Four Large-Cap Utilities With High Return on Invested Capital and Solid Dividends

Includes: D, EXC, NEE, PEG
by: George Fisher
Which large-cap management teams in the Dow Jones Utility Index has provided investors with the best return on invested capital? A few weeks ago, I developed a table and included it in an article here. The highest four on a trailing twelve month basis were Exelon (NYSE:EXC), Dominian Resources (NYSE:D), Public Service Enterprise Group (NYSE:PEG), and NextEra Energy (NYSE:NEE). These management teams and their business models could be reviewed to see if they fit into your utility portfolio. Each has a slightly different profile to their business.
Exelon operates a large number of nuclear power plants and is anchored by the regulated electric utilities serving Chicago-land, Ohio, Michigan, greater Philadelphia, and south-east Pennsylvania. Exelon’s business has been hurt by lower demand, very weak pricing, and higher fuel costs. While the economy is bottoming, demand for electricity has yet to follow. As demand and pricing improves in late 2012, earnings should as well. EXC has hedged much of its power generation, locking in cash flow, albeit at inexpensive prices. EXC’s low-cost nuclear generation capabilities will assist in increasing cash flow as the hedges expire, hopefully in a better demand and pricing environment. Share prices currently trade more on its yield and history of dividend increases than earnings growth.
Dominian Resources is a regulated electric power generator and transporter, along with natural gas storage and distribution, serving parts of Northeast, eastern Mid-West and Mid-Atlantic states. Dominian Resources has finished an $18 billion asset divesture to focus on regulated energy infrastructure. Share buybacks amounting to about 5% of outstanding shares, along with a dividend hike, have set the stage for improving shareholder returns. As management focuses on expanding its regulated business, rate decisions become increasingly important.
Public Service Enterprise Group focuses on electric and natural gas distribution in New Jersey, energy marketing, and a growing number of solar electric generation facilities. Public Service Enterprise Group is subject to recently passed New Jersey legislation that subsidizes the construction of new electric generating facilities, with the goal of potentially creating an over-supply and hence lower market prices. In addition, the length of fixed-rate power contracts are being extended from 3 years to 15 years, further adding pressure to lower prices. However, regulators are not in favor of this program and are anticipated to challenge its implementation. As this controversy gets resolved, PEG should regain its growth potential. As with other utilities, PEG is looking to expand its regulated footprint.
NextEra Energy comprises of Florida Power and Light along with electric generation using solar, wind and nuclear. NextEra Energy’s fortunes will continue to rest on its regulated Florida business. As power generating capabilities expand, mainly in renewable and nuclear, merchant power exposure will increase but won’t overtake the company’s reliance on favorable rate decisions. NEE is currently North America’s largest solar and wind power generator, but natural gas and nuclear still comprise 80% of its generating capacity.
EXC and D are rated as a “hold” by consensus opinion. Current dividend yield and dividend growth will support share prices while waiting for business improvements. PEG and NEE are rated as a lukewarm “buy”. It seems three out of the four will experience continued difficulties through next year, as shown by lower earnings. The investment thesis would be to accumulate positions waiting for improving market conditions in 2012 and 2013.
As utilities are longer-term conservative investments, reinvesting a high-quality yield and growing dividend through dividend-reinvestment programs and dollar-cost averaging a position usually improves total investment returns. Payout ratios for these companies hover around 40%, but EXC’s ratio is expected to increase as earnings decline into next year. Each company has a history of generating adequate 5-yr ROIC to support continuing dividend growth.
Exelon and Dominion Resources have higher exposure to merchant power markets and could be considered more sensitive to overall economic performance.
Dominion Resources and NextEra Energy are returning to the opportunities within the regulated utility sector. This should add stability and predictability to their earnings and dividends.
Exelon and Public Service Enterprise Group have specific external factors (merchant pricing for EXC and legislation for PEG) that will keep performance down over the next 12 to 18 months.
Based on a backdrop of potentially rising interest rates and with investors seeking 4.5% to 5.0% current yields, it could be unwise to anticipate stock prices to rise sufficiently to matching lower 5-yr average dividend yields. Dividend yield and growth will continue to an important part of overall returns until 2013.
Listed below is a table listing earnings estimates 5-yr and 1-yr ROIC, Debt to Equity ratio, 5-yr average dividend yield, current yield, and 5-yr dividend growth:
EPS 2010 $ 4.06 $ 3.32 $ 3.07 $ 4.30
EPS 2011E $ 4.00 $ 3.15 $ 2.80 $ 4.47
EPS 2012E $ 3.00 $ 3.40 $ 2.70 $ 4.73
5-Yr ROIC 11.4% 6.6% 8.1% 5.7%
1-Yr ROIC 9.9% 9.3% 9.0% 6.4%
Debt/Equity 0.9 1.3 0.9 1.4
5- Yr Avg Yield 3.3% 3.7% 3.4% 3.2%
Current Yield 4.8% 4.5% 4.2% 3.6%
5-yr Div Growth 5.7% 6.1% 3.8% 7.0%
Source: Reuters

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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