Utility Dividend Leaders and Laggards

Despite the headwinds posed by COVID-19, utilities continue to have strong growth prospects, healthy financials, and growing dividends. With many utilities trading slightly below our fair value estimates, investors have a rare opportunity for long-term capital gains and 5%-plus dividend growth. With the spread between utilities’ dividend yields and the 10-year U.S. Treasury yield near historic highs, utilities’ income characteristics have rarely looked better.

Utilities With Dividend Growth and Strong Financials We think these utilities have the best dividend growth opportunities, boosted by low payout ratios, robust capital investment opportunities, and constructive regulatory environments.

NextEra Energy NEE | 2 Stars | Dividend Growth: 11.5% | Dividend Payout: 62.4% We forecast that NextEra Energy can increase its dividend 11.5% annually over the next five years, well above its peer group average and the highest in our coverage. Additionally, its 62% payout ratio--lower than peers' 67% average --gives NextEra greater flexibility to increase its dividend as cash flows grow. Constructive rate regulation in its service territories and long-term renewable energy contracts at NextEra Resources provide additional dividend support.

American Water Works AWK | 1 Star | Dividend Growth: 10.0% | Dividend Payout: 55.8% American Water Works has begun accelerating its dividend growth with annual increases averaging over 10% during the past seven years. We expect 10% annual dividend growth to continue for the next five years. The company's 56% payout ratio based on adjusted 2020 earnings is low for the sector, so we believe there is room to increase the dividend modestly faster than earnings growth.

Sempra Energy SRE | 3 Stars | Dividend Growth: 9.4% | Dividend Payout: 59.6% Sempra has derisked its portfolio, focusing on regulated distribution and transmission utilities that are the keys to its healthy capital investment plan. This portfolio pivot, its lower-than-average payout ratio, and cash flows from the contracted Cameron LNG trains 1-3 should allow Sempra to increase its dividend over 9.0% annually during the next five years, exceeding our 6.3% annualized earnings growth forecast for that same period.

Atmos Energy ATO | 3 Stars | Dividend Growth: 8.2% | Dividend Payout: 49.1% Management has targeted a conservative 50% dividend payout ratio. With our 7.5% earnings growth estimate, we believe Atmos' annual dividend growth could top management's 6%-8% target during the next five years. Atmos enjoys constructive regulation at all of its subsidiaries.

High-Yield Undervalued Utilities These utilities offer investors an opportunity for capital appreciation and yield well above the peer group.

Edison International EIX | 4 Stars | P/FV: 0.78 | Dividend Yield: 4.7% California political risk will always be a concern for Edison. However, California's progressive energy policies also create more growth opportunities than most other U.S. utilities have. Edison's electric-only business, recent regulatory success, and $5 billion annual investment plan give us confidence that the company can increase earnings 6% annually beyond 2020. Edison has stakeholder support to harden the grid against natural disasters, integrate renewable energy, and support electric vehicle adoption. Now with the stock trading at a sizable discount to its peers and a nearly 5% yield, Edison offers a triple play of value, growth, and income.

Duke Energy DUK | 4 Stars | P/FV: 0.92 | Dividend Yield: 4.6% We think Duke Energy's valuation discount to peers is unjustified, given the company's favorable regulation and investment opportunities that support consistent earnings and dividend growth. Florida remains one of the most constructive regulatory jurisdictions, with sector-leading allowed returns on equity, automatic rate base adjustments, and strong growth investment potential. North Carolina continues to support Duke's growth investments in electric and gas transmission and distribution infrastructure. South Carolina's recent rate-setting decision was disappointing, but we think Duke has enough growth in the state to compensate. With the Atlantic Pipeline Coast pipeline canceled, management can now focus on executing its sizable regulated growth opportunities.

Southern SO | 4 Stars | P/FV: 0.91 | Dividend Yield: 4.7% Southern is undergoing one of the most dramatic transformations in the usually stodgy world of regulated utilities. In 2000, almost 80% of electricity sold to customers was generated using coal. We estimate it will be less than 20% by 2030, and the company recently announced a goal of low- and no-carbon generation by 2050 that will probably require the closure of the remaining coal plants. Nuclear, natural gas, and renewable energy are all increasing their share of generation. Southern has been providing investors with annual dividend increases of 3%-3.5% for the past 10 years, and we expect increases to continue at about this rate. The payout ratio on adjusted earnings for 2021 is estimated to be about 78%; we expect it to decline to the low 70s over the next five years following the completion of Vogtle.

