Utility Stocks: Don't Get Caught Chasing Last Year's Trend

Includes: D, DUK, ED, JNJ, MCD, PG, SO, T, WM, XLU
by: Eli Inkrot

Looking out my window, across to the horizon, I see a low-lying field that is being swept over by an innocuous yet consistent battery of snow flurries. The scene is ideal except for perhaps a single blemish; power lines strangle the top of my vision’s frame. It’s a shame - well it is and it isn’t - after-all it’s below freezing out there and I’m well above freezing in here.

Utility stocks have long been the safe man’s equity play, as their consistency is rivaled only by their fundamental necessity. Turn off the power and people scramble back to the Stone Age. Well, perhaps not quite that far, but they do weigh concerns about charging their phones and taking a shower. For Utility providers the business is essentially a geographic monopoly whereby competitors are effectively kept at bay. Further the systems are already in place and thus capital reinvestment is minimal. For years this has meant a safe bond-like investment that pays reasonable yields.

Utilities shed the low risk / low reward mantra last year as 2011 proved to be especially volatile. Investors were looking for safe havens and found it in the way of these power stocks. Against a relatively flat market, the Dow Jones Utility Average (DJU) was up nearly 15% while the Utilities Select Sector SPDR (NYSEARCA:XLU) had a total gain over 18%. The XLU Index only captures about 4% of the total S&P 500, but if you happened to overweight this sector last year I’m sure it could have beefed up your returns. However, as we all know, past performance is no indication of future returns. Here’s a look at some of the most recognizable Utility names and why they won’t fit as an overweight holding for 2012.

Southern Company (NYSE:SO) – With a market capitalization of almost $39 Billion, this Atlanta-based electric service company is the largest holding of the XLU index. The Southern Company services approximately 4.4 million customers in Georgia, Alabama, Florida and Mississippi. For income investors the 4.2% current yield and payout ratio around 77% appear to be perfectly in-line with one’s sector expectations. Furthermore, a buy on the first trading day of last year provided SO shareholders with a total gain of 25.5% for the 2011 year.

From a dividend growth prospective there does appear to some lacking. From 1998 to 2002 payouts were frozen, while the average 5-year and 10-year dividend growth rates came in at around 4%. True, with a current yield over 4% one doesn’t need too much growth for a reasonable yield on cost, as a historic 4% growth rate would turn into a YOC over 6% in about 10 years. Analysts seem to think SO already had its year of fame, as 17 brokers come to a collective 1-year target downside of about 2.5%.

Dominion Resources (NYSE:D) – Coming in with a market cap of almost $30 Billion, this Virginia-based electric services company ranks as the 2nd largest XLU holding. Dominion Resources provides energy through electric transmission, coal, nuclear, natural gas, renewables and oil. With a payout ratio of 75% and a current yield of 3.7%, D doesn’t disappoint as a Utility staple. Much like SO, Dominion had a stagnant dividend during the tech bubble, albeit much longer lasting from 1995 to 2004. While the 10-year dividend growth rate comes in at just over 4%, Dominion should be credited with its quite reasonable 7% average yearly dividend growth over the last half-decade. We’ll cut the difference and call it a 5.5% dividend growth rate for the next 10 years, for a yield on cost of about 6.3%. Reasonable yes, but certainly not overly impressive. Analysts say 2011’s 31% total return isn’t going to happen in 2012, as 14 brokers look for an average downside of about 2%.

Duke Energy Corporation (NYSE:DUK) – This Charlotte, North Carolina-based utility provides electric and gas to over 4 million customers in North Carolina, South Carolina, Ohio, Indiana and Kentucky. With a market cap of $29 Billion, a current yield of 4.6% and a payout ratio of 72%, DUK looks to be right in-line with the other utilities. Dividends were effectively stagnant in the late 1990’s and early 2000’s, and actually the payout is lower today than it was 7 years ago. Although to be sure, shareholders have seen an average dividend growth rate around 4% in the past few years. Still, without much dividend growth to go by one can’t make too many assumptions about a much higher yield on cost in the future. Between 6 and 7% appears reasonable in 10 years. The near 30% total return in 2011 was quite impressive, but that doesn’t help new investors today as 13 brokers like a collective downside of about 3.5%.

