Any Attractive Utilities?

Christine Benz: Hi, I am Christine Benz for Morningstar.com.

Utility stocks have historically been a source of rich dividend yields, but are they worth investing in right now?

Here to discuss that question with me is equity strategist and editor of Morningstar DividendInvestor, Josh Peters.

Josh, thanks so much for being here.

Josh Peters: Happy to be here, Christine.

Benz: So, let's discuss the lay of the land for the utility sector. Give a sense of what that investable universe is like for dividend-seeking investors.

Peters: Well, the industry really comes down into a couple of buckets that I think are very important to recognize before you start looking at the industry.

One group that I think most dividend investors probably won't find a lot of appeal in is the merchant energy sector. These are companies that are operating power plants and just selling whatever electricity they produce on the open market. It's a very volatile business, because energy prices in and energy prices out may not be correlated; profit margins can fluctuate widely--not such a great business.

At the other end of this spectrum, you have what are called T&D utilities, transmission and distribution utilities. These are the companies that actually will deliver electricity and natural gas, in some cases water, directly to your house or your business. That tends to be a very stable monopoly business. It's heavily regulated, but if you have the right combination of regulation and management in the company, you may be able to have a pretty good total-return profile.

And then there's sort of a mixed group of companies like Exelon here in Illinois that own both merchant power plants as well as traditional transmission and distribution operations.

Benz: So, say, I am looking at the sector and assuming I understand the various sub-sectors, what do I want to look at when evaluating one of these companies in addition to what its dividend yield looks like?

<TRANSCRIPT>

Peters: Well, I think a very good place to start is just with the payout ratio, and that is the amount of dividends being made per share divided by earnings per share; usually, measured on sort of a pro forma or estimated basis for the current year to exclude any sort of unusual factors.

Now, dividends yields and payout ratios tend to be positively correlated, which is, the more the company is paying out as a percentage of its earnings, chances are the higher the dividend yield the stock is going to have.

However, once you start getting into payout ratios that are up in the 75%, 80%, 85% type of range--a company like Progress Energy in the Southeast, for example--you're talking about a dividend that doesn't really have a whole lot of room for things to go wrong. Utilities tend to be very stable businesses, but they are also very, very capital intensive. They have to pour hundreds of millions, in some cases billions, of dollars annually into new construction for power plants and transmission lines, everything right down to the meter on the side of your house. And when you get up in that range, you're talking about a lot of financial pressure that a dividend might be placing on the utility.

If you're down below that 70% to 75% area, now you start to get a more favorable situation working for you where the utility actually is going to have a fair amount of money available for reinvestment, which means that it can make those big investments, or at least a portion of those big investments, without having to issue additional shares that would dilute your percentage ownership in the company and kind of hinder the company's dividend growth rate.

So the payout ratio is a very good place to start. Other factors, just to kind of run through them quickly: What's the state of regulation? Every utility that has fully regulated operations is allowed to earn a certain return on equity. Southern Company, for example, which has very high allowed ROEs in the Southeast, tends to be much more profitable and grow faster, grow its dividend faster than utilities that have low allowed ROEs. And they kind of range between, let's say, 9%, 9.5%, all the way up into 13%, 14%. The higher the ROE, the better and the closer the company can come to earnings its allowed ROE, the better as well.

Geography also matters. All else being equal, I'd rather own a company like Southern Company than a utility in Michigan where the economy is actually shrinking over time. And valuation, very important too; I don't want to overpay for the shares that I'm getting because that is going to have a very, very powerful impact on the kind of total return I earn from the stock.

Benz: So, Josh, that segues nicely into my next question. Given the state of the utilities sector right now, are you finding many attractively valued names?

Peter: It's tough. I am not sure that there is anything out there that I can really say is much of a bargain at this point. There's been so much interest in income investments generally in the market over the last year or so, and so much in dividend-paying stocks in particular, that it's had a predictable effect on prices; they've gone up. And all else being equal, as prices rise, dividend yields or interest yields on bonds will fall.

So where I tend to be a little bit more favorable is when I look at things on a relative basis--if I was an investor and I really had to choose for some reason between say owning 10- to 30-year Treasury bonds with yields of 3.5%, 3%, 2.5% depending on the maturity date and utility stocks whose yields were in kind of the 4% to 5% range, which is certainly not great by historic standards or by absolute standards, but at least will provide or should provide some level of dividend growth going forward. I am going to say, I'd rather own utility stocks.

But I think maybe the more important point is that we are in just kind of an inflated-price environment right now because of the search and the desire for income. Perhaps the best thing to do is to just be kind of patient and wait a little bit. Wait for a stock like a Southern Company; like an NSTAR, one of my favorites up in Massachusetts; National Grid, a transatlantic utility that I was actually able to buy a little bit more for one of my model portfolios earlier this year when it came down. Price has gone back up a little bit. Wait for them to come down to where you can get a little bit better margin of safety, because remember, whatever the yields maybe, these are still stocks; they may be stable businesses, but bad things can happen even to stable businesses. And I think no matter what kind of company you are looking at, it pays to try to pay less, and that reduces your risk and enhances your return.

Benz: Okay. Thanks Josh. Some companies for our watch list it sounds like but nothing to really pounce on right now. Thanks for being here.

Peter: Pays to be patient.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.