Time To Add To Utilities

Summary

• I discuss three utilities that are trading below their fair value estimates based on P/E ratio and have dividend yields higher than their trailing 5-year average.
• The utilities were negatively impacted by COVID-19 and are also facing their own individual operational challenges.
• The utilities are all dividend growth stocks and the dividends are reasonably safe.

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Of the 11 sectors, utilities are the worst-performing one year-to-date. The utility sector is up only +3.7%. On the other hand, the Energy sector is up +47%, and nine out of 11 sectors have double-digit returns YTD. For context, year-to-date, the S&P 500 (SPY) is up +15.8%, the NASDAQ-100 (QQQ) is up 16.8%, and the Dow Jones Industrial Average (DJI) is up +10.6%. There is always opportunity in an underperforming sector, and it may be time to add to utilities after a poor 2020 and continued underperformance in 2021.

Utility Underperformance

Utilities performed poorly in 2020, too, due to the significant negative impact of the COVID-19 pandemic on electric power and natural gas demand. In addition, demand was lower because of local government restrictions, social distancing, and commercial and industrial business closures. Residential market demand was up but often not enough to offset lower demand from commercial and industrial customers.

Demand has increased in 2021, but it has been inconsistent as consumer fears keep them outside, and some local governments reimposed restrictions. Utility stock prices recovered from their lows in 2020 but have trended down again in the past month. The sector has been down (-6.2%) in the past month. More recently, interest rates have started to rise. In general, rising interest rates put downward pressure on utility stock prices since some investors view them as bond alternatives. For example, in the last 30 days, the 10-year US Treasuries rate has gone up from ~1.3% to over ~1.5%. The yield is still below most utilities, but this is over a 10% rise in a short period and trending higher.

Some utilities are down year-to-date with declines of nearly (-10%) in the past month. I discuss three utilities that I view as long-term buys for income and dividend growth. These utilities are South Jersey Industries (SJI), Pinnacle West (PNW), and Atmos (ATO).

South Jersey Industries

South Jersey Industries is the first utility that I view as a buy. SJI is primarily a regulated natural gas utility with some nonregulated operations. SJI has three operating segments: SJI Utilities, SJI Midstream, and South Jersey Energy Solutions. The regulated operations are South Jersey Gas and Elizabethtown Gas in New Jersey, serving about 710,000 customers. The unregulated operations are the now canceled PennEast pipeline and the renewables and energy management business. In addition, SJI owns rights to oil, gas, and minerals in the Marcellus Shale.

I have recently written about SJI, and since the stock price has declined further while the dividend yield has risen. The stock price is down (-2.6%) YTD. Besides the adverse effects of COVID-19 on demand, SJI's stock price was affected by the recent cancellation of the PennEast Pipeline. SJI will likely have to take charges for the cancellation of the pipeline.

In the trailing 10-years, SJI has traded at an average P/E ratio of approximately 20X. The stock is currently trading at a forward P/E of about 13X based on consensus forward adjusted earnings per share of $1.63. Thus, based on trailing averages, the utility is undervalued. However, the market is seemingly pricing in a cut to guidance, but the drop in stock price is overdone. Even a 10% cut to earnings would make the stock undervalued.

In addition, the forward yield is about 5.7%, which is more than 1.5 percentage points over the average yield in the trailing 5-years and more than double the average dividend yield of the S&P 500. Thus, SJI is yielding considerably more than it has in the past decade except during the nadir of the bear market in Spring 2020.

SJI Dividend Yield

Portfolio Insight

If we assume earnings are only $1.50 per share in 2021, then a fair value estimate for the stock is $30 per share. The stock is trading at $21.41 as of this writing, so there is decent upside even after discounting the current consensus estimates for earnings. This stock has a trailing 5-year beta of 0.88, meaning it will add ballast to a portfolio. SJI is a long-time dividend growth stock with 22 years of dividend growth, making SJI a Dividend Contender. The payout ratio is ~74% which is reasonably conservative for a utility and suggests that the dividend should grow at the same rate as earnings.

