2017's Top Ten Utility Stocks For Dividend Growth And Income

| About: Utilities Select (XLU)

Summary

While utilities have largely been left out of the post-election rally, the sector remains quite expensive on a historical basis.

While capital gain potential appears limited, income investors still have some decent prospects for future dividend growth.

The 30 stock watch list is updated with 2017 earnings estimates and future dividend growth projections, with the top ten selected for future income potential.

Utility At Night 2016 is coming to a close, and many investors are now looking for stock ideas for when new funds become available in January. With that in mind, I figured people would appreciate an updated utility spreadsheet as they make out their shopping wish list.

The market has been on quite a run since Donald Trump was elected president, as the S&P 500 and Dow Jones are up 6.0% and 8.8% since November 8th. However, the utility sector has largely been left in the cold, with the (NYSEARCA:XLU) actually seeing a decline in price since election day.

XLU Chart

XLU data by YCharts

Does this underperformance present opportunity for investors, or is the matter simply that utilities already had their run and are dead money for the foreseeable future?

My 30 stock watch list has been updated, and while many stocks remain quite overvalued, there still appears to be several companies worth a closer look.

Results From Previous Lists

Before we get into the new picks, I'd first like to present results from the three previous top ten lists for the utility sector, and compare them with returns seen by the XLU.

The first comparison comes from the original top ten list published in June of 2015. Here you can see the selections have vastly outperformed the utility ETF, with an average return of 25.07% compared with 14.01% from the fund. Keep in mind this return is price only, and doesn't take into account the higher blended yield that the stocks provided over XLU.

Returns1

Similar results were seen from the top ten stocks selected in December of 2015, as they once again outperformed the XLU by better than 10%.

Returns2

The final top ten list was created in April of 2016, at a time when the utility sector was trading at very rich valuations, as was noted in the article:

I have to admit, I don't expect returns like this from today's picks. Both of the previous articles were written when the utility sector was in the middle of a correction, which provided nice entry points in those stocks as they were bought near fair value. This isn't the case in the current environment, after they've seen those impressive price increases already this year.

However, I do expect the picks will once again outperform the XLU, as the new list will again be selected primarily by valuation. In the case of a correction, these should have less downside risk than some of the companies with more stretched valuations that represent the XLU.

This ended up playing out as expected, as the XLU is up just 0.5% in price since the article, while the selections returned an average of 5.75%.

Returns3

The valuation problem remains today, as just 3 of the 30 companies on the watch list are trading within 10% of my "fair value" target. Even worse, that valuation is being calculated based on 2017 EPS estimates, meaning investors are not only "paying up" at today's prices, but they are also doing so on a forward basis as well.

This isn't to mean the utility sector is completely devoid of opportunity, but my expectations going forward remain guarded.

The Watch List

The watch list saw some changes for this update, as Questar and Westar were both dropped due to being acquired by other companies. They have now been replaced with Portland General Electric Company and UGI Corp.

Here is a snapshot of the new watch list:

