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Utility Stocks Are A Buy: These Are The Companies That Dividend Investors Should Focus On

by: Thomas Hughes

Utility stocks emerged as a sector of choice for me earlier this year due to earnings outlook and market conditions. It remains a top-three focus-sector for the Technical Investor.

The Utility sector is expected to produce the strongest EPS growth of any sector this quarter.

Utilities have been lagging the broad market all year, but a leadership change may be at hand.

I've scoured the sector for the stocks with the best outlook for growth, current income, and income growth.

The Utility sector emerged as a sector of choice for me earlier this year due to its earnings outlook. It is expected to post the strongest earnings growth this quarter and has one of the clearest paths to long-term growth of the 11 S&P 500 sectors. Others, like Consumer Discretionary and Industrials, have a more robust outlook for YOY EPS growth this year to next, the problem for me is they also have negative outlook for this quarter and possibly next. That is a shaky foundation for investment in my opinion.

Within the utility sector all five sub-industries are expected to post EPS growth this quarter and one, Natural Gas Utilities, should see growth in the double digits. I've compiled a list of top-paying dividend-growth stocks in the Utility Sector. This analysis whittles it down to the ones dividend-growth investors will want to target this earnings cycle.

The Sector-Level View

At face value, the Utility Sector SDPR ETF (XLU) has been lagging the broad market since the S&P 500 hit the bottom last December and that is a surprise. The sector pays a much higher average dividend, comes with a much more stable revenue stream, has insulation from the trade war/geopolitics, and an outlook for EPS/distribution growth that I expect to fuel capital gains this year and next.

In reality, while the S&P 500 is wrestling with resistance at its all-time high, XLU has been trending higher and setting one new all-time high after another. A recent break-out has put XLU ahead of the SPX where I believe it will remain for the rest of the year.

The reason for this is simple. The dividend. XLU yields close to 3.0% at today's prices, the average in my group is over 3.0%, and it's not hard to find 4%+. This makes it easy to find great safe-haven-type stocks with yields far above the broad market and U.S. Treasuries. With trade war and economic uncertainty at their maximum, investors are flocking to safe-haven, high-value, dividend-paying equities.

Own work; data compiled from Seeking Alpha

In terms of dividend safety, most of the stocks that made it through the initial screen for dividend yield of at least 2% are relatively secure. There are individual risks on a company-to-company basis, but the group boasts a low 62% payout ratio. There are a few companies with payout ratios above 65% but not many; most are between 35% and 65%. At this level, we can also assume distribution increases will be forthcoming from those with a history of doing so.

Distribution increases are another common trait among these stocks that are aiding the rally. There are four on my list that qualifies as Dividend Aristocrats, at least 20 years of increases, and two of them have been raising their payouts for over 45 years.

After that, there a handful of Aristocrat-Wannabes (6 with at least 15 years of increase), and another handful of hopefuls (10 to 15 years of increases). The outliers in this group are those that DON'T have a long history of increases, and even those have been raising their payments the last few years.

The only downside is that most stocks in the utility sector are trading at P/E valuations above the broad-market average. This is a concern but one easily dismissed. Value is where you find it, and right now, we're looking for a potential winner among market leaders. It would be amiss if the P/Es were not higher than the S&P. That said, there are still a few great values left in the group.

The Shortlist

For the first cut, I took out all the stocks with payout ratios above 65%, and with them, the two stocks expected to post negative earnings growth in calendar 2020.

From the remaining group of 13, I cut those companies expecting negative earnings growth this quarter as well. That leaves 10. Public Service Enterprise Group (NYSE:PEG) is projected with a flat EPS, but has one of the lowest five-year average distribution growth rates, so it gets cut, too.

Consolidated Edison (ED), OGE Energy Corp. (OGE), and MDU Resources (MDU) also have five-year distribution-growth rates under 5%, but they trade at some of the fairest valuations, so no cut. They stay.

Regarding P/E, the average P/E of the 10 remaining stocks is 19.75. Most of the stocks are trading in the range of 19X to 21X forward earnings. The two high-side outliers, NextEra Energy (NEE) and WEC Energy Group (WEC), are both trading near 25X forward earnings; they get cut, too.

  • Consolidated Edison - Diversified electric/natural gas distribution.
  • CenterPoint Energy (CNP) - Diversified electric/natural gas and midstream.
  • Alliant Energy (LNT) - Diversified electric/natural gas distribution.
  • AES Corporation (AES) - Diversified power generation/distribution.
  • Pinnacle West Capital Corporation - Diversified power generation/distribution.
  • OGE Energy - Diversified electric/natural gas.
  • MDU Resources Group - Diversified electric/natural gas/construction.
  • NorthWestern Corporation (NWE) - Diversified electric/natural gas.

The Shortlist, A Closer Look

The Shortlist now has eight stocks. The group yield is now 3.13%, 3 bps less than before. The payout ratio and P/E multiple have both improved. In terms of dividend safety, the payout ratio declined to 59.75% from 62% and the forward P/E to 18.3 from 18.95.

AES Corporation, A Value Trap (?) - What I notice first and foremost is the AES Corporation. Based on the numbers, it is by far the best choice on my list. The stock pays one of the highest yields at 3.4%, has the highest five-year growth rate at 25%, the lowest payout ratio at 38%, and one of the strongest growth outlooks for next year. What makes this so surprising is that AES is also trading at the lowest multiple of any stock in the group.

At only 11.14X forward earnings, it is well below the median and the mean and that raises a red flag. The most obvious cause is AES's exposure to solar and more specifically batteries. AES has pinned its growth strategy on providing storage capacity for the growing solar power industry and hit a snag earlier this year. An explosion at an Arizona grid-level storage facility using AES batteries has raised concerns for the batteries' safety.

If the cause for the explosion is unrelated to the batteries, the stock could move higher; until then it's a risk that can be avoided.

MDU Resources, A Better Value - MDU Resources trades at a slightly higher P/E than AES, but provides a much better value. The company is a diversified play on Utility/Infrastructure operating in five segments; electric utility, natural gas, midstream natural gas, construction materials & aggregates, and utility construction services.

The downside with MDU is lower yield (less than 3.0%) and slower distribution growth. The upshot is MDU has been growing the distribution for three decades and has a payout ratio low enough to ensure it will keep increasing the payout for years to come. The company just acquired another utility-construction operation in the Northwest so we can be assured of revenue and EPS growth in the coming year.

CenterPoint Energy Is Another Great Value - CenterPoint Energy is another great diversified operator within the utility sector. It operates electric transmission, natural gas delivery, midstream, and utilities services businesses throughout the Midwest.

Based on my comparisons, CenterPoint may be the best buy on the short-list. It is trading at the fairest valuation without raising a red flag, it pays the highest dividend yield, and is expecting the strongest EPS growth next year.

Regarding the current quarter, high temperatures in Texas this August may boost revenue/EPS in the current quarter. Spot prices for energy at Texas main grid-operator tripled in August from high demand and hit their highest levels on record.

The Bottom Line

The Utility Sector has been hitting new highs and trading at multiples above the broad market average. The values are high but well deserved, the sector pays an average yield above 3%, and comes with the safe-haven advantage of the Real Assets/Infrastructure asset class. A deeper look into the sector will turn up some values for dividend-growth investors. AES is certainly one, but perhaps a bit more speculative than income investors are looking for. Better values can be found in MDU and CNP among others.

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