Should You Warm Up to Gas Utilities?

In DividendInvestor, Morningstar's newsletter focused on high-yielding and high-quality dividend payers, we regularly examine different income-producing sectors such as pipelines, REITs, and utilities. (Investors can access a risk-free trial issue of DividendInvestor here.)

In the May issue, we investigated natural-gas utilities with energy analyst Paul Justice. Before joining Morningstar, he was a credit analyst at Merrill Lynch, and Paul holds a master's degree in finance from DePaul University.

Morningstar DividendInvestor: Most gas utilities sailed through the energy crisis unscathed. Why?

Paul Justice: For the most part, gas utilities maintain simpler operating models than their electric cousins. Because local gas utilities control a natural monopoly in their service areas, there wasn't the urge to deregulate gas delivery that there has been with electricity generation. And by deregulating the electric markets, generators that used higher-cost fuels couldn't compete effectively, driving some of them into financial crisis.

MDI: What kind of growth should gas utility investors expect over the long term?

Justice: I'd put industrywide growth at only about 2% annually. Gas is already the heating fuel of choice for most Americans, so growth in the industry is hard to come by. There are a few areas with above-average population and home growth, such as the Southeast or around Las Vegas, or that still use a lot of fuel oil and natural-gas liquids (like the Northeast). Everywhere else, earnings growth lags GDP growth.

The end result for utilities is that earnings growth comes from generating rate-base returns from capital infrastructure improvements, cutting costs, or switching customers from alternative fuels.

MDI: What's been the impact of high gas prices?

Justice: Gas utilities do not benefit from high natural-gas costs--in fact, higher gas prices actually hurt in the short run because consumers tend to conserve energy. The gas itself is passed directly to the customer with no markup. But the utility still depends on per-unit charges based on the volume of gas consumed.

MDI: Aren't utility earnings are tied to interest rates? Are earnings at risk?

Justice: All utilities work with regulators to establish fair rates of profitability. The utility makes investments in infrastructure and operates the network. The regulator evaluates the cost of providing service and allows the utility to recover operating costs plus a fair profit on investors' capital. Allowed returns on equity in gas, for example, are typically around 10%-11.5%.

And regulators are using today's low-interest-rate environment to thwart rate increases. When bond yields are low, as they have been for the past few years, regulators do not need to permit high returns to attract investment. Recent orders against  AGL Resources  and  SCANA  actually reduced allowed profits.

Even with slightly lower allowed returns, rates are high enough to still attract investment. Though they'd make other companies yawn, utilities are fine with modest returns as long as the risks let them sleep at night.

MDI: What else are regulators up to?

Justice: While some allowed returns are being cut, regulators are also allowing some progressive measures to stabilize utility earnings. Gas utilities are vulnerable to weather swings, but new weather normalization clauses help stabilize cash flows. We're also seeing more incentives for utilities to reduce costs by granting bonuses above allowed returns.

We're also looking at the proposed repeal of the Public Utility Holding Company Act. Many argue this 1935 law is out of date, duplicating regulatory oversight and preventing investment. Legislation to repeal the act has been delayed for years but seems to have steam in the current Congress. If it is repealed, we're likely to see significant consolidation in the industry. There are several cash-rich nonutility companies out there that are attracted to utility assets. Even Warren Buffett has expressed a desire to invest more in utilities through  Berkshire Hathaway (BRK.B), as seen with his planned acquisition of PacifiCorp (currently owned by  Scottish Power ).

MDI: How do you view nonregulated operations?

Justice: Nonregulated operations hurt a lot of utilities a few years back, but others have invested successfully. Utilities that stick with businesses in their existing value chain tend to fare better. Integrated utilities like  Oneok (OKE) and  National Fuel Gas (NFG) have energy production segments and processing centers, and they've managed to create good value for shareholders.

MDI: Do higher interest rates threaten the stocks?

Justice: Rising rates typically drive down the price of utility stocks for two reasons. First, utility dividend yields need to increase to remain competitive with fixed-income investments. So the utility needs to either increase its dividend through growth or cost-cutting, or accept a lower share price.

The other factor is a rising cost of debt. Utilities are more leveraged than the average company to keep their overall cost of capital low. But they're not able to increase their prices immediately to cover increasing debt costs. This lag can be devastating to utilities if rates increase rapidly, as they did in the early 1980s.

MDI: Let’s talk about some stocks. What are your favorite companies?

Justice: I like utilities that stick to what they do best, avoid high-risk ventures, and focus on efficiency. Many companies try to enhance returns by investing in noncore businesses only to destroy shareholder value.  Piedmont Natural Gas , SCANA, and  KeySpan  all have decent growth prospects and healthy relationships with regulators. They've also got strong balance sheets that are primed for dividend increases.

MDI: Good point--there are some really good dividend records in this business.

Justice: Piedmont has increased its dividend for 26 consecutive years, and I don't see it stopping now. National Fuel Gas has a similar record, and it has the benefit of the cyclical highs in the oil market padding its gas exploration operations.

MDI: Should we be buying the stocks right now?

Justice: As with any other stock in our universe, investors should be patient and wait for a fat pitch. In the spectrum of the equity universe, utilities hold below-average risk. That makes their 8%-11% returns more palatable. But rising interest rates are likely to drive prices down, and that could create buying opportunities for long-term investors. Sit tight and wait for the low-hanging fruit.

MDI: Thanks for your insights, Paul.

This article is from a recent issue of Morningstar DividendInvestor, our monthly newsletter dedicated to helping investors find high-dividend stocks with superior long-term return potential. To review a risk-free trial issue of DividendInvestor and receive three free investing reports, click here.