Utility stocks still make sense

  • By Lawrence C. Strauss,
  • Barron's
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Investors took shelter in utility stocks during the past few days of market declines, underscoring the sector’s time-honored role as a haven during times of duress.

The Utilities Select Sector SPDR fund (XLU) gained 1% on Thursday and was flat on Friday, outpacing broader market indexes that fell sharply amid a flare-up in trade tensions and the Federal Reserve’s first interest-rate cut since 2008.

The outperformance of defensive sectors such as utilities following a rate cut, says Wayne Wicker, chief investment officer of Vantagepoint Investment Advisers, probably reflects a flight to stocks that benefit from lower rates while investors assess the state of global growth.

But utilities have gotten more expensive in recent months, amid signs of a global slowdown and intensifying geopolitical tensions. The utilities SPDR, a good proxy for large U.S. utility stocks, trades at 18.8 times its expected earnings over the next 12 months. That’s well above its five-year average of about 17 times, according to FactSet.

Still, Wicker thinks that lower-volatility sectors such as utilities and other higher-yielding securities should continue to work well this summer, despite lofty valuations. Bobby Edemeka, portfolio co-manager of the $3.3 billion PGIM Jennison Utility fund (PRUAX), concurs: “The investing backdrop for utilities remains attractive, but with higher valuations it does pay to be more selective.”

Where to turn?

Stephen Byrd, a Morgan Stanley utilities analyst, thinks that the dividends of regulated utilities are attractive, compared with BAA-rated corporate bonds, whose yields were recently about 1.6 percentage points above those of regulated utilities, on average. That yield spread is about a full point lower than the average of 2.5 points dating to 1985.

Throw in reliable earnings growth around 5%, or a little higher in some cases, he says, and it’s not a bad place to play defense—the higher valuations notwithstanding.

Edemeka favors electric utilities, especially ones that are in regulated businesses—for instance, a power company whose rates are approved by a regulatory entity. In particular, he likes companies that have eliminated or scaled back their businesses that involve selling power on the open market; these so-called merchant-power businesses can be much more volatile than regulated ones. Investors generally pay higher price-earnings multiples for the regulated utility businesses than for the merchant-power operations.

One of his holdings is Dominion Energy (D), whose operations include the regulated utility Virginia Power, as well as unregulated units. Its various businesses include generating, transmitting and distributing electricity in Virginia and elsewhere, and it has big natural-gas infrastructure holdings. For example, it operates one of the country’s largest underground natural-gas storage systems.

The company increased its regulated utility earnings, in part, by merging with Scana, whose assets include South Carolina Electric & Gas, in January. “They have refocused on more-predictable earnings streams,” says Edemeka.

Edemeka estimates that Dominion can boost its percentage of earnings from regulated utility operations and contracts for gas infrastructure to 95% in 2022, up from 85% in 2017.

The stock, at $76 and trading around 17 times next year’s consensus profit estimate, is cheaper than some of its peers and below its five-year average of 18.2 times, according to FactSet. It yields 4.8%.

A question mark is Dominion’s attempt, along with two other utilities, to complete the 600-mile Atlantic Coast Pipeline through West Virginia, Virginia, and North Carolina. The natural-gas pipeline faces environmental concerns and legal challenges, among other hurdles. Hoping to reverse a ruling by the U.S. Court of Appeals for the Fourth Circuit in Richmond, Va., the project’s developers are asking the Supreme Court to reinstate permits to allow it to traverse the Appalachian Trail.

“If they acquire the necessary permits and finish the pipeline, that should be an earnings and cash-flow stream that is very predictable,” Edemeka says.

Another of his holdings is Exelon (EXC), a Chicago-based company that generates, transmits, and distributes power in various markets. Besides Chicago, its local service areas include Baltimore, Philadelphia, and Delaware. About half of its revenue comes from regulated businesses.

The company’s stock, trading around $44, is cheaper than many of its peers’. It fetches a little less than 15 times the $3.07 a share it’s expected to earn next year, below the average of 18.4 times for large utility stocks in the S&P 500 index (.SPX).

Exelon, Edemeka says, “over the past several years has significantly grown its regulated earnings base,” partly through acquisitions, and has made “significant organic investment in its distribution network.” Having a higher rate base, which for a utility is the value of the property on which it can earn a return, helps revenue and profit growth. “Strong capital spending will likely continue to help utilities drive base-rate growth for the next few years,” says Christopher Muir, a utilities analyst at CFRA Research.

The Fed may have helped on this front with its quarter-point rate cut this past week. This could translate into lower borrowing costs for utilities, which tend to carry big debt loads.

Edemeka expects Exelon’s regulated utility profits to grow 6% to 8% a year and to account for more than 70% of its earnings per share by 2022, up from 55% in 2018. He believes that the company can narrow the valuation gap to its peers as its regulated business grows.

Exelon is the largest U.S. operator of nuclear plants, a segment of the power industry that carries high overhead and safety risks for operators. But Exelon is being helped in some states by zero-emission credits that are helping to stabilize revenues from the nuclear assets.

“The market has not yet given full credit for the derisking of their overall business,” says Edemeka. If that does occur, the stock could appreciate at least 15%, and a dividend yield of 3.3% is a nice sweetener in the meantime.

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