Slow-Dividend-Growth Utilities On the opposite end of the spectrum are those utilities we think will struggle to increase their dividends.

• Hawaiian Electric investors HE likely won't receive a dividend increase in 2021, and we project average annual increases of roughly 3% over 2022-24.
• The economic impact of COVID-19 across Consolidated Edison's ED New York City service territory is likely to reduce annual increases to only 1%-3% over the next five years.
• PPL's PPL U.K. headwinds will create dividend uncertainty, resulting in no growth for several years in our five-year forecast.
• Finally, PG&E PCG suspended its common dividend in late 2017, and it won't come back for at least another three years based on regulatory requirements in its bankruptcy exit plan.

Valuation Metrics Highlight Industry Sell-Off The U.S. utilities sector is 2% undervalued based on our fair value estimates and market prices as of early August. All conventional utility valuation metrics using earnings, book value, and dividend yield have come down from the record peaks reached earlier this year. Price/earnings multiples, price/book multiples, and dividend yields now are more in line with historical levels for the regulated utilities we cover.

The combination of still-falling interest rates and rising dividend yields has caused a historically high yield premium for utilities. In early July, the spread between the 0.65% 10-year U.S. Treasury yield and utilities’ 3.5% trailing dividend yield nearly matched the sector’s mid-2012 record spread, when 10-year U.S. Treasury yields hit 1.5% and utilities’ dividend yield was 4.2%. In 2012, utilities gained 17% while U.S. Treasury prices fell 14% during the 18 months following the peak spread. On average during the last 30 years, utilities’ three-year annualized returns have topped Treasury bond returns by 10 percentage points when utilities’ dividend yield premiums were at least 150 basis points.

Utility Dividends Supported by Strong Growth Prospects Utilities' investment opportunities in aging infrastructure, including distribution, transmission, and renewable energy are driving earnings and dividend growth. The industry shows no signs of slowing.

In 2019, utilities we cover spent $120.8 billion on capital investment, well above the five-year inflation-adjusted average of $113.6 billion. We expect utilities to spend $130.3 billion in 2020 and $135.0 billion in 2021. The increase from 2020 to 2021 reflects our assumptions that COVID-19 supply chain disruptions and social distancing requirements will cause utilities to shift some capital investment planned for 2020 into 2021. Our 2020 capital forecast is in line with consensus estimates, but our 2021 capital forecast remains 7% above consensus estimates.

Utilities’ investment plans typically drive earnings growth, assuming consistent and constructive regulation. Earnings growth then typically drives dividend growth, adjusting for funding needs for maintenance and growth capital investments. We think the top utilities that combine growth investment with constructive regulation will support the highest dividend growth. On average, we expect utilities to increase dividends 5% through our five year-outlook, in line with sector earnings growth.

Utilities' Strong Financials Support Dividends Most utilities have reaffirmed their 2020 earnings outlooks, which we view as attainable, or at worst slightly lowered their guidance ranges, aided by strength in higher-margin residential electricity demand and the acceleration of cost efficiencies. American Electric Power's AEP $100 million and Duke Energy's $450 million targeted efficiency plans are just two examples of the aggressive measures that utilities are taking to ensure they meet 2020 earnings targets.

Our earnings outlook for 2020 is based on Morningstar's expectation for U.S. GDP to fall 5.1% in 2020, offset by utilities' mitigation measures and strong residential demand. Our macroeconomic forecast expects robust catch-up growth following 2020. This supports our long-term earnings and dividend growth forecast. By 2024, we think that U.S. GDP growth will recover to just 1% below our pre-COVID-19 expectation.

With greater clarity around long-term growth, we can now assess utility dividend security. Overall, we think utility financials support dividends across the sector. We expect management teams will use all available mitigation efforts to ensure they protect the dividend. We used three metrics to assess dividend security.

Dividend payout. The average utility dividend payout ratio (dividend per share/earnings per share) was 67% as of mid-2020. For regulated utilities, we consider a payout ratio higher than 80% indicative of a possible dividend cut if the utility has little capital or financial flexibility.

