Don’t Focus on Utilities Stocks’ Low Dividend Yields

Laura Lallos: Welcome to Investing Insights. I’m your host, Laura Lallos, filling in for Ivanna Hampton this week. The Morningstar Utilities Index currently yields less than 3%, which is the lowest dividend yield for the utility sector in at least 40 years. Meanwhile, interest rates are approaching 5%, which is a 20-year high. That’s a big difference. What does it mean for investors who are considering utility stocks? Have opportunities dried up? Not so, according to a recent Morningstar report called Mind the Yield Gap. Joining me today is co-author Travis Miller. He’s a senior analyst covering utilities and energy stocks for Morningstar.

Thank you for being here, Travis. Should we be concerned about this yield gap between utilities and interest rates? In your paper, you noted that the last time we had such a big yield gap was right before the financial crisis in 2007. And then before that, there was a big gap before the tech bubble burst in 2000. Why has there been this correlation between utility yield gap and market crashes?

Travis Miller: Yeah. No, again, thank you for having me. This is exciting. It’s always great to talk utilities after many years of covering utilities. It’s great to see utilities back in the news, back in the headlines, and in a different context. This time, we think, is much different when you’re looking at utilities both for income and for growth. This time, we now have utilities growing earnings, and this is something that really hasn’t happened in a generation, if not longer than a generation. We’re talking many, many, many years in a utilities context. So, concern is a big word. I’m not particularly concerned about utilities.

I think there might be an artifact of history going on here in terms of when that yield gap blew out before those crises. Our big point here is that this time is different. Even if you look back at how interest rates have moved and how utilities dividend yields have moved, this is a new era in terms of assessing those dividends, the dividend yields. And frankly, the big thing is growth; that growth is here and growth is real. That’s something to consider if you’re investing in utilities. Definitely something to consider is this growth element that exists now, and not necessarily worry about that spread between interest rates and utilities dividend yields.

Lallos: Low dividend yields might suggest these utilities are priced too high, but now we’re factoring growth in and that changes the picture. What do your valuations look like for the sector when you’re looking at this growth?

Miller: Yeah. Overall, we’re fairly valued on the sector and the big component there is really the long-term view. We have really good visibility with utilities investing in growth projects. A lot of management teams, these are long-dated growth projects, putting in poles, putting in power plants. These take three, four, five years to develop. We have a good visibility on the near term, at least three- to five-year investment. That’s going to lead to earnings growth. That’s why we think there’s a really strong growth case here for utilities. Our big concern is years five and beyond. We’re really trying to figure out does this data center, and I’m sure we’ll get into that a little more, does this data center boom continue? All of the electricity needs, all of the energy needs, even all the gas needs to serve these data centers—are they really going to show up?

And if they don’t show up, the valuations today in the market don’t necessarily support the possible long-term growth expectations. We’re a little hesitant there. Again, we’re fairly valued. The sector’s come down a little bit. A lot of that’s possibly interest rates or inflation, other macro elements. But there is still, we think, for some stocks, especially big ones that have been talking about a lot of data centers, we’re a little more reserved on what happens years five and beyond because of that uncertainty around who shows up and how big are they.

Lallos: Are data centers the biggest trend that’s driving this growth?

Miller: They’re certainly in terms of numbers. Some of the data center electricity demands numbers are incredible. We’ve got several utilities that are talking about 50, 60% increases in electricity demand on their entire system just from a couple of the hyperscale data centers. The big thing that everybody talks about is one large hyperscale data center is about as much electricity demand as a mid-size city. One of the very largest data center projects down in central Louisiana that Meta’s building is physically at least the size of Manhattan. It’s really, really hard to understate the amount of electricity demand that’s coming from data centers over the next five years. And that’s just the data centers that we know are committed, are putting steel on the grounds, have chips on order.

Not to mention again, like we said, what happens five and beyond? Here are some of the numbers that Meta Platforms META, Amazon.com AMZN, and Nvidia NVDA are throwing out in terms of capex. Those numbers are very large relative to what utilities frankly can even handle in capital funding to serve the data centers that all those chips are going to go into. This is really a pretty phenomenal, again, I say generational, certainly a generational shift. We have executives who we ask, executives who have been around for 20, 30, even 40 years in the industry, “Have you ever seen anything like this in terms of expectations for demand growth?” And they’re like, “No. The last time we think we saw this kind of stuff was a previous executive generation in air conditioning.” So these really, again, it’s hard to understate the potential electricity demand growth there for utilities from data centers.