Pinnacle West Capital

Pinnacle West is the second utility that I view as a buy. Pinnacle West is a regulated utility that provides electricity to consumers and businesses, mainly in Arizona. Arizona's population is growing rapidly, and Pinnacle West is benefitting. In addition, Phoenix is one of the fastest-growing metro areas. The utility serves approximately 1.3 million customers. Pinnacle West aims to have 100% clean energy by 2050 and end the use of coal-fired power generation by the end of 2031.

In the trailing YTD, the stock price is down about (-9.5%). Pinnacle West suffered during 2020 due to the adverse effects of COVID-19 and lower demand. In 2021, the utility is faced with an uncertain regulatory rate case that could potentially hit earnings in the near term.

In the trailing 10-years, Pinnacle West has traded at an average P/E ratio of about 17.5X. The stock is currently trading at a forward earnings multiple of approximately 14.4X based on consensus forward adjusted earnings per share of $5.03 in 2021. Pinnacle West is undervalued, and Arizona is experiencing strong population growth. Even if Pinnacle does not receive a favorable decision on the rate case, population growth trends mean revenue and earnings will trend higher over time.

In addition, the utility is yielding nearly 4.6%, the highest since the market depths of pandemic and the highest in a decade. Dividend growth has been about 5.7% CAGR in the past 5-years and 4.2% CAGR in the past decade. The low payout ratio for a utility likely means more increases in the future. The dividend has been growing for ten consecutive years, making the stock a Dividend Contender. The payout ratio is conservative for a utility at ~65%.

Pinnacle West Dividend Yield

Portfolio Insight

Earnings may be flat-to-down in 2021. Assuming earnings are $5.03 per share in 2021, then a fair value estimate for the stock price is $88.03 per share. The stock is trading at $72.78 as of this writing. Pinnacle West is a conservatively run utility, and the stock price is not volatile with a trailing 5-year beta of 0.32, In addition, the utility has a corporate credit rating of A- from Standard & Poor's or A2 from Moody's. Investors should look at this stock.

Atmos Energy

Atmos Energy is the third and last utility that I view as a buy. Atmos Energy is a regulated natural gas utility that operates in multiple states, including Texas, Colorado, Nebraska, Louisiana, Mississippi, Kentucky, Tennessee, and Virginia. The company has over 3 million customers in eight states, but most of its operations are in Texas.

In the trailing YTD, the stock price is down roughly (-6.8%) due in part to the impact of COVID-19 on demand. Atmos is also spending heavily on capital investment at the tune of $11-$12 billion to 2025. Much of this amount will be for replacing thousands of miles of distribution lines. The result will be negative cash flow and rising debt. On the plus side, Atmos should benefit from higher reliability and lower maintenance costs over time.

In the trailing 10-years, Atmos has traded at an average P/E ratio of about 19X. The stock is currently trading at a forward P/E ratio multiple of about 17.3X based on consensus forward adjusted earnings per share of $5.10 for 2021.

In addition, Atmos is yielding roughly 2.8%. Granted, this is not high compared to other utilities, but it is higher than bond yields and the average dividend yield for the S&P 500. It is also the highest dividend yield since the nadir of the stock market downturn during 2020 and the highest since 2015. The dividend has been growing for 37 consecutive years, making the stock a Dividend Champion. The growth has been higher than many other utilities at 8.1% CAGR over the past 5-years and 5.7% CAGR in the past decade. The very conservative payout ratio of ~50% means more increases will probably occur.

Atmos Energy Dividend Yield

Portfolio Insight

Assuming earnings are $5.10 per share in 2021, a fair value estimate for the stock is $96.90 per share. The stock is trading at $89.17 as of this writing. Atmos is a conservative stock in a high population growth area with a trailing 5-year beta of 0.44. The payout ratio is very low, and the dividend is safe. Investors seeking income and dividend growth should like this stock.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.