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Cranking Up The Power: 5 High-Paying Utilities For 2012

Article by Frank M. Bifulco, CFA – Alcott Capital Management

Utilities had a good 2011 – up about 18% on average for various utility indices. Despite a belief that utilities are the proverbial ‘widows and orphans’ stocks, investors should not be fooled by their reputation. Utilities have traditionally been as volatile as the S&P 500 during previous bear markets and financial panics, and even traditional economic recessions have hurt the stocks. Their professed safety arises from the belief that the stocks as a whole are not likely to plunge much more than the overall market or be wiped out, since utilities rarely go broke or cease operations given their heavy state and federal involvement.

Utilities are vulnerable to rising interest rates (they have large debt loads), EPA regulations, nuclear problems, and volatile wholesale pricing for fossil fuels. While many utilities have made legitimate diversification efforts into alternative power, the specter of Enron and the years spent untangling previous branching-out efforts hangs over the industry.

Utility stocks themselves face much more competition today for the retail dividend-investor than they did 30 or 40 years ago. Decades ago a lack of alternatives (and scarce publicly-available financial information) made utilities pretty much the only game in town for the dividend investor. Today they have been supplemented in the minds of most dividend-seekers and small investors by higher-yielding and sexier names like mortgage REITs, BDCs, closed-end funds, etc. But utility stocks have their own story to tell and it is one that deserves a second look.

Here are 5 utilities with attractive dividend yields in a low-rate environment that merit consideration by investors:

Exelon Corporation (EXC, $43) is merging with Maryland’s Constellation Energy Group. On the surface, it looks like a merger that can deliver on cost synergies since Exelon has surplus generating capacity and Constellation needs more electric power for marketing and sales. Legacy hedges have artificially boosted Exelon’s earnings the last few years, but even at a normalized $3.00 per share, the dividend is well-covered. Keep an eye on capital expenditures the next few years: free cash flow will be falling faster than earnings going forward so any regulatory costs above those planned could impact the dividend. At current prices Exelon yields 4.8%.

NextEra Energey (NEE, $61) is the holding company for the former Florida Power & Light (FPL). Operating mostly in Florida, NextEra also has a nice footprint in solar and wind energy. NextEra’s unregulated division owns power plants across the U.S. and this division will see pressure going forward as tight-strapped municipalities cut back on renewable capacity and subsidies. FPL should see good growth prospects going forward since the population of Florida should continue to grow once the current real estate glut abates. Like many utilities, NextEra sees some legacy hedges roll off in 2012 and 2013 which boosted earnings in previous years. However, the dividend payout is only about 50% of earnings so NextEra shareholders have some cushion to absorb any shortfalls in the alternate energy divisions without impacting the dividend. Current yield is 3.7%

Duke Energy (DUK, $22) is long-time innovative leader among American utilities and Duke made another bold stroke in 2011 with their $25 billion merger offer for in-state rival Progress Energy. Assuming the deal is completed, Duke should realize significant cost savings in the Carolinas as well as increased exposure to the fast-growing Florida energy market. Duke’s alternate energy division as well as cost-savings from the merger should continue to allow for low–single digit growth in the dividend. A 4.5% dividend yield is bumping up against a 70% payout ratio but barring a downturn in the economy or any regulatory or weather speed bumps, should be safe going forward.

Dominion Resources (D, $51) is another utility that operates in North Carolina, along with Virginia. The strong service and Washington, D.C. economies in Dominion’s home territory give it one of the stronger regulated utility divisions, and it has an added infrastructure ‘kicker’ down the line from additional natural gas development in the Marcellus and Utica Shale regions. Like other utilities, legacy hedges will negatively impact Dominion Resources merchant power division, continuing flat earnings at around $3.00 per share the next few years. Because of a stellar long-term track record in generating shareholder value, Dominion trades at steep premium valuations to her peers on some of the key utility metrics such as P/E, price-to-book, dividend yield, etc. Previously promised earnings growth beginning in 2008 never materialized, but with the merchant division bottoming out growth should start again with 2012-2013 earnings. Dominion yields 3.8% with a payout ratio under 70%.

You can also get diversified utility exposure through the Utilities Select Sector SPDR (AMEX:XLU), which has all of the above names in the Top 5 holdings and yields 3.8%. So does the iShares Dow Jones U.S. Utilities Fund (AMEX:IDU) which has the same Top 5 holdings, but a bit less concentration in the Top 10 and has twice as many names in the fund providing for more diversification. It yields 3.3%.

Complete Holdings of XLU

Complete Holdings of IDU

The utility stocks had a great 2011 and they helped weather the domestic and global volatility very nicely. As a result of this performance, their traditional buyers, and the Johnny-come-lately dividend seekers, the stocks are not cheap on relative or historic valuations. They are not grossly overvalued either, but rising interest rates, a slowing economy, or volatile wholesale commodity prices could impact the share prices. As I think the bias for the stock market in 2012 is up – especially if the Republicans are likely to remove Obama from the White House – a prudent way to gather exposure to this sector would be to scale in slowly to the utilities and use the inevitable correction resulting from European debt problems or the 2012 elections to buy more of the stocks.

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