Obama Tax Hikes May Lead To Utilities Sell-Off: Stay Away From The Sector

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As utilities undergo consolidation, the sector will produce winners and losers. Some will thrive with enhanced leverage over regulators; others will be crowded out from market saturation. Politics aside, what all, however, will lose from is the Obama administration's tax policy. The Affordable Care Act promises slapping a 3.8% surtax on investment income on top of an extra 0.9% Medicare tax for those making more than $200K per year.

In addition to greater taxes for products that those making more than $200K typically have already, the Obama administration is aiming to classify dividends as "ordinary income" for tax purposes. Even qualified dividends for long-term shareholders would be taxed as such. That means that the qualified dividend tax rate for most shareholders will go up by more than 2.5x to nearly 40%. Ditto for capital gains taxes. At the same time, income tax rates are scheduled to jump from 35% to nearly 40% next year for accredited investors. Thus, not only will investors have less money for investment, they will also have less incentive to invest. A market correction is imminent.

Now, why am I mentioning tax policy in a post focusing on utilities? The sector offers high dividend yields typically north of 4% and are thus particularly vulnerable to the Obama administration's approach to dividend distributions. Markets try to achieve an after-tax dividend yield and if the after-tax dividend distribution falls, it is axiomatic that shareholder value must also fall to return to the equilibrium yield. Has the market properly factored this in? Some argue that it has not. My own belief is that most of it has not been factored in for utilities. The sector trades at higher multiples than the broader market despite limited growth prospects and greater political risks.

Duke Energy (DUK), PPL (PPL), The Southern Company (SO) are all rated closer to a "sell" than a "buy" according to FINVIZ.com. On a scale of 1 to 5 with "1" being a "buy" and "5" being a "sell", Duke is rated a 2.8, PPL is rated a 2.6, and Southern Co. is rated a 3. I have similar reservations especially given (1) the prospect of higher dividend taxes, (2) limited growth prospects, (3) regulatory price controls, (4) high multiples, and (5) undervaluation in other high income-paying sectors, like biotech and oil & gas.

Duke is expected to realize 2013 EPS of $4.46 and then grow by just 4% annually in the near-term. This mean 2016 EPS of around $5.22. At a 17x multiple, the future value of the stock is $88.74. Discounting backwards by 7% to get present value justifies the current price. If the qualified dividend taxes goes from 15% to 39.6%, the after-tax dividend yield will fall from 3.9% to 2.8%. But the market still theoretically finds the company worth an after-tax dividend yield of 3.9%, and utilities have low betas so speculation is very low. This means that Duke's stock price must fall from $66.23 to $47 to realize the 3.9% dividend yield. Yes, it's that bad: you may either see what should have been a 4.6% yield reduced by 40% or you will see a 33% decline in the stock price. Some, but not all, of this has been factored in.

PPL faces a similar predicament. The current dividend yield is 5.2% while the current after-tax dividend yield is 4.4%. That latter figure falls to just 3.1% with the dividend tax hikes. To realize the equilibrium 4.4% yield, shareholder value will have to fall to $19.50. It still is relatively cheap at 9.9x past earnings versus 19.8x for Duke and 18.8x for Southern. Duke's merger with Progress may crowd out some market share, but PPL is still expected to realize 136 bps-greater earnings growth over the next five years. Thus, I expect the tax hikes to have less of an impact on shareholder value for PPL as it will for its peers.

Southern Co. offers a 3.6% after-tax dividend yield, which will fall to just 2.5% under the tax hike. This means shareholder value will have to fall to $33 in order to realize equilibrium. 2013 EPS is expected to be $2.82 and then grow 5.5% annually in the near-term. Growth is expected to be higher than both PPL and Duke and will translate to 2016 EPS of around $3.31. At a 17x multiple, Southern Co. is worth $56.27 per share in the future. Discounting backwards by 7% yields a price target of $40.12. The market seems to be factoring in an absurdly low discount rate of 4%, which is still not accounting for the dividend tax hikes.

Thus, while I think Southern, Duke, and PPL are great companies led by terrific managements, I recommend selling until the government backs off from its 164% tax hike proposal. The good news is that I think the government will indeed back off given how the economy has floundered worse than what economists expected and consumers hoped. Until then, the message is fairly clear: "stay away".

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