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All Contents © 2018The Kiplinger Washington Editors
By Michael Brush, Contributing Writer
| March 6, 2018
Utility stocks tanked hard starting in mid-November on worries about rising interest rates, which can be bad for supposed “bond proxies” like utes. The broad Utilities Select Sector SPDR Fund (XLU ) is off 11% since Nov. 17, versus a 4% gain for the Standard & Poor’s 500-stock index.
But given the severe damage, these fears about fallout from rising rates may be fully priced in by now. Besides, many of the worries are unfounded to begin with. Here are a few quick reasons why utility stocks look attractive in this selloff, followed by 10 companies to consider buying.
Utilities aren’t really bond proxies. Bonds pay a fixed coupon. Utilities constantly increase their earnings and dividends. So they aren’t really bond proxies, says Gabelli & Company utility-stock analyst Timothy Winter. Electricity utilities increased their dividends by 5.9% in 2017, off earnings growth of about the same amount. “They are going to grow their way right through the modest increases in the Treasury yield,” Winter says.
Fundamentals are sound. Winter predicts utilities will grow earnings 5%-6% annually over the next three to five years – much better than historical growth in the 3%-4%. Interest in renewable energy, the worn-down infrastructure and electric vehicles all support a veritable “super cycle” in utility capital investments, he says. This is good for investors because utilities make money by getting set rate of return on investments in infrastructure, which is called their “rate base.” The more they spend, the more they earn.
Interest rates might not go up as much as investors fear. Several structural forces put downward pressure on prices, such as technology, cheap foreign labor and the aging population (older people earn and spend less). If inflation fails to heat up significantly, interest rates won’t rocket higher, either. Besides, if interest rates and inflation do go up, regulators will approve higher utility bills to offset some of the damage.
Utes look cheap. Historically, when 10-year U.S. treasury yields are 2.5%-3%, utes trade at a significant premium to the S&P 500. They currently trade at a discount, says Goldman Sachs utility sector analyst Michael Lapides. “Adjusted for interest rates, the price-to-earnings multiples appear reasonable considering the strong fundamental outlook,” Winter agrees.
Utilities are defensive. If we are headed for a bear market, the end of the economic cycle or geopolitical turmoil, utility stocks will add defensive exposure to your portfolio.
Data is as of March 6, 2018. Dividend yields are calculated by annualizing the most recent quarterly payout and dividing by the share price. Click on ticker-symbol links in each slide for current share prices and more.
Dividend yield: 3.5%
Here’s quick primer on utilities to help you understand why Exelon (EXC, $37.68) looks cheap. Utes come in two flavors. There are regulated utilities, which have more predictable earnings and higher profit margins. Then there are “merchant” utilities, which generate power for sale to other utility companies in the open market. Regulated utility stocks trade for much higher multiples.
Exelon is a mix of both. It distributes power in the Northeast and mid-Atlantic. It runs nuclear plants as a merchant supplier. The catch here is that Exelon is oddly valued at a discount like a merchant supplier even though it is mostly a regulated utility.
The nitty gritty: Exelon has a price-to-book ratio of about 1.3. But it earns about the same return on equity as regulated utilities which trade for nearly two times book value, says Colin McWey, who helps manage the Heartland Mid Cap Value Fund (HRMDX). “Despite a comparable return on equity, they have a massive price to book ratio discount. It is an easy valuation case to make,” says McWey.
Earnings at Exelon’s regulated transmission and distribution business are growing at a nice 6%-8% annual clip. This represents about two-thirds of overall earnings.
Dividend yield: 4.6%
One of the largest utilities in the country, Duke Energy (DUK, $77.49) operates chiefly in the Carolinas and Florida. This brings two advantages: Regulators in both states are friendly, and Duke enjoys above-average economic growth.
Duke serves Orlando and Tampa, two of the fastest-growing cities in the country. Florida and the Carolinas are among the top states for new single-family housing permits. Residential customer growth is around 1.5% in both states. “They have a constructive regulatory environment, a growing rate base, and a good management team,” says Bruce Kaser, an analyst at the Turnaround Letter.
