Investors seeking income look for a mix of safety, predictability, and higher yields. Utility stocks fit this description.
Utility stocks are popular in the investing community for their generous dividends, safety, and stability. As these stocks usually operate in regulated monopolies, they have fairly predictable earnings growth.
On the other hand, utilities tend to be slow growth stocks. This means investors should pay great attention to their valuation before purchasing them. If you overpay for a slow-growth stock, it can take several years of growth to ‘make up for’ the inopportune purchase price.
In this article, we will analyze three of our favorite utility stocks that offer a dividend yield greater than 4%.
Southern Company (SO)
Southern Company is a major energy utility, which serves about 9 million customers in the U.S. via its subsidiaries.
Southern has dramatically underperformed the market and its peers in the last five years. It has gained just 5% whereas S&P has rallied 66% and the Utilities Select Sector SPDR ETF (XLU) has advanced 34%. The major reason behind the underperformance of Southern is its poor execution in the construction of its Vogtle nuclear units. The project has incurred several delays and cost overruns and will not be in full operation until the end of 2022. Even worse, although it has greatly increased the debt load of the company, it will contribute less than 6% of its earnings when it comes online.
The other burden of the stock is its excessive debt pile. Due to its poor execution and the acquisition of AGL Resources for $12 billion in 2016, Southern has almost doubled its net debt, from $42.3 billion in 2013 to $79.4 billion this year. This debt load is about 27 times the annual earnings of the company. Moreover, as $14.6 billion of debt matures in the next five years. The company will have to refinance this debt at higher rates due to the interest rate hikes of the Fed.
On the other hand, the stock has been punished by the market for the above issues. As a result, it is currently offering a 5.0% dividend yield, which is near an 8-year high. In addition, Southern has raised its dividend for 18 consecutive years and has not cut it for 72 consecutive years. Moreover, management expects to grow the earnings per share by about 5% per year in the upcoming years. Therefore, investors can purchase the stock at an almost 8-year high yield while they can also rest assured that the dividend will continue to rise in the years ahead.
Due to the negative effect of rising rates on the debt of the stock and its tendency to issue new shares at a 3% average annual rate, we prefer to be conservative and assume 2.5% annual earnings-per-share growth for the next five years. Moreover, the stock is now trading at a price-to-earnings ratio of 16.4, which is higher than its 10-year average of 15.9. As the stock is likely to revert to its average valuation level over the next five years, it will incur a 0.6% annualized drag due to contraction of its valuation level. Therefore, given its 5.0% dividend, the stock is likely to offer a 6.9% average annual return over the next five years.
Dominion Energy (D)
Dominion Energy is an electric utility, with more than 6 million customers in eight states.
While the company has grown its earnings per share at a 2.9% average annual rate during the last decade, it expects double-digit growth rate this year thanks to a reduced tax rate and the start-up of its Cove Point LNG project. The first cargo was loaded in April and Dominion has sealed 20-year take-or-pay export contracts in order to secure its future cash flows.
Source: Investor Presentation
Dominion has an enviable dividend record, as it has paid uninterrupted dividends for 90 consecutive years. Moreover, it expects to grow its earnings per share by at least 12% this year and about 7% per year in the next two years. As a result, it will easily fulfill its guidance for dividend growth rate of 10% until 2020 and 6%-10% after 2020. Thus Dominion currently offers an attractive 4.8% dividend yield and exceptional dividend growth rate for a utility stock.
The stock is currently trading at a price-to-earnings ratio of 17.2, which is higher than its historical average of 16.5. If the stock reverts to its average valuation level over the next five years, it will incur a 0.8% annualized drag due to contraction of its valuation level. If we take into account its 4.8% dividend and assume 5.8% annual earnings-per-share growth going forward, Dominion is likely to offer a 9.8% average annual return over the next five years.
Duke Energy (DUK)
Duke Energy is a regulated electric utility that serves more than 7 million customers and distributes natural gas to more than 1.5 million customers.
The company has markedly grown its debt load in recent years, from $68.5 billion in 2012 to $93.5 billion this year. As this debt pile is about 30 times the annual earnings of the company and the interest expense “eats” about a third of the operating income, the rising interest rates are likely to somewhat burden the company in the upcoming years.
Nevertheless, thanks to the rate hikes in its regulated business and the growth in the number of its customers, Duke Energy is on track to grow its earnings per share by 4% this year. Moreover, management has provided guidance for approximate 5.0% annual earnings-per-share growth over the next four years.
Thanks to this growth, management expects to grow the dividend at an approximate 5.0% annual rate over the next five years. The company has a remarkable dividend record, as it has paid uninterrupted dividends for 91 consecutive years. Given the current 4.4% dividend yield of the stock, investors can purchase the stock at an enticing yield and rest assured that the dividend will continue to rise at a decent pace.
Duke Energy is currently trading at a price-to-earnings ratio of 16.9, which is lower than its historical average of 17.5. However, it is critical to note that the rising interest rates exert downward pressure on the valuation of utility stocks, as they render their dividend less attractive. Therefore, we will not assume any expansion of the price-to-earnings ratio of the stock in the years ahead. Overall, Duke Energy is likely to offer a 9.4% average annual return over the next five years thanks to 5.0% annual earnings-per-share growth and its 4.4% dividend.
The above three utility stocks offer attractive dividend yields and enticing expected 5-year returns. Nevertheless, if a recession does not show up in the upcoming years, the Fed will continue to raise interest rates aggressively.
As higher rates negatively affect utilities in two ways, namely higher interest expense and a lower price-to-earnings ratio, utilities are likely to continue to underperform the market in such a scenario.
On the contrary, they are likely to outperform the market in the event of a recession thanks to their stable cash flows and recession-resistant business model. People need utility services (and pay for them) regardless of the economic environment.