Utilities' Dividends Still Best of Breed
Valuations are rich, but sector finances and growth are super strong.
Although utilities' valuations appear historically rich, the sector's financial health, dividend growth outlook, and relative yield are as good as they have been in decades. Long-term investors searching for secure income that can grow faster than inflation should consider some of these highlighted utilities as long as they're willing to take some risk that the sector will underperform the market in the near term if interest rates start climbing.
The utilities sector's yield paradox is sending mixed messages. On the one hand, the sector appears overvalued, trading at a 13% premium to our fair value estimates, an 18 price/earnings ratio, and a 3.5% dividend yield, which is below the sector's long-term average. However, income investors should like that utilities' average dividend yield still represents a historically attractive 132-basis-point premium to the 10-year U.S. Treasury yield.
Income investors are right to be split on whether this is a time to buy or sell utilities. In our view, the sector appears 13% overvalued considering a normalized long-term cost of equity between 8% and 10%. The 30 regulated utilities we cover with the strongest dividend profiles are even richer, trading at a 15% premium to our fair value estimates and an 18 P/E.
Yet there are few income alternatives for investors. The utilities' sector yield is historically attractive relative to the 10-year U.S. Treasury yield, and our historical analysis suggests that utilities could still produce 8%-10% total returns even if Treasury yields rise above 3% during the next three years.
Hot Dividend Growth
CenterPoint Energy (CNP)
We think investors should be able to count on management's 8%-10% annual dividend growth guidance even though the company's utility operating earnings are growing at only half this rate. Our confidence is based on the distributions from Enable Midstream Partners, expected to provide the largest component of the cash available for dividends. During its third-quarter earnings call, Enable reiterated its 10%-12% distribution growth guidance for 2014 and 2015 and reaching low general partner splits by the fourth quarter of 2015. Management has reiterated that future dividends will be based on 60%-70% sustainable utility earnings and 90%-100% of aftertax distributions from Enable.
Management continues to target 4%-6% annual earnings growth for its utility operations during the next five years, in line with our expectations. However, management did indicate it would probably be back-end-loaded due to the acceleration of capital expenditures and the lag in rates reflecting these investments. Also a drag on earnings growth is the expected reduction in right-of-way revenue to normal levels.
Houston Electric's rate base is expected to grow 7%-8% annually during the next five years, although potential investments like the $300 million Houston Import Project could push rate base growth to 9%-10%. The natural gas utilities' rate base is projected to increase at 8%-9% annually, but upside could push it to 10%.
Edison International (EIX)
As soon as Edison clears the final hurdle in its ongoing saga related to the retirement of the San Onofre nuclear plant in California, the board could begin its much-anticipated march of substantial dividend increases. State regulators in November approved Edison’s global settlement related to the plant’s retirement. We expect the board could approve a dividend hike this month, when it historically sets dividend policy for the following year.
Based on management's target 45%-55% payout ratio on Southern California Edison's earnings, we continue to believe Edison's dividend ultimately could reach $2 per share by 2017, a 40% increase from the current $1.42. We think the board will hit that target in a series of moves, but there's a good chance that the board could approve a step-change increase this month.
Management told us that it is keeping its target payout ratio below peers' typical 60%-70% to avoid issuing new equity for the company's $4.0 billion-$4.5 billion annual investment plan through 2017. However, constructive regulation should help the dividend grow in line with our 6%-8% annual earnings growth estimate during this period. Long-term investors could get another shot of dividend growth once Edison's investment slows and it can raise its target payout ratio.
Wisconsin Energy (WEC)
Wisconsin Energy continues to make progress on regulatory approvals for its $9.1 billion acquisition of Integrys, a move that should continue Wisconsin Energy's recent series of above-average dividend growth. We continue to see strategic rationale for the acquisition, which further increases the company's exposure to constructive regulatory jurisdictions, particularly Wisconsin. Significant Illinois growth opportunities from gas infrastructure upgrades increase the company's growth profile for earnings, which were declining as a stand-alone company.
We think combined growth opportunities should support a 5%-7% earnings growth rate and similar dividend growth. After the acquisition closes, management has said shareholders will receive an additional 7%-8% dividend increase on top of a nearly 8% dividend increase in 2014.
Steady, Secure Long-Term Growth
American Electric Power (AEP)
Through 2017, AEP forecasts a $14.5 billion increase in its regulated rate base from a 2012 year-end base of $33.2 billion, an implied 7.5% annual growth rate that should support management's 4%-6% growth rate off its 2014 original guidance. These growth opportunities should allow for above-average dividend growth.
The company's $12.0 billion capital plan for 2015-17 focuses on regulated spending. At the core of the program is building out the company's moaty regulated and competitive transmission business, focusing on regional projects to support plant retirements, local reliability projects, replacing aging infrastructure, and customer-driven projects.
For management's base case, which includes all approved projects or projects not requiring regulatory review, management predicts rate base growing to $6.4 billion by 2018, from a 2012 base of $800 million. Incremental transmission opportunities could drive that growth to $8.2 billion. The plan excludes any additional opportunities from the Federal Energy Regulatory Commission's Order No. 1000 competitive transmission projects. We think AEP is well positioned to benefit from any additional opportunities.
NextEra Energy (NEE)
Strong growth prospects support attractive dividend growth potential. Management targets a 55% dividend payout ratio in 2014, implying a 10% increase. We continue to expect dividends to grow in line with the company's highly visible earnings growth of 5%-7% through 2016.