Ticker Company # Years Div. Inc. S&P Credit Rating Debt / Cap Market Cap (B$) 52WK HIGH 52WK LOW % Below 52-week High Share Price
(NYSE:AEP) American Electric Power Company Inc Electric 7 BBB+ 44% $31.0 $71.32 $56.75 -11.5% $63.13
(NYSE:ATO) Atmos Energy Corporation Gas 33 A- 38% $7.8 $81.97 $60.00 -8.8% $74.73
(NYSE:AVA) Avista Corp Electric/Gas 14 BBB 47% $2.6 $45.22 $34.31 -11.6% $39.99
(NYSE:BKH) Black Hills Corp Electric/Gas 46 BBB 54% $3.3 $64.58 $44.65 -4.8% $61.51
(NYSE:CNP) CenterPoint Energy, Inc. Diversified 11 A- 64% $10.7 $24.98 $16.38 -0.9% $24.76
(NYSE:CMS) CMS Energy Corporation Electric/Gas 10 BBB+ 61% $11.7 $46.25 $34.96 -9.9% $41.69
(NYSE:D) Dominion Resources, Inc. Diversified 13 BBB+ 55% $48.1 $78.97 $66.25 -2.9% $76.67
(NYSE:DTE) DTE Energy Co Diversified 8 BBB+ 47% $17.7 $100.45 $78.01 -1.8% $98.65
(NYSE:DUK) Duke Energy Corp Electric/Gas 12 A- 45% $53.3 $87.75 $70.16 -11.7% $77.48
(NYSE:ED) Consolidated Edison, Inc. Electric/Gas 42 A- 43% $22.5 $81.88 $63.47 -9.9% $73.75
(NYSE:ES) Eversource Energy Electric/Gas 18 A 42% $17.6 $60.44 $50.01 -8.4% $55.38
(NYSE:LNT) Alliant Energy Corporation Electric/Gas 13 A- 44% $8.7 $40.99 $30.38 -7.3% $38.00
(NYSE:SR) Spire Inc Gas 14 A- 48% $3.0 $71.21 $57.10 -9.0% $64.80
(NYSE:MDU) MDU Resources Group Inc Diversified 26 BBB+ 36% $5.8 $29.92 $15.57 -1.8% $29.37
(NYSE:NJR) New Jersey Resources Corp Diversified 21 N/A 38% $3.1 $38.92 $30.46 -7.0% $36.20
(NYSE:NEE) NextEra Energy Inc Electric 22 A- 49% $55.9 $131.98 $102.20 -9.6% $119.25
(NYSE:NWE) NorthWestern Corp Electric/Gas 12 BBB 50% $2.8 $63.75 $52.16 -10.4% $57.15
(NYSE:OGE) OGE Energy Corp. Electric/Gas 10 A- 43% $6.7 $34.23 $23.37 -1.4% $33.75
(NYSE:POR) Portland General Electric Company Electric 11 BBB 35% $3.8 $45.21 $35.27 -4.3% $43.26
(NYSE:PPL) PPL Corp Electric/Gas 15 A- 61% $23.1 $39.92 $32.08 -14.3% $34.21
(NYSE:SCG) SCANA Corporation Electric/Gas 16 BBB+ 49% $10.7 $76.41 $59.46 -2.6% $74.43
(NYSE:SJI) South Jersey Industries Inc Gas 18 BBB+ 40% $2.7 $34.85 $22.06 -1.2% $34.44
(NYSE:SO) Southern Co Electric 16 A- 48% $48.3 $54.64 $46.00 -9.8% $49.30
(NYSE:SRE) Sempra Energy Diversified 13 BBB+ 48% $25.2 $114.66 $86.72 -11.7% $101.23
(NYSE:SWX) Southwest Gas Corporation Gas 10 BBB+ 48% $3.6 $79.58 $53.51 -3.8% $76.57
(NYSE:UGI) UGI Corp Diversified 29 N/A 45% $8.0 $48.13 $31.59 -4.7% $45.89
(NYSE:VVC) Vectren Corp Diversified 57 A- 49% $4.4 $53.33 $39.43 -1.2% $52.67
(NYSE:WEC) WEC Energy Group Inc Electric/Gas 14 A- 47% $18.5 $66.10 $50.44 -11.4% $58.57
(NYSE:WGL) WGL Holdings Inc Gas 40 A+ 33% $4.0 $79.97 $58.66 -2.4% $78.08
(NYSE:XEL) Xcel Energy Inc Electric/Gas 13 A- 50% $20.7 $45.42 $35.19 -10.3% $40.73

Although valuations remain stretched, there has been some pullbacks on the list, as 8 of the 30 companies are trading more than 10% below 52-week highs.

Of course, price relation to 52-week levels is fairly meaningless; valuation is what I am interested in. In the next part we take a look at relative valuation compared to historical numbers, and try to find some deals on the list.

Historical Numbers & Analyst Estimates

I have updated the spreadsheet with 2017 EPS estimates from F.A.S.T. Graphs and Yahoo Finance, and we can now take a look at how these companies valuations compare with historical levels. The historical "Fair Value" PE was determined by looking at various time frames on F.A.S.T. Graphs.

I've also updated the historical dividend growth information for each company from David Fish's U.S. Dividend Champions spreadsheet, to show how the various companies compare with their dividend growth rates and how they've changed over time.

Utility Watch List Valuations

As mentioned previously, just 3 of the 30 companies, Eversource Energy, Northwestern Corp., and Southern Company, are trading within 10% of the fair value target. Even more concerning, the updated PE is based on 2017 forward EPS estimates, meaning not only are the stocks expensive at current PE's, but they are on a forward basis as well.

