Are Utilities Cheap?

9/24/2012


Because of their high yields, utility stocks receive special treatment from investors.

They tend to have modest profit growth and high debt levels, while their operating results can depend greatly on the weather. At first blush, such characteristics would seem to earn the stocks only a modest valuation and limit their investment appeal. The yields keep the stocks in demand, but historically utilities have indeed traded at a discount to other stocks.

WHERE'S THE VALUE?
Below we present valuation statistics for utilities in the S&P 1500 Index. Overall, we find the best values in electric and diversified utilities, and in large-cap stocks. All seven of the valuation ratios presented below have substantial predictive power for utility stocks. In rolling 12-month periods since 1994, the top one-fifth of utilities as measured by these seven ratios outperformed the average utility by an average of at least 2.2%.
--------------- Key Valuation Ratios ---------------
Quadrix Scores
Grouping (No. Of Stocks)
Div.
Yield
(%)
P/E
Ratio
P/E On
Next-
Yr. Est.
Price/
Sales
Price/
Book
Ent.
Value/
EBITDA
PEG
Value
Overall
Industry
Electric (25)
4.1
15
14
1.5
1.5
9.5
4.5
54
45
Diversified (21)
4.2
16
15
1.3
1.6
8.7
4.7
52
40
Energy/Utility
Hybrids (3)
2.6
23
20
3.7
2.6
9.2
3.4
37
34
Natural Gas (11)
3.6
18
16
1.2
2.0
10.4
4.8
45
37
Power (2)
1.6
40
20
0.5
1.0
7.9
NM
69
46
Water (2)
3.1
21
19
3.2
2.3
10.3
6.1
41
70
12-Mo. Profit Growth
Above 8% (17)
3.9
16
16
1.6
1.8
9.0
5.3
57
56
Flat to up 8% (17)
3.8
15
15
1.5
1.7
8.9
4.4
51
42
Below 0% (29)
4.0
17
15
1.5
1.6
9.8
4.4
48
34
Stock-Market Value
Above $10
billion (17)
4.3
14
14
1.6
1.6
9.5
3.9
54
39
$5 billion to
$10 billion (11)
3.3
18
16
1.6
2.0
8.7
4.4
48
44
$2 billion to
$5 billion (22)
3.8
19
16
1.5
1.6
9.1
5.1
51
43
Below $2
billion (14)
3.8
17
16
1.3
1.7
9.9
5.1
49
42
All S&P 1500
Utilities (64)
3.9
17
16
1.5
1.7
9.3
4.6
51
42
Notes: Quadrix scores are percentile ranks, with 100 the best.  Averages exclude P/E ratios below 0 and above 75.     NM Not meaningful.

Over the last decade, utilities in the S&P 1500 Index averaged Quadrix Value scores of 68, suggesting that the average utility was cheaper than roughly two-thirds of the stocks in our research universe.

Today, however, utilities average unimpressive Value scores of 51.

Which brings us back to the headline of this story. Are utilities cheap? It's tempting to look at the Value score and answer "no." But let's be thorough and look at the sector from three angles.

Versus history

The average utility in the S&P 1500 Index averages a price/earnings ratio of 17.2, topping the 10-year average of 16.4 by 5%. The sector has averaged a P/E ratio as high as 17.2 in only one-third of the monthly periods since the end of 1994.

We can't blame these numbers on a few outliers, either; the whole sector has become more expensive. Just 17% of S&P 1500 utilities have P/E ratios below 14, versus 29% one year ago and 63% three years ago. We see similar trends at other P/E cutoffs, including 16 and 18. There are simply fewer cheap utilities these days.

On average, utilities also yield slightly less than they once did (3.9% now, versus an average of 4.0% over the last five years and 4.2% since 1994). Dividend yield is a component of our Value score and can be a proxy for valuation.

Conclusion: Utilities look expensive relative to their history. At 17.2 times trailing earnings, the average utility trades above the five-year average of 15.8 and the average of 16.6 since 1994. In contrast, the average S&P 1500 stock trades at 19.4 times trailing earnings, below the five-year average of 21.4 and the average of 20.9 since 1994.

