3 Utilities Generating Big Yields

10/11/2011 10:00 am EST

Focus: STOCKS

With utilities sporting a 4.3% trailing dividend yield at this writing, and ten-year US Treasuries still rallying, the yield spread between these two asset classes recently reached its highest level in at least 20 years, observe Travis Miller and Mark Barnett of Morningstar StockInvestor.

Utilities' dividend yield spread against investment-grade corporate bonds reached a 20-year high in August at 68 basis points. We think utilities with strong recession-proof growth prospects and yields near 5% look attractive.

But is this time different?

Lackluster energy demand, lower allowed returns, and large investment mandates could slow dividend growth. Treasuries above 4% could cause a landslide. The large, unprecedented worldwide monetary policy experiments increase uncertainty around inflation expectations, a potential death knell for utilities.

Our thinking on the situation boils down to this:

  • Utility dividend yield spreads have been a good leading indicator. Following the last two yield-spread peaks, utilities posted a 10% average one-year return and a 59% average three-year return.
  • We favor utilities with 5% yields and above-average growth prospects. Despite a median 1.05 price/fair value ratio for the sector, we think several utilities offer dividend yields and growth prospects that can produce 10% total returns, in line with our cost of equity assumptions.
  • Focus on geography and regulation. Utilities with low rates, economically resistant customer bases, and constructive regulation are best positioned.

Yield spreads between utilities, ten-year Treasuries, and the S&P 500 peaked during the last month. Since January 2008, the utility dividend yield spread against Treasuries is up 360 basis points, mostly due to the drop in Treasury rates from 4% to below 2%.

The utility sector dividend yield is up just 30 basis points during that same period. The S&P 500 now yields 2.3%, in line with ten-year Treasuries, also marking a 20-year peak.

Despite bullish indicators from peak spreads, we think utilities are fairly valued based on our 10.5% "fair" total return assumption. None of the 31 regulated utilities we cover are trading at more than a 10% discount to their fair value estimates, and we have 19 utilities trading at one- or two-star valuations.

Notably, we think utilities such as Piedmont Natural Gas (PNY), WGL Holdings (WGL), and Great Plains Energy (GXP) are trading 20% above their fair value estimates, with above-average payout ratios and below-average growth prospects.

The simple explanation is the normalized 4.8% long-term Treasury rate we use in our discounted cash flow valuations. Although this is well above current rates, we believe it is in line with the 200 to 250 basis-point premium and 2% to 3% inflation at which Treasuries have traded historically.

If we adjust our discount rate to reflect the current ten-year Treasury rate, all of our utility fair value estimates would rise 10% to 20%, and all would trade at or below their fair value estimates.

NEXT: The Picks

|pagebreak|

In this environment, we recommend buying utilities with the following characteristics:

  • Dividend yield near 5% or higher;
  • Growth investments that do not rely on customer usage growth;
  • Automatic and timely rate-adjustment mechanisms that do not require a review of allowed returns;
  • Low payout ratios.

Westar Energy (WR)
Located in the Kansas wind alley, Westar has an enviable pipeline of high-return transmission projects that will connect rural wind farms to population centers to meet renewable-energy standards.

Since 2008, the utility has increased core earnings at a 9% average annual rate, and we think it can sustain that through 2014. The company's favorable rate structures ensure strong cash flows and should allow the board to pick up the pace of dividend increases. This growth potential makes up for its relatively high 70% payout ratio.

National Grid (NGG)
With a dividend yield that tops its peers, and prospects for above-average growth, we think this UK utility is compelling.

Management has raised the dividend at least 8% for seven consecutive years; that should continue, barring an unexpected change in UK utility regulation. We expect the annual fiscal 2012 dividend to climb above 39 pence per share ($3.11 per ADR share).

Early discussions in National Grid's 2013 to 2021 UK rate review suggest regulators will support National Grid's current 7% allowed real returns on equity with the opportunity to earn above 11% nominal returns if it meets operating performance targets.

In the US, rate activity and decoupling provisions have improved its lackluster earned returns. With its attractive growth prospects and allowed returns, we're not concerned about its relatively high 70% payout ratio.

Exelon (EXC)
Rarely has Exelon offered investors such a juicy yield with such attractive upside. Its under-ten P/E ratio is its lowest since 2003, and its 5% yield is among the highest in the sector. However, Exelon's fundamentals are much different than the other utilities we highlight.

Exelon's large nuclear fleet sells into wholesale power markets, giving it a rare low-cost advantage and wide moat. But it also exposes investors to volatile commodity prices.

We expect earnings to bottom next year near $3 per share, with little or no dividend growth until 2014. This puts Exelon's forward valuation in line with its peers. But beyond 2013, we think Exelon's upside far exceeds its peers.

Subscribe to Morningstar StockInvestor here.

Related Reading:

Related Articles on STOCKS