The company launched a huge $42 billion capital spending plan last year which will run through 2021. Duke is modernizing its grid, and investing in natural gas infrastructure. It’s also spending to grow its small renewable energy business. All of this spending should support 6% annual earnings growth, and dividend hikes of around the same amount.
Dividend yield: 2.6%
The power supply in the U.S. keeps getting “greener,” and this is a key trend for utility investors to ride. More states are mandating a bigger mix from renewable sources like solar and wind. Companies looking to boost their “sustainability” image are keen on buying more power from green sources. Falling costs of wind and solar farms make renewable energy more attractive.
NextEra Energy (NEE, $155.02) is a big beneficiary of this trend, Winter says. It has a subsidiary called NextEra Energy Resources which builds and operates renewable wind and solar energy farms. This subsidiary is the biggest owner and operator of renewable energy in the country. It accounts for about half of NextEra’s overall business.
The other half is a traditional utility, or Florida Power & Light, which is one of the best utilities in the country, says Bill Costello, portfolio manager at Westwood Funds. He expects NextEra Energy to produce 6%-8% annual earnings growth over the next five years.
Distribution yield: 3.8%*
Power companies have big plans for green energy. They will add 96 gigawatts of wind and solar generation to the 1,200 GW capacity in the U.S. by the end of 2021, Winter predicts. Analysts at Goldman Sachs predict that power producers will spend over $200 billion to develop 150 GWs of renewable energy by the end of 2025.
All of that spending will help NextEra Energy Partners (NEP, $38.05), a high-growth limited partnership formed by NextEra Energy to develop and operate renewable energy projects that sell power to other utilities. The company also runs natural gas pipelines. In short, NEP is a pure play on renewable energy development, excluding the gas pipelines.
NextEra Energy Partners is growing faster than its parent. Its cash flow grew 16% last year to $743 million. Distributions to shareholders grew 15% to $1.52 per “unit,” or share.
Investors expect more of the same. “We’re well positioned to capitalize on one of the best environments for renewables development in our history,” CFO John Ketchum said during the company’s fourth-quarter earnings call in January. NextEra Energy Partners forecasts 12% to 15% annual distribution growth through 2022.
*Master limited partnerships pay distributions, which are similar to dividends, but are treated as tax-deferred returns of capital and require different paperwork come tax time.
Based in Orange, Connecticut, Avangrid (AGR, $48.87) operates traditional electric and gas utilities in New England and New York. But like NextEra Energy, it has a division that develops renewable energy, called Avangrid Renewables. A Spanish company with renewable energy expertise, called Iberdrola, owns 81.5% of Avangrid stock. It shares knowhow in wind farms and solar energy.
Given the popularity of sustainable investing, consumer-facing companies like to show they are hip to the trend. This helps explain why Nike (NKE) has been signing agreements to buy power from Avangrid.
Meanwhile, other utilities striving to meet renewable energy mandates are in the market for electricity generated by wind farms and solar energy. Both Edison International (EIX) in California and Austin Energy buy from Avangrid. “Avangrid has the balance sheet to support more renewable development using Iberdrola’s expertise, says Gabelli’s Winter, who counts this company among his favorite utilities. He’s forecasting 8%-10% earnings growth.
Dividend yield: 3.7%
Speaking of Edison International (EIX, $60.67), shares of the California utility fell hard in December after wildfires broke out in the region. Investors fear it may face huge liabilities if the state finds that its power lines caused the fires. But the Edison share price decline may be a buying opportunity.
“Investors understandably are nervous,” says Morningstar analyst Travis Miller, but the stock decline is “excessive” based on the potential liabilities. He concedes his 7% annual earnings and dividend growth projection may be at risk, but he’s maintaining his $66 fair value estimate on the stock.
Where’s the growth coming from? California’s utilities have an aging infrastructure and the state has set aggressive targets for renewable energy production. So Edison has plenty of investment opportunities to support growth.
Shares of PG&E (PCG) have also fallen sharply because of potential fire-related liabilities. PG&E suspended its dividend in December to preserve cash, and the stock got hit even harder. By now, investors have overly discounted the potential damage, which makes PG&E a buy, believes Hugh Wynne of Sector & Sovereign Research, an independent research shop.
