In a climate of intense competition and an improving economy, I find the high multiples of utilities to be unjustified. I think the reason why some utilities trade at elevated multiples stems from investors seeking shelter from a macro storm. But with the Obama administration pushing to raise dividend taxes by 164% and the economy moving towards full employment, investors are likely to head for the exits. Accordingly, I recommend investors back PPL Corporation (PPL) over Duke Energy (DUK) and the Southern Company (SO). The company not only has the lowest multiples, but also the most discounted future. Below, I review the fundamentals of each company.
Duke trades at a respective 20.2x and 15.2x past and forward earnings with a dividend yield of 4.54%. Analysts currently rate the stock a 2.9 out of 5 where "5" is a "sell" (source: FINVIZ.com) and forecast just 2.9% annual EPS growth over the next 5 years. A quick ratio of 0.97 and regulatory antitrust headwinds will also make acquisitions for non-organic growth challenging.
Upon acquiring Progress, Duke became the largest electric utility in the United States with nearly $100B in combined assets. While I am optimistic about the amount of leverage that this greater scale will grant the company in pricing negotiations, value creation has been compromised by the merger benefits given to Progress investors. At the same time, a greater percentage of business now comes from regulated units, which will help increase visibility. Depending on fuel savings in Carolina and how it renews and how it changes the business's relationship with regulators, the merger is a toss up between being a win or loss.
Management has forecasted $650M in customer fuel savings, and I believe this will be very challenging to meet. Over the last few years, Duke has been able to achieve higher customer rates, but capital expenditures still remain high. The company is seeking to hold several free market auctions to set electricity prices, which is likely to put pressure on margins through 2014.
The Southern Company
Southern Co. trades at a respective 19.5x and 17.2x past and forward earnings with a 4.1% dividend yield. Analysts currently rate the stock a 3 out of 5, according to data from FINVIZ.com. Assuming the company meets the 5.4% annual EPS growth forecast, 2016 EPS will come out to $3.30. At a 16x multiple, the future value of the stock is $52.80 - nominally higher than the current market assessment.
Discounting backwards generously by 7% yields a present value of $37.65, which indicates that the firm is very overvalued right now. Thus, while growth does not yield significant appreciation over the next five years, value also does not suggest a strong margin of safety. Again, should the Obama administration dividend taxes kick in, the firm's stock will fall considerably since much of the "defensive" appeal will disappear.
During the second quarter, management delivered performance that was roughly in-line with expectations. EPS came out to $0.69, and the firm expressed confidence in long-term growth expectations of as high as 7%. The Southeast economy was a bright spot as customers grew 2.1% on a weather-adjusted basis. At the same time, due to changes in the Mercury and Air Toxics Rule, the company has reduced environmental compliance capital expenditures to $2.3B from 2012 through 2014. I am almost pleased with the company's bullishness on natural gas, which it expects to represent nearly one-half of the generation mix this year alone. Five years ago, natural gas only represented 16% of the generation mix, so this is favorable progress that will be value-creating in the long-term.
Compared to most of the market, Duke and Southern Co., PPL trades at compelling multiples of 10.3x and 12.2x past and forward earnings. The dividend yield is nearly 5% and volatility is less than 61% of the broader stock market. Even still, analysts rate the stock closer to a "sell" than a "buy" according to data sourced from FINVIZ.com.
Fortunately, three-quarters of PPL's EBITDA will come from regulated businesses in Kentucky, Pennsylvania, and U.K. by 2013, which provides greater visibility over operations. PPL has been able to make this transformation through a series of acquisitions, but power prices are depressed and have limited the upside story.
Management has been able to generate higher returns than peers while diversifying across coal, hydro, nuclear, natural gas, and oil. Conservative management of busload operations help to increase safety but reduce upside. PPL is expected to hedge at $51 to $55 per megawatt-hour for 2012 generation output.
If I had to choose a utility to invest in, I would opt for PPL. The firm has a monopoly position in its field and a low bar set for higher risk-adjusted returns. Analysts forecast just 1.3% annual EPS growth over the next half decade, and I expect this to get boosted upwards when energy demands increase from a full recovery. At such low multiples of 10.3x, PPL is an exception to the industry while still offering very high dividend yields. Accordingly, I recommend buying the shares.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.