A side effect of the rich valuations is lower dividend yields for new investors. More than half of the companies now have yields under 3.5%, which is a surprising thing to see coming from what is known as an income producing sector.

However, current yield and PE don't tell the whole story; this is a forward looking exercise. In the next part we will add in growth estimates to the equation.

Income & Total Return Projections

While current yield is an important metric for investors, its importance is sometimes overstated. For those who don't immediately need the dividends for income, or for those who have a longer time frame needing the income, a higher growth rate on a smaller dividend can quickly result in a higher income for your portfolio.

This next table will show my projections for future income for each of the members on the list. I do this by searching through company conference call transcripts and presentations and looking at historical payout ratios, along with analysts' EPS growth projections, to predict what the dividend growth rates over the next few years will be.

These numbers are then used to calculate a 5-year yield on cost ("YOC") estimate, for both organic growth as well as with reinvestment of dividends. The numbers are also used along with the "Delta PE" number to project the total and annualized returns over the next 5 years.

Utility Growth Projections

Here again you can see how the current overvaluation weighs on potential future returns for investors. Even with using the updated 2017 earnings estimates, 17 of the 30 companies on the watch list are projected to have annual total returns of under 6% over the next 5 years, and just 4 are expected to see annualized returns over 8%.

Income potential is also hit hard by current prices, as just 7 companies are expected to produce a yield on cost of over 5% within 5 years. For investors who are used to buying utilities with an initial yield that high, it's a tough pill to swallow.

The Top Ten

While the sector as a whole isn't attractive, the purpose of this article is to pick the ten best available, and that is what I'll do. Since dividends are easier to predict than capital gains, the top ten will again be selected primarily by expected income potential.

With that in mind, here is my list:

Top Ten Utility Stocks For 2017

As you can see, many of these are familiar names, as Dominion, OGE, PPL, DUK, SO, CNP, and WEC have made multiple appearances on the top ten list.

Here is some additional info for each company.

Dominion Resources, Inc. recently announced a 7.9% dividend increase, which pushes its yield to 3.9%. Additionally, management reiterated that it expects to continue growing the dividend at a ~8% rate going forward, which when combined with the relatively high initial yield moves it to the top of the list.

Dominion was the acquirer of Questar, which is one of the two companies removed from the watch list. This acquisition is expected to diversify the company and add to its growth prospects in a new geographic region. Additionally the company has interests in mid-stream assets and the Cove Point LNG plant that is expected to open in 2017.

D FAST Graph

Shares are a bit overvalued at current prices, and analysts are projecting just 2% growth in earnings in 2017, but I believe that once the acquisition is digested and its projects under construction are complete, those estimates will be raised down the road.

OGE Energy Corp. is another repeat selection, as it's been in the top 5 of every list to date. This is due to one of the highest expected dividend growth rates, as management has been consistent in its guidance for 10% dividend growth over the next few years. This coupled with a decent 3.6% yield moves it towards the top of the future income projections.

OGE FAST Graph

OGE has produced a 6%+ earnings growth rate over the last decade, and has seen its payout ratio increase a bit with the recent 10% dividend growth rates. The payout ratio still looks reasonable at 64% of earnings, but is something to keep an eye should earnings growth continue to lag.

PPL Corp. is making its 3rd consecutive appearance on the list due primarily to its high initial yield of 4.4%. I will admit, this is one that I'm less comfortable with than others, mainly due to its lack of earnings growth in recent years. The payout ratio has crept up to 70% of expected 2017 earnings, and I may be a bit aggressive with my dividend growth projection of 4%.

PPL FAST Graph

Management has targeted a 5-6% earnings growth rate going forward, but if that doesn't materialize, dividend growth may end up closer to 1% than my projection.

Duke Energy makes its 4th appearance on the list, again due more to current yield than growth expectations. While dividend growth has ticked up to 4% with the most recent increase, analysts are projecting just 2.9% earnings growth going forward, roughly half of managements 4-6% target.

DUK FAST Graph

Duke is one of the more reasonably priced stocks on the list, but with a payout ratio up to 73.5% against a 65-70% target from management, my future dividend growth projection may prove too optimistic.

The Southern Company is another regular on the list, due primarily to a depressed share price that has it trading near fair value, providing a yield a 4.5%. This is likely because of its "albatross" Kemper Clean Coal plant which has seen multiple time and cost overruns that are running into the billions of dollars. However, that project is 99% complete, and should become less of a question mark in the quarters ahead.

