Utilities blur the line
In a year when you can define “winning” as losing less than the other guy, utilities are winning. So far this year, the S&P 1500 Utility Sector Index is down 31%, versus a 40% decline for the broader index.
Understandably, such Pyrrhic victories don’t excite investors. But from 2005 through 2007, the utility index rose 48%, more than double the broad market’s performance.
The market has traditionally viewed utilities as defensive stocks with steady profits and attractive dividend yields. In part, this still holds true. Utility companies still sell electricity, natural gas, or water to retail customers at regulated prices.
However, that steadiness is not new — even taking dividends into account, slow and steady utilities have underperformed the market over long periods of time. One of the main reasons utilities have performed so well in recent years is that they are no longer just utilities. Many modern utilities augment stable, recession-resistant businesses with forays into new, higher-growth markets.
The proliferation of nonregulated operations may be part of the reason utilities now command a premium valuation after years of trading cheaply. Since January 1996, the S&P 1500 Utility Sector Index has averaged a price/sales ratio 27% below that of the broader index. As of Dec. 22, the sector index’s price/sales ratio was 0.88, versus 0.78 for the broader index. Utilities haven’t been as expensive relative to the overall market in nearly 13 years.
While utility stocks have been kind to investors in recent years, the Forecasts does not expect that largesse to continue. As the economy recovers, utility stocks are likely to revert to a valuation below that of the broader market, underperforming the market in the process.
Today’s more diversified, more cyclical utilities should comprise no more than 25% of an income investor’s portfolio. Our favorite stocks in this sector are utility/energy hybrids that generate much of their profits from the production of natural gas — and pay modest dividends. For investors who wish to own more traditional utilities, we recommend buying in bulk for safety.
In the following paragraphs, we review three interesting stocks that offers both solid income and growth potential that outstrips the average utility:
Shares of Energen ($27; NYSE: EGN) have fallen in recent weeks, largely on concerns about low natural-gas and oil prices, making the stock attractively valued given its growth potential. At seven times estimated year-ahead earnings of $3.90 per share, the stock trades at a discount to its five-year average forward P/E ratio of 12.
Consensus estimates project a sixth consecutive year of earnings growth in 2008. While Energen faces a challenging environment in 2009, management says the company is well-positioned to weather a recession and lower energy prices. The firm expects organic production growth of 5% in 2009 — an increase from the 3% growth projected for 2008 — and has hedged about 62% of next year’s estimated production to blunt the effects of price volatility.
Energen says it has the wherewithal to spend on production projects, acquisitions, and stock repurchases using its projected 2009 discretionary cash flows of $137 million to $167 million. Energen, which earns an A rating in the Utility Update, is also a Long-Term Buy.
Questar’s ($31; NYSE: STR) exploration-and-production division enjoys strong production growth, including a 34% increase in the September quarter, paced by a 42% increase in the mid-continent region. Questar expects full-year 2008 production growth of about 20%. The company also operates natural-gas pipelines and distributes gas to retail customers, primarily in Utah, through its regulated utility.
Revenue and per-share-earnings growth have been impressive, up 30% and 49% respectively in the nine months ended September. In response to lower commodity prices and tighter credit markets, the company plans to spend less on capital projects in 2009 — $1.6 billion, down from $2.6 billion in 2008. At nine times expected year-ahead earnings of $3.36 per share, the stock trades well below its five-year average forward P/E of 14. Questar, which has increased its dividend 35 times in the last 36 years, is rated A in our Utility Update. The company also earns a Long-Term Buy rating.
Southern Union ($13; NYSE: SUG) operates a regulated natural-gas utility, though 72% of 2007 sales come from unregulated operations. The company gathers, processes, transports, and stores gas, and in recent months the stock has fallen along with other energy-related firms. Sales rose at double-digit rates in each of the last four years and by at least 22% in each of the last three quarters.
At seven times trailing earnings, Southern Union trades at a slight premium to the average gas storage and transportation company but a steep discount to the average gas utility. Southern Union’s valuation looks attractive, considering its results should be more stable than those of most energy pure plays.
Consensus estimates project per-share earnings will climb 4% in 2009, followed by a 3% decline in 2010. Considering the company’s solid growth history, expectations seem conservative. Southern Union earns an A rating in the Utility Update and is being added to the Top 15 Utilities portfolio. WGL Holdings ($31; NYSE: WGL) is being dropped from the Top 15 portfolio, as the stock has outperformed and seems expensive.