For dividend safety, try regulated utilities like American Electric Power or First Energy

  • By Lawrence C. Strauss,
  • Barron's
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One of the most appealing things about utilities , besides their reliable dividend income, is that many have operations that are entirely or largely regulated.

While a regulated business is a negative factor in many sectors, for utilities it essentially means that a government will allow a reasonable return on their investments. For income-hungry investors, this brings some coveted certainty.

Utilities already have shown their mettle during the coronavirus-driven selloff since February. The Utilities Select Sector SPDR exchange-traded fund (XLU) is down about 12% since the S&P 500 (.SPX) peaked on Feb. 19, compared with an 18% plunge for the broader market. The ETF’s recent yield was about 3.2%, versus nearly 2.2% for the S&P 500.

While some observers say utility valuations had gotten stretched before the selloff, the relative outperformance in recent weeks should continue, barring a lengthy recession or worse.

“These companies are better positioned to withstand the upcoming economic slowdown than they’ve been in the last 20-25 years,” says Bobby Edemeka, a portfolio manager of the PGIM Jennison Utility fund (PRUAX).

Still, utilities, known for heavy debt loads and big capital spending needs, face head winds as the economy grinds to a near-standstill during the coronavirus fight. Among the concerns: legions of unemployed customers not paying their monthly utility bills; falling commercial and industrial electricity use; potential disruptions to supply chains; and the specter of interruptions of important utility construction projects.

Any of those factors could easily pressure profits in the short run. “But we don’t see a long-term issue in terms of their earnings power,” says Stephen Byrd, a Morgan Stanley utility analyst.

By and large, regulated utilities remain solid and should weather this crisis with dividends largely intact, several longtime industry observers tell Barron’s. “I would be shocked if we see any utility that is truly regulated cut their dividend,” says David Giroux, the longtime portfolio manager of the T. Rowe Price Capital Appreciation fund (PRWCX).

The latest consensus 2020 FactSet earnings estimate for the Utilities Select Sector SPDR is $3.23 a share, down slightly from $3.26 at the end of February. That compares with $3.18 last year. “Earnings power for the market is going to be dramatically less than we thought in ’21, ’22 , and ’23, but that earnings power in the intermediate term has not changed at all for regulated utilities,” Giroux adds.

One of the fund’s holdings is American Electric Power (AEP), an Ohio-based company that primarily operates regulated utilities.

The stock’s yield was recently 3.2%, and last year its payout ratio—the percentage of earnings handed out in dividends—was about 64%, pretty standard for the industry. “That, we think, is very sustainable,” Byrd observes. “We don’t see any reason why they couldn’t keep that going.”

A payout ratio in that range would allow a utility such as American Electric to maintain its dividend even if earnings fall a little—though the analysts Barron’s spoke to aren’t bracing for a big drop across the industry. These companies traditionally don’t buy back much stock, if any, preferring to pay a dividend and invest in their businesses.

For its part, American Electric said in a recent filing that the pandemic’s “ultimate impact also depends on factors beyond our knowledge or control, including the duration and severity of this outbreak.

A key part of utilities’ evolution into more durable enterprises, Edemeka says, is that many have jettisoned volatile operations, such as merchant power—producing electricity to sell to other utilities—which is subject to the vagaries of spot market prices.

FirstEnergy (FE), for instance, exited its troubled merchant-power business to help it focus on regulated operations. The stock yields 3.5%.

That company looks like it’s fortified to withstand the pandemic and its economic fallout. First Energy’s businesses include regulated electricity distribution operations in its home state of Ohio, and in Pennsylvania, New Jersey, Maryland, and West Virginia. Consider also that roughly two-thirds of its customers are residential. In a recent filing, FirstEnergy said its “operations are well positioned to manage [an] economic slowdown.”

“Utilities in general make a lot more money on residential sales than they do on commercial sales,” says Byrd. Commercial sales also stand to be hit harder than residential sales as businesses are shut and more people are working from home.

First Energy also outlined the sensitivity of its earnings to changes in electricity loads. Every 1% change in residential electricity sales, up or down, impacts earnings by 2 cents a share, versus 0.005 for industrial customers.

Another plus for First Energy is that its rate structure in Ohio is decoupled. Decoupling, which is pretty widespread these days in an effort to encourage energy conservation, severs the connection between how much energy a utility sells and the revenue it receives.

Morgan Stanley expects overall power demand to fall 5% this year, with commercial volume dropping 10% and industrial by 6%—partially offset by a 2% increase in residential volume.

Not every dividend in the industry has been safe, however. An exception is CenterPoint Energy (CNP), a Houston-based utility that announced on April 1 that it was slashing its dividend to weather the coronavirus crisis.

Charles Fishman, a Morningstar utility analyst, says that company’s “exposure is somewhat unique” due to its majority stake in Enable Midstream Partners (ENBL), a master limited partnership that also cut its payout. CenterPoint’s stock is down 32% since the market peaked, one of the worst performers in the industry.

Another company that looks well-bulwarked is Dominion Energy (D), based in Richmond, Va. Its gas infrastructure is “defensively positioned,” says Edemeka, adding that “80% of revenues come from end users such as gas utilities which are reserving capacity on their pipelines, rather than the gas producers.” Dominion, which yields 4.6%, is down only about 6% since the S&P 500 set its record, making it one of the group’s strongest performers.

Dominion also operates regulated electric utilities with a healthy mix of residential customers in Virginia and South Carolina, among other assets.

One company that doesn’t fit the mold of a regulated utility but that could be a good bet is Florida-based NextEra Energy (NEE). While its holdings include Florida Power & Light, a regulated utility in a fast-growing state, its less-regulated energy-renewables business is helping to drive growth. That renewables operation, which includes solar and wind power, looks pretty sound. For example, Byrd says, NextEra’s “wind farms have 20-year contracts.”

The stock yields 2.3%, a nice rate considering that the 10-year U.S. Treasury was recently at 0.73%.

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