Diversify Within Utility Sector
In the past year, S&P 1500 utility stocks in three key industries — diversified, electric, and natural gas — have generated fairly similar total returns, all between 22.6% and 30.0%. But we don't see such congruence every year.
In the 12 months ended Dec. 22, 2013, natural-gas utilities returned 26%, dwarfing the 8% return for electric utilities. A year earlier, in the 12-month period that ended Dec. 22, 2012, electric and gas utilities returned less than 3%, while diversified utilities returned 21%.
Owning stocks in multiple industries within the utility sector can help insulate investors from the effects of weakness in any individual industry. Our Top 15 Utilities portfolio contains stocks from the electric, natural-gas, and diversified industries.
While electric, natural-gas, and diversified utilities account for 83% of the 76 stocks monitored in our Utility Update, we do break the sector into three other groups — energy/utility hybrids, independent power generators, and water utilities. None of our current Top 15 Utilities comes from these groups.
In the table above, we compare the characteristics of different industries within the utility sector. Some look better than others.
The electric-utility industry offers an attractive blend of strong share-price action and valuation. Despite relatively soft operating momentum, the average electric utility in our Utility Update has returned 29% this year — highest of the utility industries.
Even after the strong returns, electric utilities' average trailing (18.4) and forward (18.8) price/earnings ratios are below the sector average. The industry also averages a yield of 3.4%, second-best in the sector. Few electric utilities are making significant dividend hikes, reflected by average five-year annualized growth of just 3%.
Allete ($55; ALE) has delivered at least 10% sales growth in each of the last three quarters. This new addition to the Top 15 Utilities portfolio supplies electricity to nearly 160,000 customers in Minnesota and Wisconsin and also serves about 27,000 natural-gas or water customers. Allete also generates power (much of it from renewable resources) and owns two nonutility businesses — a coal-mining operation in North Dakota and a real-estate concern in Florida. The consensus projects per-share profits will fall 16% in the December quarter but rise 11% for the year, then another 9% next year. Despite a three-month total return of 22%, above the industry average of 16%, Allete trades at 18 times trailing earnings, in line with its peers despite superior growth potential. Allete is being added to the Top 15 Utilities portfolio.
Idacorp's ($66; IDA) regulated electric utility serves customers in parts of Idaho and Oregon. The stock's payout ratio of 51% is among the lowest of our monitored electric utilities, which average 62%. But Idacorp's three-year annualized dividend growth of 13% ranks third in the industry. The utility has raised its quarterly dividend 9% to 15% in each of the past four years to bring the payout ratio closer to its long-term goal of 50% to 60% of "sustainable" earnings. In November, Idacorp said it expects future dividend hikes to exceed 5% until its payout ratio nears the upper end of its targeted range.
Many natural-gas utilities are raising users' rates to offset slowing customer growth and rising maintenance costs. As a group, natural-gas stocks rank near the middle of the utility sector based on P/E ratios and 12-month sales and profit growth. The presence of two master limited partnerships (MLPs) skews the average yield higher. Most of the natural-gas selections in the Top 15 Utilities portfolio are cheaper than the industry average and have delivered superior sales and profit growth over the last year.
Atmos Energy ($55; ATO) delivered 17% higher per-share profits on 27% revenue growth for the 12 months ended September. In November, Atmos raised its quarterly dividend for the 27th straight year, a 5% hike to $0.39 per share.
Atmos also has nonregulated operations in gas storage and transportation. The consensus projects 2% lower per-share profits in the December quarter, but a 7% gain in 2015. Atmos has met or exceeded the consensus in seven straight quarters. At 19 times trailing earnings, the stock trades on par with the average for the natural-gas utilities we cover, a valuation that doesn't reflect its growth potential.
Diversified utilities offer better growth prospects than other utility industries, with per-share profits projected to rise 3% in the coming year.
Otter Tail ($31; OTTR) operates an electric utility in Minnesota and North and South Dakota. It has exposure to the economic recovery via subsidiaries that manufacture metal components, construct power and water plants, and make PVC pipe. These nonutility businesses should account for nearly half of Otter Tail's income this year.
For the 12 months ended September, Otter Tail's per-share profits jumped 21% on 9% higher revenue, exceeding the average (11% profit growth, 7% sales growth) for diversified utilities in our Utility Update. That operating momentum helped Otter Tail shares outperform their peer group over the past three months. Although earnings per share are projected to fall 14% in the December quarter, the three-analyst consensus anticipates 4% growth in 2015, a conservative target.
Scana ($60; SCG) provides electricity or natural gas to roughly 2 million customers in North Carolina, South Carolina, and Georgia. It earns a Quadrix Overall score of 82, highest among the diversified utilities we monitor, and also the best in the Top 15 Utilities portfolio. Five of six category scores exceed 65 and both sector-specific ranks top 80.
Although near-term earnings growth may prove challenging, analyst estimates have drifted higher for both the December quarter and 2015 over the last 60 days. Despite generating a total return of 33% so far in 2014, the shares seem priced for more gains. At 16 times estimated year-ahead earnings, the stock trades at a 13% discount to the average for S&P1500 diversified utilities.
PNM Resources ($30; PNM) is being dropped from the Top 15 Utilities portfolio. Despite profit declines in four of the last five quarters, PNM has outperformed its peer group over the last year and trades at 20 times trailing earnings, 7% above the industry average.