced 18% three-year annualized total returns and 17% five-year annualized total returns after spreads last peaked in June 2003. These returns handily beat annualized returns for the S&P 500 (9% for both periods) and Treasuries (negative 8% and negative 3%, respectively). They also handily beat the sector's three- and five-year annualized total returns following the most recent trough in spreads in January 2000.
Picking Utilities Wisely
Even though we think the current yield spread between utilities and U.S. Treasuries suggests attractive returns ahead for utility investors, we caution investors to pick wisely. A stagnant economy could stymie energy demand, reduce the need for infrastructure growth, and encourage regulators to cut customer rates--all limiting dividend growth. If inflation strikes, both utilities and Treasuries could face lackluster returns. Moreover, we think some utilities have simply run up too far and are trading at absurd valuations. Overall, we think the fully-regulated utilities as a group are about 10% overvalued.
The utilities we still think can produce outsize returns are those with above-average dividend yields (to protect against inflation) and growth projects that don't depend on a rebound in the U.S. economy. Our favorites right now are Westar (WR), Portland General (POR), and National Grid (NGG).
Westar, the largest utility in Kansas, currently yields 5% and we think it is poised to grow earnings nearly 9% annually during the next three years, from its wind energy transmission projects and its coal plant environmental projects to meet federal mandates. Similarly, Portland General, with a 5% dividend yield, should benefit from transmission projects to support renewable energy in Oregon and power plant upgrades to reduce customers' volatile energy costs. We project 10% annualized earnings growth during the next three years for Portland General.
Another regulated utility we like is National Grid, a London-based utility yielding 6% that earns about half of its profits from its U.K. transmission grid and half from several distribution utilities in the Northeast U.S. With management's GBP 22 billion investment program during the next five years and the U.K.'s shareholder-friendly regulation, we think National Grid can grow earnings and dividends 8%-10% annually. Currency exposure to the British pound could affect realized returns for U.S. investors. Southeast U.S. utility giants, Southern Company (SO), and Duke Energy (DUK) also yield near 5%, and we think they can produce 5%-7% annual earnings and dividend growth.
Stay Out of the Yield Laggards
We think the market's cyclical rotation into the steadiest regulated utilities has left many with overly-rich valuations. This is most concentrated among gas distribution utilities, which many consider to be the most consistent of regulated businesses. While we note that the business fundamentals of these companies are solid, we believe that the flight from risk has driven some investors to turn a blind eye to the below-average growth profiles these companies offer. As a group, we think the gas utilities in the Morningstar coverage universe are about 12% overvalued.
For utility investors, dividend yield makes up a substantial portion of expected return, and across similar businesses, lower yields can frequently indicate an overvalued stock relative to its peers. We think one of the richest right now is Piedmont Natural Gas (PNY) with utilities in North Carolina, South Carolina, and Tennessee. While we think Piedmont's conservative business model provides a rock-solid foundation for its consistent and modestly growing dividend, the firm's valuation at 17 times our forecasted 2012 earnings is, in our view, far from justified by the 5% growth rate we think it will achieve during the next five years and the stock's relatively modest 3.8% dividend yield. Nicor (GAS) an Illinois gas utility with a fully-saturated service territory and little organic growth, also garners a premium multiple to peers at 14 times our 2012 earnings estimate despite our projection for just 4% average annual earnings growth through 2014 and a 4% yield.
Two more gas utilities show signs of overheating, despite organic customer growth opportunities that exceed their peers'. New Jersey Resources (NJR) serves some of the wealthiest counties in New Jersey and has more opportunities than its peers to grow its earnings base by converting customers from heating oil to natural gas. However, at 14.5 times our 2012 earnings projections and yielding just 3.4%, we think investors' enthusiasm for NJR's healthy utility and customer growth opportunities is overzealous. As the company's marketing arm faces declining margin opportunities from changing gas flows in the Mid-Atlantic region, we expect the utility to constitute a greater share of earnings going forward but with slower growth, averaging 5.5% annually from 2010 through 2014.
WGL Holdings (WGL) appears similarly overvalued at 15 times our 2012 earnings while yielding just 4%. WGL's service territory is relatively robust--serving seven of the nation's 15 wealthiest counties--but we project 3% average annual earnings growth through 2014, which lags peers' growth. While investors might prize the stability of the company's dividend, we believe that WGL faces the same risks as the rest of the regulated utility universe--rising interest rates, inflation, higher dividend taxes, and regulatory disallowance--while offering lower growth and a lower yield.
Equity Analyst Mark Barnett contributed to this report.
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