Capital flexibility. The higher the ratio of capital expenditures to depreciation, the easier it will be for utilities to sustain and increase their dividends. Traditional rate-making ensures utilities have plenty of cash to invest at depreciation levels to maintain the system while paying out a robust and healthy dividend. But as capital expenditures climb higher than depreciation, utilities must pull back on the amount of cash they pay out through the dividend. Utilities have been investing capital at historically high levels across the value chain. Utilities with large growth investment plans will have to retain more earnings, raise new equity, and raise new debt to keep their capital structures in line with regulatory requirements. All of this puts pressure on dividends. Utilities with smaller or more flexible growth plans should have an easier time covering the dividend. The average utility is planning to spend nearly 2.4 times depreciation. We think most utilities can maintain this spending level and a healthy, growing dividend as long as macroeconomic conditions don't worsen beyond our forecast.

Financial flexibility. We think most investment-grade utilities must keep leverage below 6 times EBITDA to maintain a healthy dividend. The current average 4.9 times net debt/EBITDA across our utilities coverage universe suggests most utilities have plenty of financial flexibility to maintain investment-grade credit ratings and continue paying their current dividend even if macroeconomic conditions worsen beyond our forecast. Most utilities were able to raise substantial amounts of debt at attractive rates even when markets tightened in March due to coronavirus concerns.

At first glance, a handful of utilities do not screen as well as their peers, making their dividends more at risk. However, we still view dividend cuts as unlikely, even for this group.

Avangrid’s AGR management execution missteps have resulted in lower expected earnings and a higher dividend payout ratio. Avangrid’s 81.5% majority ownership by European utility Iberdrola leaves it most susceptible to a dividend cut, in our opinion, given European utilities’ more flexible approach to dividend policy. However, Avangrid’s low leverage--a legacy of its spin-off from Iberdrola in 2015--does provide the company with ample financial flexibility should it chose to use it. We expect 3% average annual dividend growth over the next five years. This is below our earnings growth rate, bringing the dividend payout ratio down and in line with its peers by 2024.

Emera’s EMA leverage remains elevated after the acquisition of Florida utility TECO. To help pay down debt, the company smartly divested its no-moat merchant generation unit and its less attractive regulated business in Maine. Dividend growth will lag earnings growth, allowing its dividend payout ratio to decline to a more reasonable peer average. With steps in place to increase financial flexibility, Emera also has capital flexibility. It is investing significant growth capital in Florida, which we believe management could dial back or delay to mitigate any need to reduce the dividend.

Southern has long been a consistent dividend growth machine, providing investors with annual dividend increases of about 3.5% for the past 10 years. We estimate its dividend payout ratio on 2020 adjusted earnings will be near 85%, making it difficult for the company to continue to increase dividends in line with our earnings growth projections. Although its payout ratio is higher than the sector average, Southern’s earnings power is spread over several jurisdictions, and the company enjoys capital and financial flexibility. The completion of Georgia Power’s Vogtle nuclear plant is also key to dividend security. We expect Southern’s payout ratio to fall into the mid-70s over the next five years as earnings growth outpaces dividend growth following the completion of Vogtle.

CenterPoint and Dominion Dividend Cuts Not a Harbinger for U.S. Utilities On April 1, CenterPoint Energy CNP cut its dividend to an annual rate of $0.60 per share from $1.16 following the announcement by 53.7%-owned Enable Midstream Partners that it would reduce its common unit distribution by 50%. Enable's distribution cut will reduce cash flow to CenterPoint by approximately $155 million on an annual basis.

Other factors contributed to the dividend cut, further supporting our view that the CenterPoint situation is not indicative of dividend security across the sector. On March 5, we lowered our 2020 EPS estimate to $1.40 from $1.59 due primarily to a regulatory ruling at Houston Electric that had a bigger negative impact than we anticipated. A $1.4 billion equity infusion from investment firms allayed the need for CenterPoint to issue sharply discounted equity. Additionally, CenterPoint’s 2019 Vectren acquisition has been more dilutive than management expected.

Dominion Energy’s D dividend cut was related to two factors that we believe were unique to the company: the sale of most assets in its gas transmission and storage segment and abandoning development of the Atlantic Coast Pipeline. The GT&S assets, excluding a 50% interest in Cove Point and investments in renewable natural gas projects, are planned to be sold to Berkshire Hathaway Energy for a total consideration of $9.7 billion, including the assumption of $5.7 billion of debt.

Dominion plans to cut its dividend to an annualized rate of $2.50 per share beginning in the fourth quarter due to the loss of earnings from GT&S and ACP. The new dividend represents a payout ratio of 64% on our 2021 EPS estimate. Dominion’s 88% pre-dividend-cut payout ratio had been a material concern for investors, and the payout is now in line with regulated utility peers.