There are utility dividend yield bargains out there; here's how to find them (along with one stock pick)

08/20/2013 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Today let’s talk dividends. And specifically dividend-paying utility stocks.

How do you tell if any stocks in this beaten down sector yield enough to make them buys in the current risky market?

The looming possibility that the Federal Reserve will start to taper off its $85 billion in monthly purchases of Treasuries and mortgage-backed securities has sent global financial markets into a tizzy of guessing

Suddenly income investors who have been longing for anything paying more than 2% are confronted with 10-year Treasuries paying 2.8% and dividend stocks with yields on 4%, 5% or even more.

The problem, though, is figuring out if those yields are worth the risk. Prices of bonds and dividend-paying stocks have plunged. They could keep falling. What look like fat dividend yields might not be adequate compensation for the risk of losses to capital. And maybe yields tomorrow will be even higher.

Frankly, we’re all guessing here. What I’m sure of is that all this guessing will produce over-reaction and mis-pricing. And that I’d like to be ready to pounce when the inevitable over-reaction produces attractive mis-pricing.

But I’ve also started to see scattered examples of dividend-paying stocks, even in the battered utility sector, where current yields look like an adequate return for likely risks to capital.

In recent posts—my August 13 post http://jubakpicks.com/2013/08/13/get-ready-for-the-september-madness/   --I’ve argued that you want to make sure you have some cash on the sidelines ready to put to work if September and October produce some bargains.

In this post—and one next Tuesday, August 26 (just before I take a few days off for the Labor Day weekend)—I’m going to point you to some specific stocks in parts of the market where I think current yields are a good value.

Today I’ll be taking a look at utility stocks—and laying out what you should be searching for right now if you’re trying to find a high yield that is high enough.  Next Tuesday, the focus will be MLPs (master limited partnerships) and REITs (real estate investment trusts.)

But, first, let me explain why “guessing” is likely to produce bargains in the financial markets.

I’d break “guessing” down into two parts.

First, there’s the guessing that I’d call “what’s it worth” in asset classes that are clearly connected to the Federal Reserve’s program of asset purchases. (The second I’d call “what’s connected.” If the Fed does start to taper off its purchases, how will that affect seemingly unrelated assets such as Brazilian stocks. Today and my August 26 post will focus on the first kind of guessing. I’ll take a look at the second kind of guessing after those posts.)

It makes sense that if the Federal Reserve stops buying so many Treasuries and so much mortgage-backed paper, the yields on these assets will climb. And with Treasuries serving as the benchmark for so much of the income sector, it makes sense that yields will rise across much of the financial market and that prices of these assets will fall.

The guessing here, though is how big an effect a Federal Reserve taper that is so far unspecified in its schedule—will it be September or October or… –and in its dimension—will it be a taper to $75 billion a month from $85 billion or to $65 or to ?...—will have. The 10-year U.S. Treasury closed at a yield of 2.85% on Friday, August 16. A month ago the yield was 2.53%. A year ago it stood at just 1.81%. A year from now?

Of course, the answer depends on way more than just the pace of any Federal Reserve taper. The yield on the 10-year Treasury in August 2014 depends, in addition, on the inflation rate, on the strength of the dollar, on the availability of attractive alternatives to Treasuries and the dollar, on growth in the U.S. economy, and on the level of fear in the financial markets—to name just a few factors.

Not to belabor the obvious, but no one knows for sure what any of those other factors will look like. (Just as we don’t know, more immediately, if we’ll see a government shutdown over the budget and the debt ceiling at the end of September.)

But the inability to know how these trends will play out over the next year has a powerful effect. With yields already so low and the level of and timing of a tapering off in purchases by the Federal Reserve unknown but relatively near, according to recent Fed speak, selling strikes many income investors as the best policy. So in June, for example, overseas investors sold U.S. Treasuries at the fastest pace on record. Foreign investors, according to the U.S. Treasury sold $40.8 billion in Treasuries, the highest monthly amount on record. China, the biggest holder of U.S. Treasuries, sold $21 billion in June. Japan, the second largest holder, sold $20 billion.

Utility stocks, as an income vehicle with Treasury-like qualities and clearly at risk from any Fed taper, have taken the increasing worries of a September or October move by the U.S. central bank really hard. The iShares Dow Jones U.S. Utilities ETF (IDU) is down 4.06% in the last month. Some individual utility stocks have been hit even harder, especially recently. Duke Energy (DUK), the largest regulated utility in the United States, is down 4.15% in the week that ended on August 16. Southern Company (SO) is down 5.22% in the month that ended on August 16 and 7.35% in the last three months.

That pummeling on price has driven dividend yields on utility stocks to what, initially, look like very attractive levels. Duke Energy now shows a dividend yield on 4.65%; the dividend yield for Southern Company is 4.79%.

The question for utility stocks, as for Treasuries themselves and other income vehicles, is are those yields enough? Are they attractively high now or due to get yet higher as the actual Fed taper begins? And would any dividend payout be more than wiped out by a tumbling stock price as interest rates rose after the Fed began reducing its asset purchases?

So many uncertainties. So much to guess at. You can understand why utility stocks, like Treasuries, have headed lower: There’s not much in this situation to encourage anyone to buy.

Unfortunately, I don’t have any magic solution for resolving these uncertainties. I suspect that the Fed’s reduction in asset purchases will be very slow and the effects less damaging than the markets now reflect. But that’s only a suspicion and I’m very reluctant to advise a course of action based on a suspicion or hunch.

