Picking The Best Utilities
Many of you have asked why we don't recommend any utility stocks on our buy lists.
It's a fair question, and we'll provide three reasons.
First, utility stocks in the S&P 1500 Index average Quadrix Overall scores of 59, middling among the 10 market sectors. But only 13% of utilities earn scores above 80, the threshold we use to select candidates for new buying. Seven of the 10 sectors boast a higher percentage of top scorers.
In part because there are very few utility stocks that fit our criteria for new buys, we usually advise subscribers to find safety in numbers through our Top 15 Utilities portfolio. Investors should purchase equal-dollar amounts of the 15 stocks listed in the table at the bottom of the page, a strategy that has outperformed the S&P 1500 Utility Sector Index by 48.9 percentage points since the start of 2007.
Second, the average utility company's sales and per-share-profit growth of 6% and 4%, respectively, over the past year are middling among market sectors. The average utility's long-term profit-growth estimate of 6% is by far the lowest.
Third, while utilities look cheap on an absolute basis, the picture changes when you consider valuation relative to likely profit growth. Utilities average Quadrix Value scores of 72 and trailing P/E ratios of 17, both the best among S&P 1500 sectors. But utilities average PEG ratios (P/E on estimated year-ahead earnings divided by the long-term estimated earnings-growth rate) of 3.0, far pricier than the other sectors.
Critics of the PEG ratio point out that because of utilities' high yields, the profit-growth rate understates the stocks' total-return potential. So we calculated a modified PEG ratio that measures valuation relative to the sum of expected profit growth and the indicated dividend yield. The spread between cheap and expensive sectors narrows using the modified PEG, but utilities are still the most expensive.
Of course, while the utility sector as a whole suffers from uninspiring fundamentals, some companies stand out from the crowd. This week we looked at the stocks in our Top 15 Utilities portfolio — a diversified, equal-weighted portfolio within the sector — and identified the six with the best potential for year-ahead total returns.
While we considered a variety of factors in our stock-selection process, we gave particular weight to Quadrix scores, growth, and valuation to identify the utilities discussed in the following paragraphs, all of which are part of our Top 15 Utilities portfolio.
AGL Resources ($47; GAS) a natural-gas utility, enjoys steady growth, with per-share profits rising in eight of the past 10 years. AGL has also delivered eight straight quarters of at least 10% revenue growth. Quadrix scores are rising, and strong Momentum (84), Value (83), and Earnings Estimates (86) scores contribute to an Overall rank of 85; just one other S&P 1500 utility scores above 80 in Quadrix for three categories.
Unseasonably cold weather boosted September-quarter results for AGL, which has about 4.4 million utility customers in Illinois (49% of customers), Georgia (35%), Virginia (6%), New Jersey (6%), Florida (2%), and Tennessee (1%). Recent growth also reflects the $2.5 billion acquisition of Nicor, an Illinois-based utility-holding company, in December 2011. AGL, unlike many of its rivals, has primarily focused on its gas-utility business, rather than making big investments in nonregulated energy operations.
Atmos Energy ($45; ATO) dates back to 1906, when two brothers began to manufacture coal gas in the Texas Panhandle. Today, it consists of six gas utilities operating mostly in the South and Western states. The shares have delivered a 33% total return this year, compared to the median of 23% for gas utilities in the S&P 1500, yet the stock still has room to run. Atmos earns a Value score of 76, and its trailing P/E ratio of 18 is 8% below the median for its industry.
Rising analyst estimates project Atmos will earn $2.76 in fiscal 2014 ending September, implying 12% growth. If Atmos meets that target and its P/E ratio holds at the current level, the shares will advance 12% in less than 10 months. And the stock will rally 19% if Atmos meets the consensus and its P/E rises to the industry median of nearly 20.
Idacorp ($53; IDA), an electric utility in Idaho (about 95% of sales) and Oregon (5%) grew per-share profits 3% and sales 13% in the past 12 months. Although per-share profits are expected to contract 2% in 2014, the stock has delivered an 11% total return over the last three months.
In November, Idacorp hiked its quarterly dividend 13% to $0.43 per share. The dividend has grown at an annualized rate of 8% over the past three years, ahead of the 5% average for S&P 1500 utilities. Idacorp seems capable of maintaining outsized dividend growth, given that it redistributes just 52% of earnings as dividends.
Indeed, management said last month that it plans to raise the dividend more than 5% a year until its payout ratio reaches the upper end of a 50% to 60% target range. With per-share profits projected to rise 4% annually over the next five years, a 58% payout ratio implies Idacorp's quarterly dividend could reach $0.62 per share by 2017.
With a stock-market value of $1.91 billion, New Jersey Resources ($46; NJR) ranks among the smallest utilities in the S&P 1500 Index. The company has raised its dividend for 18 consecutive years. Its gas utility generates 66% of net income, followed by storage and transportation (19%), clean-energy projects (9%), and other energy ventures (6%). Sales surged 42% in the 12 months ended September, stronger than any other S&P 1500 utility, while earnings per share climbed 22%.
Operating momentum will moderate in the coming year, with both sales and per-share profits expected to rise 4%. Growth should remain steady at the utility, which expects to maintain its 1.5% annual growth rate for the customer base over the next two years. The company bought its first onshore wind project in October and plans to continue diversifying beyond solar.
UGI ($41; UGI), a diversified utility, scores in the top 10% of our research universe for Momentum, one of just two S&P 1500 utilities to do so. In fiscal 2013 ended September, UGI grew per-share profits 38% on 10% sales growth. The AmeriGas Propane unit (47% of net income) drove growth, while the gas and electric utility (24%) grew its customer base nearly 3% to 600,000. UGI's international business (18%) distributes propane to Austria and France, while also participating in a partnership in China.
Recent growth has benefited from UGI acquiring nonregulated businesses, and management says it will continue this strategy. UGI is expected to earn $2.73 per share in fiscal 2014 ending September, up 11% and well ahead of the 7% average for S&P 1500 utilities. Yet the stock looks cheap relative to peers on most valuation metrics. It trades at 15 times estimated fiscal 2014 earnings.
Westar Energy ($32; WR) is one of four utilities in the S&P 1500 to score at least 80 in Quadrix for both Value and Earnings Estimates. At 14 times trailing earnings, Westar shares trade 22% below the median for S&P 1500 utility stocks and 7% below their own five-year average. Westar's 4.3% yield exceeds the S&P 1500 utility average of 3.7%. Westar pays out 59% of earnings in dividends, below the sector average payout ratio of 64%.
Westar supplies electricity to nearly 700,000 customers in Kansas. Sales were flat in the September quarter, though the consensus projects 6% growth in the December quarter, followed by 5% in 2014. Profit growth may be more modest, with the consensus projecting a 3% gain in 2014. However, analyst estimates are rising, and Westar has topped expectations in each of the past six quarters.