Lallos: As you mentioned, some of these data centers are the size of Manhattan and that’s probably why we’re starting to see backlash against them. It seemed at first most states were like, yes, come to our state, welcoming these data centers wholeheartedly, and now we’re seeing communities pushing back. Is there some risk there?

Miller: Oh, absolutely. What we’re really trying to discern is that growth element. Again, we go back to that kind of construct where you have interest rates and you have dividend yields. What’s the sandwich in the middle, right? If you think about interest rates are the top piece of the bread and the dividend yields are the bottom piece of the bread, that growth is the meat in the middle of the sandwich. And we’re trying to figure out how big is that sandwich. The key here is affordability. Affordability has been a huge political issue during this cycle. Governor races have been very competitive in states where electricity prices are going up, and that’s causing us a little bit of concern on that growth element.

Again, we’re trying to figure out how much growth is really there. The typical utilities business model is invest in infrastructure and get a return of and a return on that infrastructure through customer bill and customer rate increases. That’s worked very well for the last hundred years because we’ve never had as much infrastructure growth as is necessary now. It doesn’t work so well when companies are investing twice their market cap in capital to serve a data center or serve a couple of data centers. How those costs are allocated is a massive issue right now. In states where they’re not allocated correctly or there’s poor regulation, affordability is going to slow down that growth potential. In states with constructive regulation and a lot of support from politicians, utilities are going to grow like we think they are. They’re going to hit some of those 7%, 8% growth rates. But we’re really watching state by state at this time of the year, election by election, and that’s going to determine which utilities can grow faster.

Lallos: You give utilities companies a regulatory ranking. You’re thinking about this. Looking ahead to Tuesday’s elections and thinking about these rankings, are there companies that are particularly at risk?

Miller: Yeah, we focus on a couple of states. And these are, like you suspect, areas where there are a lot of data centers going in and there’s a lot of concern about affordability for energy prices. A big state we’re looking at is Georgia. In Georgia, the commissioners who oversee utilities rates are elected officials. So, literally two of them are on the ballot and the state will decide who essentially sets utility rates for the next six years. At least two of the five of them. Pennsylvania is a big state we’re watching. Gov. Shapiro there has made a big deal about electricity affordability, bill affordability. Pennsylvania was always supposed to be the number one or number two place where data centers wanted to locate. There’s a lot of cheap energy in the states, a very large state, and now there’s a lot of pushback in terms of how data centers, how all the infrastructure’s going to be priced into electricity bills, and that’s becoming a political issue.

California and New York are an interesting situation. They’re not so much data centers, but they are interesting races in terms of renewable energy and how that’s playing into affordability. But I’d say Georgia, Pennsylvania, and Texas, because Texas is supposed to be and has plans to be one of the largest data center states in the country, at least over the next few years, and massive amounts of data centers and tech interest down in Texas. Very, very tight governor election, very, very tight US Senate election, and affordability. Energy affordability is a big issue in Texas.

Lallos: What are your top picks right now, thinking about all these variables in addition to, of course, valuation, who do you expect to do well through this, at least for the next five years? We can’t say beyond.

Miller: That’s a great question. Yeah, because again, like I said, we’re watching state by state, jurisdiction by jurisdiction, regulator by regulator, because that’s really going to determine who hits those growth numbers. Again, the big issue here is you don’t get yield, you don’t get relative yield right now out of utilities, so you have to get earnings growth, and we’re watching that risk around earnings growth. Our favorites are the ones where we have transparent growth that we can see: transparent growth, steel in the ground, data center contracts signed, regulators supporting data centers, a political environment that supports data centers, economic development. We’ve been talking a lot about Midwest mid-cap utilities. The Midwest is an area that’s very accommodating to data centers when there’s a lot of state policy, but even more important on the energy side, there’s a lot of cheap energy and there’s a lot of energy capacity.

A data center locating in Indiana, Iowa, Missouri, Michigan, there’s not a whole lot of new infrastructure that has to be built. Over the last 20 years, all of the renewable energy that’s been built because of tax credits, federal policy, state policy, there hasn’t been any demand over the last 20 years to suck up all of that renewable energy. When Microsoft MSFT and Amazon, Oracle ORCL, and all these companies are looking, where can we get online the fastest and where can we have a lower environmental impact? The Midwest is really coming up and checking all the boxes. So, huge data center growth there and a lot of electricity capacity, so you don’t have to build a bunch of infrastructure. For a mid-cap utility, these projects are so large that all they need is one or two data centers to go from 4% earnings growth to 7% or 8% earnings growth. There’s a scale issue here where all they have to do is win one contract and all of that growth is extended out five, 10, 15 years because of contracts being signed. What fits those buckets, we like right now, Alliant Energy; LNT is the ticker.

