If you combine some ingredients, you can have a recipe for disaster. Inviting your politically conservative nephew and your left-leaning cousin to an intimate, multicourse dinner, for instance. Or trying to convince your teenagers you’re trendy by posting dancing videos on TikTok. Or thinking while on a cross-country drive that your Tesla can make it to the next charging point (wherever that may be), even though the battery icon is already on yellow. All will likely lead to unpleasant outcomes.
There's a recipe for disaster brewing among utilities stocks this year, too. In a recent episode of Dividend Stock Deep Dive: Utilities, Morningstar energy and utilities strategist Travis Miller explains that another quarter or two of high inflation—and higher energy prices—could ding earnings and growth prospects in the sector. To make things worse, Miller thinks the sector overall is overpriced, adding price risk to the mix. And of course, as interest rates inch higher, the dividend yield premium that utilities offer relative to Treasuries is shrinking.
That being said, Miller calls the dividends on utilities “very secure.” “You've got very strong balance sheets right now in the sector,” he notes. “We expect most of the dividend growth across the sector is going to be in line with earnings growth, and that's going to range in the 5% to 6% if we just look generally. Now, what you want is the utility that's going to grow faster than that and has a more attractive yield.” He also stresses focusing on utilities with good growth-focused projects and that operate in constructive regulatory environments—and that have low energy costs.
Miller suggests dividend stock investors consider two utilities stocks in particular on a market pullback.
Miller’s first pick is Entergy ETR. “They yield well over 3% right now and we think their growth is going to be in the 6%, possibly even up to 8% type range between usage growth and all of the investments they are making in renewable energy in the Southeast,” he says. We think Entergy is worth $112 per share.
The second pick is NiSource NI. Miller notes:
“It's a gas utility primarily based in the Indiana and Midwest region and also is a very large electric utility in Indiana. Now, you wouldn't necessarily think about Indiana as the center of green energy. But they're actually one of the most progressive states in terms of moving from coal—which for many, many years has been the predominant energy source in Indiana—to winds. Indiana is obviously a very good place for wind resource and even solar. So, NiSource is a good one in terms of a higher dividend yield, a more-attractive valuation, and some really good earnings growth that come out of especially the Indiana electric utility and also gas utilities doing safety investments.”
We assign NiSource a fair value estimate of $31.00.
Watch: Dividend Stock Deep Dive: Utilities
Here’s a little bit more about Miller’s picks, taken from his most recent Stock Analyst Reports on each.
Entergy Morningstar Rating for Stocks (as of April 20, 2022): 2 stars Economic Moat Rating: Narrow Forward Dividend Yield: 3.21%
“Entergy has nearly completed its transformation into a fully regulated utility like many of its peers. Now we think it can benefit from several advantages it has relative to other U.S. utilities.
Entergy has a growing, energy-hungry Southeast U.S. service territory, constructive state regulatory frameworks, and a long runway of clean energy growth opportunities. This supports management's plan to invest $4 billion annually for at least the next five years to upgrade its expansive grid and replace its coal and old natural gas generation with renewable energy. We forecast this will support annual earnings growth at the high end of management's 5%-7% target.
Entergy was the second-largest U.S. nuclear owner for nearly two decades with six plants in the Northeast and four rate-regulated plants in the Southeast. The plants in the Northeast at their peak earned more than Entergy's rate-regulated utilities. But they became a drag on earnings, dividends, and shareholder returns as power prices fell and never rebounded.
Management began exiting the business in 2014 by selling and retiring the plants, most notably the Indian Point units that supplied as much as 25% of New York City's electricity but succumbed to antinuclear policymakers. Entergy's last nonutility nuclear plant, Palisades (Michigan), is scheduled to retire in May. Entergy has turned over decommissioning responsibilities to other companies, eliminating the risk of unexpected decommissioning costs.
Entergy's unique risk is severe storms that hit its service territory regularly. From Hurricane Katrina to Ida and many in between, Entergy regularly faces billion-dollar storm repair costs. Regulators have a long history of allowing Entergy to recover those costs from customers, limiting the financial risk for shareholders.
Given the exit from Northeast nuclear generation and the growth potential of Entergy's utilities, we expect dividend increases to track earnings growth.”
NiSource Morningstar Rating for Stocks (as of April 20, 2022): 3 stars Economic Moat Rating: Narrow Forward Dividend Yield: 2.93%
“After decades of deriving most of its income from natural gas distribution and midstream businesses, NiSource has transitioned to a more diversified earnings mix. About 60% of NiSource's operating income comes from its six natural gas distribution utilities and 40% from its electric utility in Indiana following the 2015 separation from Columbia Pipeline Group. The electric utility might increase its share of earnings if new CEO Lloyd Yates decides to divest some of NiSource's smaller gas utilities.
NiSource's utilities have constructive regulatory frameworks that allow it to collect a cash return of and a cash return on the bulk of its capital investments within 18 months. We expect NiSource to invest more than $8 billion over the next three years, including what could be $2 billion of renewable energy projects in Indiana, where NiSource enjoys favorable regulation.
That growth could extend even longer based on electric and gas system infrastructure improvement projects NiSource has identified. Replacing steel and cast-iron pipe with plastic at its natural gas distribution utilities is a key initiative along with investments across the business that reduce greenhouse gases. Almost all of these investments receive favorable regulatory treatment, allowing NiSource to earn near its regulatory allowed returns.
In October 2020, NiSource sold its Columbia Gas of Massachusetts utility and received $1.1 billion of proceeds that it used to strengthen the balance sheet and prepare for its planned infrastructure investments. The sale came nearly two years after a natural gas explosion on NiSource's Massachusetts system killed one person north of Boston. Insurance covered roughly half of the almost $2 billion of claims, penalties, and other expenses.
Earnings are set to rebound quickly from their low in 2020 when COVID-19 pandemic costs, lower energy use, the Massachusetts utility sale, and a large equity issuance weighed on earnings. We expect modest customer growth combined with NiSource's infrastructure growth investments to support 8% annual earnings growth and 6% annual dividend growth from 2022 to 2026.”
Watch prior episodes of Dividend-Stock Deep Dive: Dividend-Stock Deep Dive: Energy Ideas Dividend-Stock Deep Dive: Picks for 2022 Dividend-Stock Deep Dive: Drugmakers
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