If investors are hesitant about the macroeconomy, they may have a reason to be eyeing utilities. These companies pay lavish dividend yields commonly north of 4%, have little volatility, and are known for stable growth. The problem is twofold. First, multiples are overly high under little growth expectations. Second, the Obama dividend tax hikes will take away what little advantage the sector had over others. Accordingly, I recommend investors hold out from buying shares in Duke Energy (DUK), Southern Company (SO), CenterPoint Energy (CNP). Below, I review the fundamentals of each firm.
Duke trades at a respective 20.3x and 15.9x past and forward earnings with a dividend yield of 4.5%. Growth is forecasted to be extremely low at 3.3% annual EPS returns over the next five years. This implies 2016 EPS will be around $4.71. At a 15x multiple, the future value of the stock should be $70.65 - roughly in-line with the current market assessment.
But what is the present value of $70.65? Discounting backwards by 7%, it is $50.37, which makes Duke significantly overvalued. Analysts rate the stock closer to a 'sell" than a "buy," according to data sourced from FINVIZ.com. More devastatingly, free cash flow over the TTM has averaged -$500M over the past five years. The figure worsened from -$331M at 1Q11 end to -$812M at 1Q12 end. In fact, the problem has accelerated since the free cash flow loss was "just" -$312M at 1Q10 end. On the positive side, margins have meaningfully improved from 10.9% in mid-2008 to 12.4% in mid-2012 - the latter of which is above the 5-year average.
During the second quarter, management beat expectations with adjusted diluted EPS of $1.02. The company recently closed its merger, which will allow for an unmatched operational scale than can help further grow margins. Moreover, greater penetration into regulated businesses allows for a reduction in uncertainty. Despite how low the current PE multiple is against the historical average, Duke's upside from revenue and cost synergies have been mostly factored into the stock price. Concessions given to Carolina commissions for merger approval have limited the potential for accretion.
Southern is similarly expensive at a respective 18.9x and 16.7x past and forward earnings with a 4.2% dividend yield. Analysts also rate the stock closer to a "sell" than a "buy," according to data sourced from FINVIZ.com. Growth is forecasted to be slightly higher at 5.4% annual EPS returns over the next half decade.
At a PE multiple of 18.9x, Southern is meaningfully higher than the historical 5-year 16.2x average. The PE multiple has been rising since 1Q10, after which Southern has risen a dramatic ~50%. Management has beaten expectations in four of the last five quarters for an average of 2% - good, but not worthy of a double-digit return, when you are dealing with quarterly EPS in the territory of $0.40 to $1.10. Free cash flow generation has been more positive than Duke's, since Southern has been in the black since 1Q11 end. At the end of 2Q12, free cash flow was actually $1.1B versus -$185M in 2008. Thus, I am more attracted to Southern's operational fundamentals against Duke's.
In terms of financial position, Southern is fairly strong. In this year alone, it has been able to raise $2.5B in long-term debt at an average yield of 3.68% due 23 years. Uncertainty over the pending court decision in Mississippi with Ratcliffe has been a headwind for value creation. Management claims that it can implement rates if they do not hear back from the Supreme Court within 180 days under state statute #77372.
CenterPoint is the cheapest of the three utilities highlighted in this report. It trades at a respective 11.6x and 16.8x past and forward earnings with a dividend yield of 3.9%. Annual EPS growth is still forecasted to be between Duke and Southern's at 4.8%. This means 2016 EPS should come out to $1.44, which at a 15x multiple, translates to a future stock value of $21.60.
Discounting backwards by 7%, the present value of the stock is $15.40 and yet it trades at $21.04. As it stands, too much growth is being implicitly factored into the stock price, as revealed by the PEG ratio of 2.4. Even the dividend yield has become less compelling as shares have become increasingly overvalued of late. Top-line growth has meanwhile fallen into negative territory of -7.5% in June 30, 2012 and deteriorated from the high single-digits to low double-digit returns commonly seen between the end of 3Q07 to the end of 4Q08.
It should be noted that management has done a terrific job in terms of beating expectations. Over the last five quarters, management has beat consensus by an average of nearly 16%. Despite excellent performance, appreciation has underperformed peers over the last trailing twelve months. While I find CenterPoint to be a more compelling investment than Duke and Southern, I would still hold out until greater clarity is given over the Obama administration's dividend tax hikes.