“There are lot of potentially mitigating circumstances,” says Wynne. The severe stock decline suggests investors assume PG&E will be found responsible for all of the fires, which may be a stretch, Wynne says. It also assumes negligence, which hasn’t been demonstrated yet. Without a finding of negligence, PG&E may be able to pass the cost of fire related losses on to customers. Miller, at Morningstar, projects annual earnings growth of 6% over the next few years for PG&E, despite the potential impact from the wildfires.
Dividend yield: 4.5%
Because cheap natural gas has driven down the cost of producing electricity, it’s been tough for utilities operating expensive merchant nuclear power plants to sell power on the open markets. It makes sense to shut the plants down.
That’s exactly what Entergy (ETF, $78.57) is doing. It plans to close its New York Indian Point and Michigan Palisades nuclear plants by 2021-22. That will pretty much turn Entergy into a fully regulated utility, which will guarantee a decent return on investment, instead of leaving margins to the vagaries of the market.
What’s more, Entergy serves customers in areas with decent economic growth, such as Louisiana, Mississippi and Texas, points out Kaser, at the Turnaround Letter. That makes Entergy an attractive investment for long-term investors, he says. He thinks the stock looks cheap here. Despite the big change in the business model, Entergy probably will continue to increase its dividend by around 3% a year, according to Morningstar analyst Charles Fishman.
Dividend yield: 2.9%
For takeover potential in the utility section of your portfolio, consider natural gas utilities. These companies distribute natural gas to get it to end users. Southwest Gas (SWX, $67.56), which serves 2 two million people in Arizona, Nevada, and California, also has an infrastructure construction division called Centuri Construction.
Gas utilities are a play on the booming business of fracking. Producers continue to get better because of improved technology, so fracking costs keep coming down. This means more of it is produced. Natural gas demand growth should continue because it’s viewed as a cleaner energy source for utilities than coal.
“Given the significant long-term demand for natural gas, most gas distribution utilities are highly coveted takeover targets,” Winter says. Southwest Gas is one of his favorites.
Another is Spire (SR), which yields 3.5%. This company serves the St. Louis area and northern Alabama. It’s been growing via acquisitions. Spire looks attractive in part because it trades at a discount to the group, Winter says.
Dividend yield: 4.4%
Akron, Ohio-based FirstEnergy (FE, $32.63) recently got a cash infusion from Elliott Management and some other investment shops. The plan is to give FirstEnergy the breathing room it needs to get out of its merchant energy business and become a 100% regulated transmission and distribution utility.
That’s a plan that McWey, at the Heartland Mid Cap Value Fund, can live with because it means FirstEnergy also will have the financial strength to upgrade Ohio’s transmission infrastructure.
“It is comprised of a lot of little regional transmission lines,” says McWey. “The need is there, and FirstEnergy’s ability to invest has been constrained by its balance sheet. A lot of that got addressed with the strategic investment.” McWey thinks 5%-7% annual earnings growth and cost cutting will drive earnings to $2.25-$2.40 a share in 2020 and support a $40 stock price, compared to roughly $32 now. “You’ll collect a 4.4% annual dividend yield while you wait.”
Dividend yield: 3.3%
When Fiat Chrysler (FCAU) announced in January it’s moving some truck production to Michigan from Mexico, it was really just part of an ongoing trend. Manufacturing jobs have grown steadily in Michigan since the recession.
That’s good news for DTE Energy (DTE, $102.57) which offers electricity and gas service in Michigan. The company also operates natural gas pipelines and storage in the Marcellus and Utica shale plays in Pennsylvania and West Virginia.
The Michigan utility represents about 75% of earnings and the Marcellus business accounts for the rest, says William Costello, a portfolio manager at Westwood Funds, which holds this company. DTE is growing earnings at about 5%-7% a year, and is boosting its dividend by about 7% a year. Besides the ongoing growth, Costello likes the reliability of the management team. “They have hit their numbers well,” he says. DTE has met or beaten guidance for 11 straight years.
This kind of dependability is worth having exposure to, at a time when market volatility seems to be heating up.
Michael Brush had no positions in any stocks mentioned in this column as of this writing. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.
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