In the meantime the company has continued adding other assets, and at a $48B market cap should be able to overcome that debacle.

SO FAST Graph

Management is guiding for 4-5% earnings growth ahead, and this has been one of the steadiest performers among the utilities. With shares trading near fair value, a 4.5% yield and 4% growth rate aren't a bad place to be.

CenterPoint Energy Inc. makes its 3rd consecutive appearance, but moves down a few slots to #6. This is understandable, as it was one of the best performers from the last update, with a gain of ~15%.

Despite that increase in share price, it still yields over 4%. That coupled with an expected 4% dividend growth rate makes it an attractive income investment.

CNP FAST Graph

CenterPoint's payout ratio of over 80% is a bit of a concern, and management has guided for dividend growth to be below earnings growth going forward. However, with analysts and management both expecting a 4-6% earnings growth rate, I feel fairly comfortable in my 4% dividend growth target.

NextEra Energy Inc. makes a second consecutive appearance on the list, driven largely by its double-digit dividend growth rate. The company has been a top performer among utilities, putting up an 8% earnings growth rate over the last decade.

With a payout ratio of just 53% against a target of 65%, there is plenty of room for future dividend growth. Management has guided for 12% dividend growth through 2020, and I think that is a reasonable target. Assuming the 7.9% earnings growth from analysts, this would result in a ~67% payout ratio after 5 years, in line with many of its peers.

NEE FAST Graph NextEra is due for a dividend increase with its next declaration, meaning the current 2.9% yield is more like a 3.25% yield on a forward basis. The stock remains a bit pricey yet against historical levels, but on a further pullback this is a name I will be watching as a potential add to my portfolio.

American Electric Power Company Inc. returns to the top ten list after missing out with the last update. AEP doesn't stand out in any particular metric, but is solid across the board with a 3.7% yield and expected growth of around 5.5%.

As mentioned by Jim Cramer, AEP could be one of the beneficiaries of President Elect Donald Trump's loosened environmental policies, as it currently generates about 47% of its energy from coal. I don't pretend to know what impact potential changes will have on AEP's bottom line, but I thought it was an interesting angle, and will be one to follow in the coming months.

AEP FAST Graph

AEP currently sits around the mid-point of its guidance for a 60-70% payout ratio, so I feel pretty confident in a 4-6% dividend growth rate going forward.

WEC Energy Group Inc. returns to the list after missing out on the last update. This company is a favorite among dividend growth investors, and has done well in recent years with a 14.8% dividend growth rate over the last decade. I don't expect that to continue going forward though, as the payout ratio is now within company's guidance of 65-70%.

WEC FAST Graph

Still, with management guidance for 5-7% EPS growth and the possibility of a bit more expansion towards the 70% payout level, WEC could still provide an attractive growth rate going forward.

The final company, DTE Energy Company, makes its first appearance on the top ten list, and it just squeaked by in getting there. It has a current yield of just 3.3%, but saw a 7.1% dividend increase with its most recent announcement, and I am projecting a similar growth rate going forward.

DTE FAST Graph

Like many others, the stock is trading well above normal valuation levels, so it may be worth waiting on a pullback. But generally speaking, its been a pretty solid utility over the years.

Closing Thoughts

It remains tough sledding for income investors in the current market. The search for yield has driven many utilities to price levels that are a bit uncomfortable, especially if one is concerned about capital gains. However, there are still several companies offering yields in the ~4% range, and for the most part, the growth prospects for those dividends look good as well.

Personally, I am hoping to add to my positions in either Dominion Resources or WEC Energy, and am also holding out hope for an opportunity to buy NextEra on a market correction.

Hopefully this update helps those looking for investment ideas as we enter 2017 and provides some positive insight into the utility sector. If you would like to read future articles covering the utility and other sectors, please click the follow button next to my profile at the top of the page.

Additionally, I would like to announce I have created my own investment blog/website called www.DGIfortheDIY.com, where I plan to provide more frequent market commentary and a bit of a library of information on the dividend growth investing strategy. The site is a work in progress as I add content, but I am hopeful it can become a good resource for investors.

I feel this will be a great complement to my work here on Seeking Alpha, and I have every intention of continuing to publish articles here as well.

Happy New Year!

Disclosure: I am/we are long D, MDU, WEC, XEL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a Civil Engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.

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