Energy Resources continues an impressive buildout of its renewable energy portfolio with plans to add more than 2,500 megawatts of U.S. wind projects in 2013-15. Management also expects to add 1,600-1,800 MW of solar development in 2013-16. Florida Power & Light's $12.1 billion of committed projects includes completing its generation modernization program, storm hardening, and infrastructure upgrades. It has another $1 billion of capital project opportunities in natural gas supply, solar investments, and peaker upgrades.
Also supporting our dividend growth outlook are expectations for growing distributions at NextEra Energy Partners. Management projects increasing annualized distribution rates to $1.125 per share by year-end 2015 and growing distributions by 12%-15% annually from 2016 to 2020. The company recently accelerated its growth objectives, announcing plans to acquire 270 MW of solar and wind projects for $291 million. The 250 MW Palo Duro wind project in Texas was not part of the initial right-of-first-offer portfolio identified in the initial public offering, and management sees additional opportunities to accelerate asset drop-downs, given current tax equity financing. Aside from renewable projects, management said assets with long-term power purchase agreements and even fossil generation would be eligible for NEP's yieldco structure.
Westar Energy (WR)
Westar's hyperinvestment phase of the past five years should start paying off for investors as management brings in more cash flow for dividend increases. Westar has doubled in size since 2006, but its dividend has grown just 3% annually.
We continue to forecast 5% earnings growth through 2017, assuming stable regulatory developments in its planned 2015 rate case. This is in line with management's 4%-6% five-year annualized earnings growth rate target. Most of that growth is due to the $200 million it plans to invest annually in transmission projects through 2018, representing 12% annualized growth in its transmission rate base. After talking with management, we think that investment rate could continue beyond 2018 just for replacement and upgrade projects, suggesting that transmission could eventually represent more than one fourth of Westar's consolidated earnings base.
Westar management has said it is investigating opportunities to bid on competitive transmission projects, likely with a partner such as Berkshire Hathaway Energy, but we think those growth opportunities in the Plains region will be relatively minor compared with the noncompetitive transmission investment in its service territory. Westar would probably have to win projects outside the Southwest Power Pool for that business to have a meaningful impact on its long-term growth.
Income Investors Beware
Exelon's heavily leveraged exposure to wholesale power markets hurt income investors in early 2013 when management cut the dividend 41%. Power markets are only creeping upward, and Exelon has shifted its strategy to dilute some of that commodity market exposure with more consistent regulated earnings. We think Exelon's long-term upside and wide-moat nuclear plants make an attractive investment package, but it's not necessarily a good pick for dividend investors. Based on current market conditions, we don't think Exelon will be able to raise the dividend for at least another two years after it has closed its $12 billion Pepco Holdings acquisition.
Exelon Generation, which contributes about half of consolidated earnings, continues to be a drag. Management is adamant that it intends to hedge at a consistent rate to the extent that it can cover dividend and interest payments. Management recently disclosed it has hedged 27%-30% of its expected 2017 generation at prices that suggest a slight year-over-year uptick in hedged gross margin in 2017 compared with 2016 and 2015, in line with our mark-to-market estimates. Exelon Generation's hedged gross margin estimate for 2017 is $7.95 billion, and management presented a 95% confidence interval range of $6.0 billion-$10.55 billion. If margins come in at the low end of that range, we expect another dividend cut could come.
After incorporating the Pepco acquisition, we think its regulated utilities will be able to cover the current $1.24 per share dividend with earnings. But Exelon still will need enough cash from Exelon Generation to support about half of the dividend given the capital investment plans at the regulated utilities. If management can hit its target $0.15-$0.20 per share earnings accretion from the Pepco acquisition, we estimate Exelon's payout ratio would drop below 50%, a level at which we think management would be comfortable considering a dividend increase. We estimate earnings could get an additional $0.05-$0.10 per share boost starting in 2017 if earned returns at Pepco's utilities can improve.
The pain for shareholders from the San Bruno pipeline explosion in September 2010 in California is not over, and management has said that it won't address the dividend until all outstanding gas pipeline issues are resolved, including its Gas Transmission & Storage rate case. That dividend discussion likely won't be until 2016 at the earliest based on our recent discussions with management, marking more than six years without a dividend increase.
We suggest income investors check back in late 2015. CEO Tony Earley suggested to us that a 60%-70% payout ratio is a reasonable long-term target, implying a $2.28 per share dividend based on the midpoint of management's $3.45-$3.55 per share 2014 earnings guidance. The current dividend is $1.82 per share. The management team also suggested that it can return to and maintain a sector-leading earnings and dividend growth rate with investment projects beyond its explicit three-year forecast.
PG&E plans to spend an average of about $5.5 billion annually in 2015-16, and management told us that the firm has enough systemwide projects that could sustain investment around $5 billion for several years beyond 2017. Constructive California regulation should ensure dividend growth can track earnings growth as it did before San Bruno and the gas pipeline issues.
We recently changed our fair value uncertainty rating to high from medium, driven by the continued volatility of Alberta power prices and decreasing time until the Canadian coal plant power purchase agreements begin rolling off in 2018. Once the agreements expire, TransAlta's Canadian coal-fired plants will be subject to commodity prices. A high uncertainty rating is consistent with U.S. independent power producers.
Our discussion with TransAlta CFO Donald Tremblay confirmed our opinion that medium-term financial performance will continue to be driven by Alberta power prices. Although Tremblay indicated that he is committed to maintaining the company's investment-grade credit rating, we came away from our meeting concerned that this might not be possible if Alberta power prices remain weak. A reduction to below investment grade would result in higher collateral costs for power sales agreements. In addition, we believe continued depressed Alberta prices could result in an additional dividend cut in 2015 even after TransAlta cut the dividend 38% earlier this year.
Andrew Bischof does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.