Consolidated Edison (NYSE:ED) – This New-York-based diversified utilities company provides electricity to about 3.3 million customers and delivers gas to approximately 1.1 million more in the New-York metropolitan. Much like the other utilities, ED has a reasonable current yield around 3.9% and a higher payout ratio at around 65%.On the dividend scene Consolidated Edison has been one of the steadiest of Eddies having not only paid but also increased its dividend for 37 consecutive years. However, this isn’t quite as admirable as it sounds as both the 5-year and 10-year average dividend growth rate is under 1%. This is due directly to Consolidated Edison’s 11 year streak of half-a-cent dividend increases. Using 1% as a dividend growth rate provides a comparatively dismal 4.3% yield on cost and it doesn’t even contend with inflation. Last year ED had an impressive total return of 32%, but 14 brokers think it was well overdone as they come to an average downside of about 8%.

Utility stocks make a lot of sense for the current income investor. They provide a business model that is both consistent and fundamental, which requires little capital reinvestment. For shareholders this means higher payout ratios and consequently higher current yields. With the huge sector run-up last year, these power stocks have surely caught many income investors attention. Imagine the safety of a reasonable yield, coupled with the potential price growth that crushed last year’s market. But for the dividend growth investor, using a long term horizon, utility stocks don’t appear to hold much weight. For such investors, it is important to find a balance between current yield and dividend growth. Utilities simply do not have the payout growth to create high yields on cost in the future. I believe there are a variety of alternative investments that will work to this goal more completely.

Even if you like the utility environment whereby competition is limited and services are fundamental, there appear to be more attractive investments for the dividend growth investor. For example, one might look to waste collection or even telecommunications.

Waste Management (NYSE:WM) – We all make trash, over 4 pounds a day in fact, and Waste Management is the number one company to help clean it up. (WM is also the lead in recycling.) This Houston, Texas– based company competing in the aptly named ‘waste management’ industry sure looks like a utility with its fundamental business, 4.2% current yield and 66% payout ratio. However, the dividend scene looks much better, as WM has not only paid but also increased dividends for the last 9 years. The first increase in 2004 was a monumental step-up from $0.01 a year to $0.188 a quarter. Since then dividends have been growing at an average rate of about 7% a year. Extrapolate this out a decade and you have a yield on cost over 8%, far outpacing SO, D, DUK and ED.

AT&T (NYSE:T) – This Dallas-based Telecommunications Company isn’t a pure Utility, but the demand for communicating does make AT&T a fundamental business. T has increased its dividend payout for the last 28 years and currently yields 5.8%. This is already well ahead of most utilities, with a similar average dividend growth rate of about 5%. In 10 years time that could equate to yield on cost of nearly 9.5%.

Skeptics can even look to lower yielding stocks that are both consistent and diligent with dividend payouts, but who have more favorable dividend growth prospects. For example:

Johnson & Johnson (NYSE:JNJ)

49 straight years of increased payouts.

3.5% current yield.

5-year average dividend growth rate = 8.7%.

10-year average dividend growth rate = 12.2%

Implied 10-year YOC = about 9%

McDonald’s (NYSE:MCD)

35 straight years of increased payouts.

2.8% current yield.

5-year average dividend growth rate = 22.8%

10-year average dividend growth rate = 28.58%

Conservative 10-year YOC = about 11%

Proctor & Gamble (NYSE:PG)

55 straight years of increased payouts.

3.1% current yield.

5-year average dividend growth rate = 11.1%

10-year average dividend growth rate = 10.7%

Implied 10-year YOC = about 8%.

Here’s the bottom line. Utilities are great for both a reasonable current yield and inherent stability. But if you’re looking for another 2011, you might want to keep looking. Utility stocks should be treated as essentially bond-like investments providing current income. They are perfectly suited for those looking for immediate payouts, reasonable yields and overall safety. However, for the majority of investors with a long-term time-frame utility stocks are unlikely to provide the growing power needed to create lasting wealth. There are a plethora of alternatives that look to provide a greater added value in the future. Don’t get caught chasing last year’s trend.

Disclosure: I am long WM, T, JNJ, PG.