The toughest assessment I made over the weekend was to determine which was more expensive:
A) Pumpkins Grown in New England, or
B) Utility Stocks.
With all the heavy rain accompanying Hurricane Irene several weeks ago came a total washout of the New England pumpkin crop, literally. One farmer claims upwards of 20,000 of his best and plumpest pumpkins ended up floating in Lake Champlain. Those that were not washed away have been subjected to outbreaks of mildew and phytophthora fungus. This fall, it may be less expensive to buy a 12-pack of Heineken than a traditionally large Halloween pumpkin.
Utility stocks have been the best performing sector in the market year to date, rising 6.5%. With a collapsing bond yield represented by 10-year Treasury notes under 2.0%, the average utility sector stock yield of 4.3% could seem like income nirvana. In the face of a potential slowdown of already anemic economic growth or a stumble into negative territory, investors have been moving into a defensive position, increasing awareness and relative prices for utilities.
However, compared to a market valuation comparison, utility share prices are getting expensive. The sector currently sports an average PE of 14.6 times 2011 earnings and 13.4 based on estimates for next year. With current S&P 500 earnings estimates of $98 this year and $111 next, the average utility could be trading as much as 20% premium to market multiples. If S&P earnings estimates decline for next year, which seems likely, then the relative premium utility investors are currently paying will increase further.
In addition, with the demise of share prices in non-utility stocks, competitive yields also seem expensive. For example, Honeywell (HON) offers a 3.2% yield, higher than 20 of the 93 U.S. utilities companies paying a dividend, and GE’s (GE) current yield of 4.0% bests 38 of the same 93.
Screening on Finviz.com the U.S. utility sector for dividend yields in excess of 5.0%, with a forward PE of less than 15 and a payout ratio of less than 60% jettisons all stocks except two: Atlantic Power (AT) and Entergy (ETR). The goal of this screen is to find stocks with above industry yield, with reasonable PE valuations compared to the average and whose payout ratio is low enough to afford dividend increases over time. Under “normal” markets, there should be numerous choices, but not in today’s potentially overvalued utility market.
Of these two, I prefer Atlantic Power.
Atlantic Power is a Canadian company, domiciled in Canada but with a Boston headquarters. The stock is dual listed on the Toronto and the NYSE. The company is a merchant electric power producer with a focus on renewable resources, such as wind, bio and hydro. AT pays a monthly dividend of CND$0.0912 in Canadian dollars, or annualized at CND$1.09. Exchange rate risk is minimal with the Canadian dollar with a current 3% variance based on an exchange rate of CND$0.97=USD$1.00. However, keep in mind that a strengthening USD will reduce the cash yield to US investors. For instance, the 5.1% spike in the USD to the CND over the past two weeks, from $1.03 to $0.97, reduces the cash payout to US investors by $0.05 a year.
The dividend is subject to a 15% Canadian withholding tax that should allow for an offsetting credit when filing IRS 1040 forms under “foreign tax paid.” If the stock is held in a U.S. tax-advantaged account, such as an IRA, the current tax treaty with Canada may exclude levying the withholding tax. From the company’s most recent dividend payment press release, “Taxpayers should always seek their own independent qualified professionals regarding the tax consequences of purchasing or owning common shares of the Company. Individuals who believe the withholding tax exemption applies to their IRA should contact their broker to determine how to claim the exemption.” The press release is here.
While the company has preannounced a 5.0% dividend increase in the fourth quarter, reduction of its modest debt over consistent dividend growth is a higher priority. Five-year average annual dividend increase will be 2.5%, after the announced jump in payout next quarter. Based on current long-term power contracts, management believes the dividend is well supported by distributable cash flow until 2016.
Atlantic Power is in the process of acquiring Capital Power Income LP, another small merchant power producer. After the merger, generating capacity will increase from 924MW to 2,170MW, of which 78% will be gas-fired. AT will operate 31 generating facilities with an increasing platform of biofuel and wind generation.
For more information:
- Previous article here.
- Second qtr earnings release here.
- June 2011 investor presentation with proforma merger data here – and highly recommended for investors, both new and current.
While a bit higher in the risk scale due to its merchant power exposure compared to a regulated utility, Atlantic Power offers a very compelling yield of 7.4% based on USD$1.06 dividend and a $14.30 share price. The company offers potential for future earnings growth, both through organic growth of its biofuel projects and acquisitions. For example, the upcoming acquisition will more than double generating capacity and the average purchase power agreement will have 9.1 years remaining.
While AT has trailed the overall stock performance of the sector over the past 12 months, its substantially higher relative yield compensates for the lack of stock performance. AT is a great example of yield on invested capital comprising a majority of an investment’s Total Stock Return.
It could be a tough choice this fall – a traditional Halloween Pumpkin or one share of Atlantic Power - I will pick the share.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.