Where Are The Good Utilities?
If you purchased the S&P 1500 Utility Sector Index at the end of 2006 and held it, you'd be down 3%. Factor in the index's dividend yield, and you're looking at a 19% total return, an annualized 3.5%. But that doesn't tell the whole story.
Suppose you had purchased the S&P 1500 Electric Utilities Index, which contains all the electric utilities in the broader sector index and accounts for about 50% of the utility sector's stock-market value. You'd have earned an annualized return of 2.6%. In contrast, the industry indexes featuring diversified utilities (5.7%) and natural-gas utilities (7.2%) delivered superior annualized total returns, while the water-utilities index generated annualized returns of just 2.1%.
Five years ago, our Quadrix stock-rating system favored power generators and natural-gas utilities and did not like water utilities. Today, Quadrix tells a different story, as shown in the table below.
The S&P 1500 Index includes only two water utilities, suggesting we can't read too much into the industry average. For the seven water utilities in our broader Utility Update, mediocre Quadrix scores and unattractive valuations are the norm. In December, our Top 15 Utilities portfolio added its first water utility, the reasonably priced American States Water ($37; AWR), which earns an Overall score of 78, second-highest in the sector.
While every S&P 1500 industry group other than water utilities averages Quadrix Overall scores below 42, electric utilities earn above-average ranks in our sector-specific scores that compare utilities only to other utilities. At the moment, the Top 15 Utilities portfolio contains six electric utilities.
Utilities as a sector don't look cheap, averaging a price/earnings ratio of 16 and a 2% premium to their three-year average P/E ratios. Electric and diversified utilities average lower P/E ratios than other utility stocks. On the yield front, electric and diversified utilities lead the pack, though the electrics average three-year annualized dividend growth of just 2%, versus 5% for the sector as a whole.
So where is the sweet spot in utilities? There really isn't one, other than to avoid independent power generators, which we have done. Gas utilities also look somewhat weak, pricier than the average utility and with subpar Quadrix scores. We find few appealing gas utilities, and the Top 15 Utilities portfolio contains only one, Laclede Group ($39; LG).
With no part of the utility sector demonstrably superior to the rest, our strategy of diversification within the sector makes sense. Check out our Top 15 Utilities portfolio. Stocks in this portfolio tend to earn higher Quadrix scores and carry lower price/earnings ratios than the average utility. This week, we are making a change to the portfolio, with Westar Energy ($27; WR) replacing UniSource Energy ($36; UNS). Below we discuss the rank change, and we also review a high-scoring utility — PPL ($28; PPL).
In the second half of 2011, Westar's operating profits per share jumped 19% on 6% sales growth, unusually strong operating momentum for a utility. While profit growth should slow in coming quarters, the consensus projects gains of 7% this year and 6% next year — again, solid for a utility.
Westar has divested most of its nonregulated businesses in recent quarters. Profit margins and returns on equity and investment are on the rise, reflecting a cleaner post-divestiture expense profile. Westar, the largest electric utility in Kansas, provides service to about 700,000 customers. With low unemployment and an improving industrial climate, Kansas' economy looks healthier than that of the nation as a whole, providing an environment conducive to growth. Westar earns an A (above average) rating in our Utility Update and is being added to our Top 15 Utilities portfolio.
UniSource's per-share operating profits have declined in each of the last four quarters. Profit margins are narrowing, as the combination of rising operating expenses and three years without a rate increase take their toll. The company's profit estimates declined after a disappointing December quarter, and the consensus now projects a 10% decline in 2012 before a 25% increase in 2013. Despite its weakening operational picture, UniSource shares have risen so far this year, a feat managed by just 27% of utility stocks.
UniSource's future depends heavily on a 2013 rate increase the company estimates at 40% to 50%. Unfortunately, such aggressive projections rarely come completely true. UniSource seems at risk of missing the 2013 profit estimate. The stock is being dropped from our Top 15 Utilities portfolio, and its rating in the Utility Update is falling to B (average).
PPL provides electricity to 1.4 million customers in Pennsylvania, 900,000 in Kentucky, and 7.6 million in England. PPL also provides natural-gas service to 320,000 customers in Kentucky, and its plants generate more than 19,000 megawatts of power.
The consensus projects per-share profits will fall 14% this year and rise 5% next year, targets that seem unduly conservative, particularly if an improving economy sparks increased demand for power. At just 10 times trailing earnings, PPL trades at a 34% discount to the median electric utility in the S&P 1500 Index and a 28% discount to its own three-year average P/E ratio. PPL earns an A (above average) rating in our Utility Update and is a component of our Top 15 Utilities portfolio.