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Need Yield? Check Out Utilities

Josh Peters, CFA

Josh Peters: Hello, I am Josh Peters Editor of Morningstar DividendInvestor. If you've been looking at the markets lately you might see that utilities have been running kind of hot. Why don't we take a little opportunity to shed some light on the subject. Here with me today is Morningstar's senior utilities analyst, Travis Miller.

Travis Miller: Hi, Josh.

Peters: Hi, Travis. How was that for the bad pun of the year award?

Miller: Yeah, we do think there are some attractive opportunities in utilities right now. Especially for income investors. If you look at the spreads right now between dividend yields, about 4.5% right now across the regulated utility industry and you look at where interest rates are these days. So, look at the 10-year, the 30-year Treasury. The spreads are at historic highs, almost 200 bps on the 10 year treasury.

So, we think if you're looking at relative yield plays that utilities still are a good place to go.

Peters: Well, obviously the relative yield spread is very interesting, but what about absolute returns. If we are looking at dividend yields for utilities relative to long-term treasury yields might now we just be seeing the idea that treasuries are overvalued and under yielding?

Miller: Yeah, that's certainly possible. But we want to look for in a good high yielding utility is the opportunity for growth investment. So, the utilities that we like right now are the ones that don't depend on inflation, they don't depend on the economy to rebound. Utilities that have projects that are economically insensitive. Projects such as environmental, capital expenditures such as infrastructure rebuilding that don't need an economic rebound to produce growth for dividend investors.

Peters: What's your favorite example of this phenomenon?

Miller: We like Westar, ticker WR, right now is one of our best picks. It's a Kansas-based utility. Couple of things that we like about them, one, if we go back to growth projects that don't need an economic rebound, Westar has about 90% of its generation from coal-fired power plants. Given the environmental regulations that are coming out, even excluding carbon regulations, they're going to have to put billions of dollars in capital into those coal plants to clean up all of the noncarbon emission; sulfur dioxide, nitrous oxide.

Kansas also as everyone knows is the Saudi Arabia of wind. So, as other utilities build wind projects in Kansas the transmission lines to get that power from the middle of Kansas to demand centers are very high return types of projects for Westar. Should produce 6%-8% dividend growth and earnings growth we think.

Peters: Well, I do have to ask you about the environmental capital expenditures. I mean, doesn't that sound like they are just going to pour a lot more money into just stay where they are at already?

Miller: Well, yes, they do need to upgrade those plants to keep that generation available for the customers. But there are also high return projects for the utility and shareholder investors.

Peters: Also they are allowed to earn a return on those investments?

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Miller: Absolutely. As long as the environmental capex programs go through the regulatory structure which we think they will in Kansas and there is a fairly supportive and constructive regulatory environment there, then it should produce the 6% to 8% earnings growth that we see.

Peters: Well, backing out to look at the whole sector again. Are there any dividends that you think are at risk of being cut?

Miller: Certainly those utilities that have less attractive growth prospects out there could be cut. So, we look at the Florida utilities as an example of this. Florida utilities, Progress Energies, PGN and the portion of Next Era Energy, NEE, that's located in Florida.

Now, these are utilities that saw a great growth opportunities over the last decade, as population boomed down there, as demand grew down there, as the housing market created more customer opportunities down there. Since then, the economy has tanked and regulators have been reluctant to give rate increases there.

So, all of a sudden, the Florida Utilities are seeing reduced demand, reduced customer accounts and a less constructive regulatory environment.

Peters: Do you think this might actually put their dividends at risk of being cut or is that more of just a no-growth scenario?

Miller: No. We don't think there'll be cut. We think there is plenty of cash flow available for dividends, but we do see a much slower growth profile. So, perhaps you get a six or seven even percent yield on some of these names, but the growth prospects are very, very small for the next few years.

Peters: Let's take one more look at the question for the industry, kind of coming up here recently, on merger and acquisition activity. What's going on?

Miller: Sure. There has been quite a bit on both sides of the utility industry. One is the merchant space and also merchant generation space, and the other side is the fully regulated space that we're more familiar with as dividend investors.

The latest is Northeast Utilities and NStar two very similarly sized utilities in the Northeast U.S. have decided to combine. So, what it does produces a utility that's about 9.5 billion market cap. A very good-sized utility with one of the largest customer bases in the Northeast. What we like for NStar is the opportunity to access the growth projects that Northeast Utilities has in transmission projects, in infrastructure upgrades.

For Northeast Utilities, we like the cash flow profile that NStar contribute. So, instead of Northeast Utilities facing a financing requirement over the next few years. NStar's cash flows and strong cash flows and operating structure should improve the profile for Northeast Utilities.

Peters: I understand that the combined entity thinks that it could grow earnings and dividends at a 6% to 9% annual rate that really sounds high by utility standards. Do you think they can do it?

Miller: I think they can, yeah. We certainly are pricing that into our fair value estimates and projections. Where do we think that comes from? Mostly the Northeast states in the U.S. have very strict renewable portfolio standards. To get all the wind and hydropower that they will need into that region, these utilities are going to have to build very large transmission lines accessing either Canadian hydro or wind projects and Maine solar projects, even offshore wind projects that are contemplating right now.

So, all of these transmission projects require a lot of capital and produce high returns for shareholders.

Peters: Certainly, it sounds like a pretty good story. I don't see any treasury bonds out there offering 6% to 9% types of growth rates.

Well, thank you very much Travis for joining us; very good to get a little bit of an update on the utility industry.

I might mention also that DividendInvestor has a pair of modeled portfolios our Builder and Harvest modele portfolios that invest in dividend paying stocks. And two of the stocks that we've been discussing NStar NST and Westar Energy, WR, are part of those two portfolios. So, you may be interested in checking those out. I also own NStar in my own personal accounts, little bit of disclosure there.

So with that, I'd like to thank you very much for watching. For Travis Miller, I'm Josh Peters, editor of Morningstar DividendInvestor.