Lallos: Which is in Wisconsin.

Miller: They’re based in Wisconsin and Iowa. Those are two service territories. Wisconsin has a very progressive, constructive regulatory environment, has many years of being constructive in its regulatory decisions for utilities, making sure utilities are fairly compensated, making sure affordability is not an issue for customers. And Wisconsin has a couple of very large data center projects going in, especially up the western and eastern sides of Wisconsin where you have a lot of electricity capacity available. So, Alliant is one of them.

Iowa also, big data center hub. Like I said before, renewable energy buildout. There hasn’t been a whole lot of electricity demand growth in Iowa, as you can probably imagine, but Iowa’s one of the top renewable energy states in the country. There’s so much wind energy in particular that’s been added in Iowa. There’s a lot of capacity. Data centers can go in there, large data centers can go in there and not have any problems hooking up almost immediately. Alliant is one where you have a lot of confidence looking at up to 8% earnings growth, which is really astounding for a utility. Again, we’ve never seen growth rates like this in utilities. So that’s one.

And then, to stay on the mid-cap Midwest theme, DTE Energy DTE. DTE serves the Detroit metropolitan area. Most of Eastern Michigan, they already have a signed contract, steel going in the grounds for a 1.4-gigawatt data center with Oracle. Put that in perspective, a nuclear plant serves about one gigawatt. This size of a data center is sucking up about one and a half nuclear plants’ worth of electricity just from this one project, which is really astounding in a place like Detroit, Eastern Michigan, where they also haven’t had any kind of demand growth. In fact, energy demand has been shrinking for the last 30 years in the Detroit area.

Recently talked to the CEO there, who’s been with the business for 30-plus years, and asked her, “Have you ever imagined you’d have growth like this in the Detroit area?” She’s like, “No, they’ve been fighting declining electricity demand for many, many, many years.” So, to finally have some electricity demand growth from the Oracle site, and they’ve got a Google site contract that’s going through the regulatory process right now, and they’ve got two more very large data center projects that could be coming along very soon. They’re talking about huge growth in electricity demand. We think that translates into seven-plus percent earnings growth over the next five years.

Lallos: Any companies you’re wary of? I mean, one I’m thinking of is Portland General Electric POR, which I know has been a pick, but also has a lot of regulatory issues or concerns around it, and I think it does not do so well on your regulatory ranking.

Miller: Portland General is an interesting situation. They’ve been benefiting a lot from both data centers and from semiconductor manufacturing. A lot of the tech infrastructure, the second and third layers of tech, have relocated to the Portland area. And what they’re actually seeing is a small-cap utility, a relatively small area of the country. They’re seeing so much demand growth that they can’t keep up with Oregon’s renewable energy standards; it’s kind of a situation where Oregon put in really, really strict, aggressive renewable energy standards five years ago, not knowing that the data centers and semiconductor manufacturers would show up. Portland General’s stuck here, and as a small cap, that’s really hard because they have to both serve all this new demand and reconfigure their generation fleet to meet the environmental regulations in Oregon law.

There’s a lot of debate about how that impacts customer bills. They have to build a lot of renewable energy. They’re a small-cap company. Can they raise the funding at a reasonable cost? Are they able to pass along some of those infrastructure costs to customers, and how much? Regulators have a lot of decision-making to do and it has to happen quickly because they’re seeing electricity demand growth like crazy out there.

Lallos: We’ve been focusing on growth, which is sort of the big headline story for utilities, but there are still many investors who are relying on utilities or wanting to rely on utilities for dividend income who traditionally approach the sector that way. Are these companies still reliably positioned to pay and increase dividends even as they’re focusing on growth?

Miller: Yeah, no, it’s a great point. Great question. That’s something we’ve been exploring with every single utility is top of mind. Our take is you’re safe with dividends. If you’re getting your dividend now, you’re going to keep getting your dividend. We don’t see any risk of cuts across the sector; no risk of cuts. The growth rate is the issue. If you’re counting on dividend income to keep up with inflation, to mirror what you would get in the fixed income product, that’s where we have some concerns potentially. The big deal with utilities, they have to find some way to fund all of this growth, all of the capital they’re putting on the ground. They can issue bonds; they can issue stock.

