Focus on Utilities for High Yield (Barrons)

Boring Beauties With Powerhouse Yields
By ANDREW BARY
Barron's Andrew Bary says that electric utilities may look dull - if cheap stocks, stable companies and fat dividends aren't your thing. Why they could outrun the market.

ELECTRIC-UTILITY STOCKS may lack sizzle, but many sport attractively low price-earnings multiples and offer ample dividend yields.

Regulated utilities now trade for an average of 12 times projected 2009 profits, a sharp discount to the Standard & Poor's 500 stock index, which, at around 1040, fetches around 17 times this year's anticipated profits. Based on 2010 earnings estimates, the utilities' P/E multiple of 11.5 likewise is comfortably beneath the broad market's 14. Utility dividend yields average just over 5%, more than double the 2.1% of the S&P 500.

Many utilities have big capital-spending projects, financed by equity and debt. A credit-market rally has facilitated borrowing.
The yield spread between the utilities and the S&P 500 is near a five-year high. The utility dividend yield also stacks up well against 10-year Treasury bonds, which now yield 3.3%, and top-grade 10-year municipal bonds, now yielding 3% or less after the sharp muni-market rally this year. Dividends paid by the major regulated utilities look safe, and investors could see modest annual increases, enhancing the appeal of utility stocks relative to bonds.

Most utilities are expected to report average earnings gains of 6% to 7% in coming years -- impressive for a supposedly dull industry. Warren Buffett is a fan of the sector, admiring its predictable, if moderate, gains. One of the largest divisions within Buffett's Berkshire Hathaway (ticker: BRK-A) is MidAmerican Energy, which owns regulated utilities in Iowa and the Pacific Northwest.

Investors won't make a killing in the major utility stocks. Still, many of the shares could see upside of 10% or more in the coming year; include dividends, and the total return might top 15%. And given their defensive characteristics, utilities are apt to hold up better than the S&P if the stock market corrects.

Utilities are a contrarian investment these days. Hoping to capitalize on a recovering economy, many investors are piling into "offensive" shares in the faster-growing financial, technology and industrial sectors. Reflecting this mood, most equity strategists featured in Barron's cover story in our Sept. 7 issue urged investors to underweight utilities.


Playing Defense: Utilities have trailed the market lately as investors chase faster growers. That could mean opportunity.
"This is not ordinarily a time to buy utilities, given the economic recovery and the associated risk of higher inflation and interest rates," says Hugh Wynne, the utility analyst at Sanford C. Bernstein. "But utility stocks may already have factored in the threat of higher rates as well as the risk of increased taxes on dividends when the Bush tax cuts expire in 2011. You shouldn't assume they will underperform." Dividends are now taxed at a favorable rate of 15%. Historically, the bulk of utility returns have come from dividends.
Wynne likes PG&E (PCG) and Edison International (EIX). To those who argue that utilities will underperform in a market rally, he and others counter that this already has happened. The Dow Jones Utility Average is up about 25% from its March low, roughly half the gain of the S&P 500. But year to date, the utility index is flat, versus the S&P's 15% rise. Stocks such as Southern Co. (SO), American Electric Power (AEP), Entergy (ETR) and Exelon (EXC) are down in 2009.
The risks to utilities appear modest, especially compared with the threats facing big telecoms, such as Verizon Communications (VZ) and AT&T (T). Most utilities are in the midst of big capital-spending programs to rebuild their power grids, construct new transmission lines and open new plants.

Utilities typically are allowed to raise electric rates to fund new infrastructure. Most state regulatory commissions agree that the companies need roughly 10% equity returns on their investments in order to keep building capacity. Power demand has dropped about 4% in the past year, owing to the recession -- but that hasn't hurt most utilities. Over time, U.S. electricity demand is likely to rise modestly, spurred by population growth, a recovering economy and increased ownership of electric cars.

There's little variation in the P/E ratios of the big regulated utilities. Companies such as Southern, Consolidated Edison (ED), PG&E, Duke and American Electric are among the safest in the group, because they get the vast majority of their revenue from regulated power operations and little from independent power divisions, whose profits swing, based on market prices for electricity. Prices have been weak because of the recession, a cool summer in much of the country and falling natural-gas prices.

MOST UNREGULATED POWER producers own low-cost nuclear and coal plants. When natural-gas prices are high, open-market electric prices tend to increase, providing a pricing umbrella for the independent power operators. With gas tumbling this year to $3 per thousand cubic feet, power prices have fallen, reducing the independents' profits.

Among the big regulated utilities, Wynne favors PG&E, which serves the northern and central parts of California. Its operations are almost entirely regulated, and its shares trade around 40, or for nearly 13 times projected 2009 profits of $3.16 a share and almost 12 times estimated 2010 earnings of $3.40. Wynne contends that PG&E's profits can expand at an 8% annual clip in the coming years, fueled by capital spending, primarily on new transmission and distribution infrastructure. His price target is 45

A CASE CAN BE MADE for most of the major regulated utilities. Con Edison is low-risk because it is involved mostly in the transmission and distribution of electricity and gas. It is largely out of the power-generation business, and is allowed to pass on changes in purchased-power costs to its New York customers. It yields nearly 6%. Southern historically has had one of the highest P/Es in the group, owing to a favorable regulatory environment and good growth prospects. Its stock has lagged this year, leaving it undervalued.

Citigroup analyst Brian Chin favors American Electric Power, which has one of the group's lowest P/Es. At 30, it trades for less than 11 times projected 2009 profits and yields 5.3%. With operations in the Midwest and Texas, American Electric Power is more exposed to weak industrial markets, and the regulatory environment in Ohio is viewed as difficult. Also, environmentalists and others have stalled construction of a half-finished $1.6 billion coal plant that an American Electric unit is building in Arkansas.

EDISON INTERNATIONAL, Dominion Resources (D), Entergy, Exelon, FPL Group (FPL) and Public Service Enterprise Group , or PSE&G (PEG), are integrated utilities, which have a mix of regulated and unregulated operations. Thus, they carry more risk than regulated companies. Their stocks have trailed those of regulated operators, reflecting weakness in power prices.




Wynne likes Edison International, the parent of both Southern California Edison and independent power producer Edison Mission Energy, which owns a group of coal-fired generators. He has called Southern California Edison "perhaps the fastest-growing, most favorably regulated electric utility in the United States."

SoCal Edison, which is expected to contribute about 80% of Edison's projected earnings of $3 a share this year, is capable of generating 11% growth in annual profits in the next five years. Wynne values SoCal Edison alone at $33 a share, in line with Edison's current share price. That means that investors effectively get Mission Energy free. Wynne has a price target of 36 on the stock.

Edison's profits are expected to fall almost 20% this year, reflecting declining earnings at Mission. If power prices recover, Mission will do better, potentially lifting the stock. It peaked around 60 in 2007.

Exelon, with the largest independent power unit fueled by nuclear plants, is a play on carbon legislation. The more onerous the burden on carbon-heavy coal plants, the better the outlook for Exelon's low carbon-emission nuclear plants.In sum, electric utilities, with safe and ample dividends and decent growth prospects, are good bets for investors seeking income or protection from the next slide in stocks.


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E-mail: andrew.bary@barrons.com