Dow Jones Utility Average: Have Utility Stocks Gotten Ahead of Themselves? (EXC, SO, WMB, POM, XEL, PCG)
Utilitiesâ€™ formula for long-term growth is to invest in vital infrastructure and operate those assets in an efficient manner that generates a solid return on capital deployed. This simple strategy helped keep sector dividends rising during the credit crunch and recession of 2007-09.
As â€œGrowth Enginesâ€ shows, utilities expect to spend at least $2.4 trillion on power, gas, communications and water systems between now and 2030. Thatâ€™s a lot of fuel for further dividend boosts, which push stock prices higher.
Companies strive to earn a reasonable return on capital expenditures. Those that meet this challenge will prosper and build shareholder wealth; those that canâ€™t will become graveyards of capital for the unwary.
Sorting winners from losers is even more complicated today because large pieces of power, gas and even water industries are no longer operated as integrated monopolies as they were in decades past. Profits on power and water sold on wholesale markets, for example, depend on supply and demand for those commodities. Meanwhile, distribution of electricity, gas and water is a regulated monopoly, as itâ€™s been for more than a century.
Regulated vs. Unregulated
Despite jagged volatility and a few dips along the way, the stock marketâ€™s performance since the March 2009 bottom has been among the best on record. However, thatâ€™s done little to lift the gloomy spirits of many investors, who remain convinced a day of doom is fast approaching that will dwarf even the calamity of 2008.
Consequently, itâ€™s no great surprise that investors have favored regulated utilities stocksâ€”whose returns are literally set by lawâ€”over companies with exposure to the unregulated side. Thatâ€™s the point underscored by â€œPower Plays,â€ which compares five-year total returns of Southern CompanyÂ (NYSE:SO), which operates regulated power plants, with that ofÂ Exelon CorpÂ (NYSE:EXC).
The latter is the nationâ€™s largest producer of nuclear energy, which it sells to wholesale power markets in the Northeast and Midwest. Exelon Corp also has a sizeable retail marketing business, which sells electricity to consumers and businesses at market rates.
Until mid-2008, Exelon was by far the better performing stock, as investors chased growth. Then came the market crash and recession. Long-term price hedges protected Exelonâ€™s profits, but its stock has skidded sharply and now trades at a lower price than in March 2009. In contrast, Southern has continued to levitate higher.
Underperformance of Exelon and other mostly unregulated utilities, such as Williams Companies (NYSE: WMB) has prevented the DJUA from making new highs. That in turn has held down returns on utility stock exchange traded funds and other products designed to mirror the averages.
Investing in their regulated rate bases is still the highest percentage way for utilities to lift profits, provided regulator relations are healthy. The question is whether the current era of good feelingsâ€”forged at a time when about two dozen utilities were either in bankruptcy or a hairâ€™s breadth from itâ€”can last when so many Americans are feeling the pinch of stagnant wages and sluggish economic growth.
So far, the answer has been yes, although utility bashing has returned in some states. Most at risk is Pepco Holdings (NYSE:POM), the utility serving Washington, DC as well as much of Maryland, Delaware and southern New Jersey.
The companyâ€™s second-quarter profits took a 36 percent hit year over year, largely because of clean-up costs in the wake of the Derecho storm that devastated its service area in late June. Worse, Pepco faces potential penalties as regulators and politicians allege poor storm response.
Pepco may measure up to its challenges, but itâ€™s not pricing in much risk, with a projected 2012 price-to-earnings (P/E) ratio of 16. And if there is a dividend cutâ€”the second-quarter payout ratio was 100 percentâ€”the stock will head lower in a hurry.
Momentum reversal is another key risk facing regulated utilities. With all-too-many investors equating rising stock prices with safetyâ€”and falling prices with riskâ€”sector favorites have enjoyed buying momentum. Any change in sentiment, however, would quickly reverse those gains.
For example,Â Xcel EnergyÂ (NYSE:XEL) now yields less than 4 percent and trades at almost 20 percent above our buy target of 25. Itâ€™s â€œall systems goâ€ at the company itself, which this month sold 30-year bonds at an interest rate of just 3.4 percent. But after returning nearly 40 percent over the past 12 months, the stock is a candidate for taking at least a partial profit.
The same is true to a lesser extent for shares of Southern Co, which is trading at a rather lofty valuation.
Caution is also called for with water utilities such as American Water Works (NYSE: AWK), which now yields less than 2.7 percent after a 50 percent 12-month return. Even PG&E Corpâ€™s (NYSE:PCG) stock price is near new highs, despite regulatory and legal scrutiny over a 2010 pipeline explosion that claimed several lives and a likely cut in allowed returns by California regulators.
For most investors, utility stocks are more or less permanent holdings. Even companies that stumble eventually return to health by cutting operating risk and debt and repairing relations with regulators.
However, timing purchases and occasionally taking a profit can enhance returns. Today, that means scrutinizing the unregulated side.
Exelonâ€™s key weakness is that wholesale prices are tied to falling natural gas prices, a trend that has weighed on the companyâ€™s results and stock price. Fortunately, Exelonâ€™s successful acquisition of Constellation Energy Group for $7.7 billion earlier this year reduced the impact of a feared â€œearnings cliff,â€ as Exelonâ€™s selling price hedges come off.
Thatâ€™s why I expect the stockâ€™s projected earnings per share (EPS) of $2.55 to $2.85 for 2012 to represent a bottom for the year, even though theyâ€™ll still comfortably cover the 5.5 percent dividend. For more on Exelon and 4 other dividend-paying stock picks, check out my free report, Top 5 Companies That Pay Dividends.
Roger Conrad is the preeminentÂ financialÂ advisorÂ on utility stocks and income investing. He is the editor of Big Yield Hunting, Australian Edge, and Canadian Edge, as well as Utility Forecaster, the nationâ€™s leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks. Mr. Conrad has a track record spanning three decades, delivering subscribers steady double-digit gains of 13.3% annually since 1990. And heâ€™s done it all with a focus on capital preservation and risk minimization by investing in big dividend stocks including Canadian Income Trusts, high-yield REITs, MLP investments, among many others. Mr. Conrad has a Bachelor of Arts degree from Emory University, a Masterâ€™s of International Management degree from the American Graduate School of International Management (Thunderbird), and is the author of numerous books on the subject of investing in essential services, including Power Hungry: Strategic Investing in Telecommunications, Utilities and Other Essential Services.