One of the other ways they can fund this is to take all of their cash flow that they had been putting into the dividend and reinvest it in all of this infrastructure to grow earnings. It doesn’t grow the dividend, but it grows earnings. There’s a trade-off here that utilities are facing, management teams are facing. Should they grow their dividends 3%, 4%, 5%, or should they grow their dividend maybe 1% and not have to issue stocks, thus earnings per share go up faster? I think investors who are counting on the dividend income can still count on the dividend income. I don’t think it’s going anywhere. And I do think it’s going to grow at least at inflation level. But for those utilities that are investing huge amounts of capital relative to their size, the payout ratios could come down, and the dividend growth might not be quite as much as you’ve seen over the last 10 to 15 years.

Lallos: Would it be safe to say that the larger-cap names are going to be more reliable on that dividend growth here for that reason?

Miller: Yeah, it’s a scale issue. The large-cap companies are able to digest, so to speak, these data centers and have a lot of the infrastructure already in place. That takes some of the cash flow concerns off of that and allows them to maintain slightly higher payout ratios. That said, we just had American Electric Power AEP, one of the largest utilities in the US, come out and say they’re going to invest $100 billion over the next five years. We’ve never had anything like that in the utility sector. If you thought large cap was the place to go for your consistent, reliable dividend growth, again, the dividend is safe; no concerns about the dividend. AEP is well positioned, strong balance sheet. They’re going to have to fund $100 billion over the next five years. That is not a small number. Even the large-cap companies are having capital investment programs that have blown away some of the numbers before, just on a macro level and sector level.

In US utilities, we’re investing somewhere between $200 billion and $250 billion as a group and that adjusts for some sizes and stuff. It’s going to be double that across the sector. Capital investment’s going to double across the entire sector in the next five years. Again, utilities have to fund that some way. Issuing equity, issuing bonds, there’s a certain cap to that. There’s only so much equity in bonds the market will digest. Payout ratios, slowing dividend growth, is another way they can fund that investment.

Lallos: With all of these issues and variables in mind, an investor today approaching the sector, what should be top of mind? What should they be looking at?

Miller: Yeah, beat a dead horse here, but growth is the number one thing we’re looking at. And growth in the context of what does it mean for customer bills? Because at the end of the day, utilities have to pass through all of these costs. One key thing that we’re seeing develop, and a reason why affordability is going to change across states and different jurisdictions, is this idea of data centers paying their way, or another phrase is bring your own power. If a data center shows up, they’re paying for 100% of the infrastructure cost to build all the wires, to build the transmission, to build all the power plants that might be needed. That way, and some companies, some utilities have talked about it, not only do they pay their own way, but to the extent that they use the existing system, it makes it cost-efficient for residential and small commercial customers.

We’ve got several utilities that are saying, not only are we going to keep your bills flat, not only are data centers going to pay their own way, they’re also going to give money back. We’ve had several utilities saying you will get bill credits as soon as these data centers ramp up because they’re using the grid that hasn’t been fully utilized in the past. At another example down in Louisiana with Entergy ETR, a big Meta facility, they’re actually giving schoolteachers raises because the data centers are coming in with so much money, they’re paying their own way, and they still have money left over that they’re supporting the communities.

Lallos: So, a positive spin on the data center coming to your community that I hadn’t considered. That’s interesting. Anything else you feel it’s important to say, or have we sort of wrapped it up?

Miller: Again, I think the reason why we’re here talking, the reason why utilities are getting watched, is the fact that this spread has really expanded between what people usually consider a safe, reliable income source in equities, utilities dividend yield, and interest rates. Typically there’s a one-for-one. Interest rates go up, utilities dividend yields go up, dividend yields go up, stocks go down. There’s been, historically, this relationship. This time it’s different.

Lallos: On the record, this time is different.

Miller: Interest rates have gone from 3% to 5% and utilities have rallied all this time. So, dividend yields have gone down, and now we’re at a place where we have not seen this spread between utilities, dividend yields low and interest rates high. The big dynamic there, the big question is, does growth show up for utilities this time?

Lallos: Terrific. Thank you so much for sharing your insight, Travis. Appreciate you being here.

Miller: Thanks for having me.

Lallos: That wraps up this week’s episode. Thanks for making the show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you and subscribe to Morningstar’s YouTube channel to watch new videos from our team. Thank you to senior video producer Jake Vankersen and associate multimedia editor Jess Bebel. I’m Laura Lallos, managing editor at Morningstar.