Home>Video>Which Utilities Are Best Positioned for Dividend Growth?

Which Utilities Are Best Positioned for Dividend Growth?

Fri, 10 Jan 2014

Some heavily regulated utilities are lined up to sustain and substantially grow their dividends, but there are other ways to play utilities today.

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Video Transcript

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

I'm joined today by Travis Miller, who is the director of our utilities team, and we're going to discuss which utilities are best positioned for dividend growth going forward.

Travis, thanks for joining me.

Travis Miller: Sure.

Coffina: Utilities are considered one of the most interest rate-sensitive sectors. Should investors be worried about what happens to utility stocks if rates continue to rise?

Miller: In the short term, certainly. Utilities, like you say, are sensitive to interest rates. They are sensitive both in a fundamental sense and in an investor sense in that a lot of investors are looking at fixed-income returns versus utility returns.

But if you look at a study we did over the last two decades, you see almost no difference in annualized returns during periods of either rising rates or falling rates. We actually think that as short-term fundamentals change in terms of interest rates and opportunity costs for investors in fixed income, this is a great buying opportunity when you are looking at those dividend-heavy, very stable, regulated or mostly regulated utilities.

Coffina: In one sense, low interest rates have actually been a headwind to utilities. That's because regulators have been cutting their allowed returns on equity in response to the low-rate environment. Where are allowed returns on equity right now, and where do you see them going over the next few years?

Miller: You are right. The key earnings driver for a lot of regulated utilities is the return on equity that regulators grant in so-called rate cases, when they're determining rates for customers. Over the last two decades, we've seen allowed returns--which is, again, one of the primary earnings drivers--fall from almost 13% on equity all the way down to below 10%. Several utilities in the last six to 12 months earned less than 10% returns on equity from regulators. That's a key earnings headwind for them.

So, as you've gotten the tailwinds on the investor side from low interest rates, you've also gotten a bit of an offset on the earnings side, certainly affecting earnings growth going forward for several utilities.

Coffina: What's your outlook for allowed returns going forward?

Miller: They are certainly sensitive to interest rates. So to the extent that we're in this period of 2% to 3% 10-year Treasuries, then you're going to have this earnings headwind. There are lot of utilities still out there earning 11%, 10.5% returns on equity. That's very attractive in an interest rate environment with 3% 10-year Treasuries or even less than that. So, there is still downside risk that would affect earnings growth for these utilities that are still at those high levels.

Coffina: Demand is also an important driver of earnings growth for utilities. Here there's a very different story between electric utilities and natural-gas utilities. What's your outlook for demand going forward?

Miller: There are two very different demand stories, like you say. On the electric side, we're quite bearish on demand right now. You've seen over the last almost 50 years, a 4% annualized increase in electric demand. In the last year or two, we've seen almost no increase, and in some areas, a decrease in electricity demand. Energy efficiency mandates and other activities that customers are undertaking right now are really hurting electricity demand.

But if you look at natural gas demand, that is the complete opposite story. We're very bullish on natural gas demand, primarily because the offset to natural gas heating is fuel oil heating and other oil-based heating sources. So, when you look at the spread right now between natural gas costs that have come down substantially and oil costs that have been sticking up at high levels, there's a very big value proposition for customers right now to switch to natural gas. So, you see booming gas demand right now on the residential side, in particular, in areas like the Northeast that are fuel oil heating heavy.

Coffina: Investors are most interested in utilities for their dividends. Which utilities do you think have the strongest dividends and the best prospects for dividend growth going forward?

Miller: We'd point investors to the heavily regulated utilities right now. Look at Southern Company: very constructive regulatory jurisdictions in the Southeast primarily. You look at [their] good relationships with regulators. They have a lot of good growth projects that have regulatory support. We think Southern Company, ticker SO, is a highly attractive name right now. They're also in areas with good electricity demand growth.

We like several other highly regulated [names]. You look at a large cap like Duke Energy; we think it is well-positioned to sustain and substantially grow its dividends.

On the flipside, if you look at those utilities that have some kind of merchant generation or commodity exposure, we think those dividends are not necessarily at risk, but certainly not going to grow for several years. If you look at, in that case, Exelon EXC, or you look at FirstEnergy FE, we see those dividends not growing for the foreseeable future.

Coffina: That said, our stock picks don't necessarily align with our outlook for dividend growth, because valuation is also a consideration. You have a stock like Exelon, where investors have pretty low expectations. What are some of your top picks in the utility sector?

Miller: Exelon certainly is, and that's a play on higher power prices. We have to distinguish here between a Southern Company, where you play the regulatory environment, you play growth opportunities on electricity demand, versus Exelon, which is highly levered to power prices, particularly in the Midwest and Mid-Atlantic. Power prices have been very poor for the last several years; that's really hit Exelon's earnings. Given the way that Exelon manages its hedge program, we don't see those earnings coming back for another two to three years.

The key for investors here is, they want the upside to power prices. So we think that as demand, if it does grow even a little bit on the electricity side, Exelon benefits. To the extent that environmental regulations are shutting down coal plants, that benefits Exelon. And to the extent that natural gas prices rise, that also raises costs for competing generation sources, and that helps Exelon.

So investors [in Exelon] might not see any dividend growth, but they should see earnings growth and capital appreciation if our thesis on higher power prices comes out to play.

Coffina: Thanks for joining me, Travis.

Miller: Thanks Matt.

Coffina: In conclusion, utilities offer attractive absolute returns, even though they tend to underperform in a rising-rate environment.

Demand is a bit of a headwind for electricity and a bit of a tailwind for natural gas.

And we think that allowed returns will remain under pressure as long as the low-rate environment persists. But higher rates in the future could help to alleviate some of this pressure.

Top picks from the utilities team include Southern Company on the regulated side and Exelon on the merchant-generation side.

For Morningstar StockInvestor, I'm Matt Coffina.


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