Fortunately, I think there is a way to approach the uncertainty that the Fed has introduced into the income markets. It doesn’t yield a big picture call on any sector but it does give investors a way to find individually good stocks in this environment.

The key to this process is to find income vehicles that are different from Treasuries in one critical way—that is, they have a way to increase cash flow and thus the money available for dividends over time. Treasuries and other bonds don’t—that’s why they’re called fixed income. They have a fixed call on the underlying cash flow and the cash that they payout doesn’t increase over time. The higher the potential for dividend increases, the more likely that a utility’s stock price will hold up in the current environment and the more likely that a current high yield is a bargain that you ought to take seriously.

There’s no magic formula for finding these stocks—just old-fashioned block-and-tackle fundamental research that focuses on the details of a utility’s business and its cash flows.

Let me contrast two utility stocks, Duke Energy (DUK) and TECO Energy (TE) to give you an idea of what I think you should look for in the current environment.

First, in the looks too much like a Treasury bond category, Duke Energy (DUK,) the country’s biggest regulated utility.

About 85% of 2010 EBIT (earnings before interest and taxes) came from the company’s regulated businesses. In that part of the business, state regulators rule on rate increases submitted by the company by looking at the company’s growth in assets and deciding how much of a return on equity the company should earn. That makes the regulated utility business into one where the utility spends to build new assets so that it can add them to its rate base and earn the allowed return. Duke’s capital spending program amounts to about $18.7 billion in 2013-2016.

Duke’s basic business is a play on the spread between what the market charges for the money it borrows to build new assets and the return that regulators allow. Duke Energy finished 2012 with $36.4 billion in long-term debt (up from $18.7 billion at the end of 2011) and $4.2 billion in short-term debt (up from $2.3 billion at the end of 2011.) As you might imagine that results in a hefty interest bill at Duke--$1.5 billion for the trailing 12 months. That’s up from $1.2 billion for 2012 and $859 million in 2011.

 

It’s this basic business model, which Duke Energy shares with most utilities, that makes the company’s stock so exposed to worries about climbing interest rates that might result from a Federal Reserve Taper. Higher interest rates would add to the company’s bill for its current debt and make that $18.7 billion in proposed capital spending less profitable for the company.

 

For the next stage in your analysis you need to see if there are any significant wrinkles in this model at an individual company. For example, Duke Energy acquired Progress Energy, another utility. The company has projected synergies of $600 million to $800 million from combining the two utilities. That’s clearly a potential boost to Duke’s earnings. Unfortunately for shareholders, Duke has promised regulators that the bulk of those savings will be passed through to its customers. Very little if any of those synergies will get passed along in the form of higher dividends.

 

What you’ve got with Duke Energy is pretty much a plain vanilla regulated utility—one with a history of solid management—where the business model is very exposed to higher interest rates. So yes, the 4.65% dividend yield is attractively high (especially because there’s little doubt that the company will be able to maintain it) but, to me, the yield isn’t high enough to offset Duke Energy’s exposure to any Fed taper

 

Contrast this to TECO Energy (TE), another regulated utility but one where the business model has lots of potential wrinkles.

 

TECO’s biggest business unit is Florida’s Tampa Electric. That’s a good business for a regulated utility now because with the recovery in Florida’s economy Tampa Electric’s customer base is forecast to grow by about 1.2% to 1.4% in 2013. And Florida’s utility regulators have been, historically, some of the most “generous” in the country. In its last rate increase request, Tampa Electric received approval for an 11.25% return on equity.

 

But TECO piles lots and lots of wrinkles on that basic business model. The company is in the midst of a restructuring that looks to sell non-core assets and to reinvest in the core regulated business. So far that has resulted in the sale of TECO’s operations in Guatemala and the pending purchase of New Mexico Gas with its 500,000 regulated gas customers for $950 million.

 

The big question for TECO—and for investors—is what will happen in the next year to the company’s big non-core asset TECO Coal. Historically the coal business has provided about 20% of the company’s operating earnings, but that hasn’t been the case recently as falling coal prices and volumes have blasted the coal-mining sector. In the second quarter TECO Coal reported operating earnings of just $700,000 versus $12 million for the second quarter of 2012. TECO Energy has said that it is looking to sell the coal business—if it can get an attractive price. That would seem unlikely in the current market except that in November 2011 TECO Coal announced the addition of 65 million tons of metallurgical coal to the proved reserves at its Appalachian mines. Metallurgical coal is clearly the most attractive part of the coal market and it’s likely to recover more quickly than thermal coal with growth in the global economy.

 

With TECO Energy I think you’re looking at a high 5.25% dividend yield that isn’t likely to increase significantly in 2013 or 2014. Payment ratio for 2013 is a high 92% and I don’t think management will go any higher. (Nor should it.) But the key issue for TECO Energy is when/if it will sell its coal business. A sale of that asset, which would remove a drag on earnings and give the company cash to reinvest in is regulated business, would result in a resumption of dividend growth. When might investors expect a sale and when could they expect dividend growth? Those questions hang over the stock and are the likely driver for any change in share price. Which, paradoxically, gives TECO Energy shares some protection from worries about higher interest rates in a Fed taper.

 

If for Duke and its regulated utility business, the macro question of interest rates is likely to drive the share price in the short- and mid-term, for TECO Energy the wrinkles to the business model—when will the company sell its coal unit—is the key driver. To me that argues that the 5.25% yield at TECO Energy is a better bargain in this interest rate environment than the 4.65% yield at Duke Energy.

 

I’m adding shares of TECO Energy to my Dividend Income portfolio http://jubakpicks.com/ today.

 

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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