Versus other stocks

The average utility trades at an 11% discount to the average S&P 1500 stock based on P/E ratio. Since the end of 1994, utility stocks have averaged a 22% discount to the broad index. Ten years ago, the average utility stock's price/earnings ratio of 15.9 was 29% below the index average and 15% below the average for any other sector. But today, four sectors average P/E ratios less than 10% above that of the average utility.

Quadrix Value scores can help illustrate utility stocks' shrinking discounts. Since 1994, utility stocks have averaged Value scores of 71, well above the 57 of the broad index and the 63 of the sector with the second-highest score — materials. Today, utility stocks average Value scores of 51, versus 54 for the broader index, and only three sectors average lower scores.

Conclusion: Relative to other stocks, utilities look more expensive than they have in past years. However, investors seeking yield might not look at technology or health-care stocks as an alternative to utilities.

Versus bonds

Utility stocks compete with bonds for the money of income-oriented investors. To value stocks relative to bonds, we can compare the spread between bond yields and the stocks' earnings and dividend yields. The earnings yield, or E/P ratio, measures profits as a percentage of the stock price.

The average utility stock's earnings yield is 4.0% higher than the yield of the 10-year Treasury bond, a spread higher than 92% of the last 213 months. The earnings yield tops the yield of the average Baa-rated corporate bond by 0.8%; the spread has been that wide in only nine of the monthly periods since 1994. In fact, since 1994 utility earnings yields have averaged 0.9% below the corporate-bond yield.

Conclusion: Utilities look very cheap relative to bonds.

The verdict

It's tough to call utilities great values, but given their appeal relative to bonds, the shares should attract investors as long as bond yields remain unusually low. Will they lead the market over the next year? Probably not. But we also don't expect a drastic repricing of utility stocks any time soon.

Notably, the sector does contain some pockets of value.

Based on P/E ratios, the cheapest groups within the sector are the electric and diversified industries, and utilities with stock-market values above $10 billion — all of which are either electric or diversified. The above groups also earn higher-than-average Value scores and look attractive based on other valuation ratios. Independent power producers also look cheap, but they face serious headwinds, and we're staying away from them.

By at least one measure, growth is cheap in the utility sector. While we expected high-growth utilities (profit growth of at least 8% over the last year) to earn superior Overall scores, their Value score of 57 was a surprise.

We aren't issuing a blanket buy on utilities, but investors seeking utility exposure should consider our Top 15 Utilities portfolio, shown below. For more information on that portfolio, visit www.DowTheory.com/Go/Top15. We tend to favor utilities with above-average growth, and 80% of our stocks are in the electric or diversified groups — the best place to find values.

This week, we are removing two stocks from the Top 15 Utilities Portfolio and adding two more. Laclede Group ($42; LG) and Sempra Energy ($65; SRE) are out and NV Energy ($18; NVE) and Sunoco Logistics Partners ($49; SXL) are in. See Portfolio Review for the rationale behind the moves.

TOP 15 UTILITIES
---- Quadrix Scores * ----
Company (price; Ticker)
Value
Overall
Amer. Electric ($44; AEP)
60
49
Amer. States Wtr. ($44; AWR)
53
85
Cleco ($41; CNL)
43
42
CMS Energy ($23; CMS)
52
45
Entergy ($68; ETR)
78
44
NextEra Energy ($67; NEE)
54
56
NV Energy ($18; NVE)
53
58
OGE Energy ($55; OGE)
52
45
Plains All Amer. ($91; PAA)
53
62
PNM Resources ($20; PNM)
72
81
PPL ($29; PPL)
82
75
Public Svc. Ent. ($31; PEG)
73
49
Sunoco Logistics ($49; SXL)
54
95
Westar Energy ($29; WR)
58
59
Wisconsin Ene. ($37; WEC)
42
57
Portfolio Average
59
60
Sector Average
51
42
* Percent rank, with 100 the best.

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