Be Picky With Utilities

9/26/2016


So far in 2016, the S&P 1500 Utility Sector Index has returned 18.2%, tops among the 10 broad sectors and more than 11 percentage points above the broad index. The strong showing has investors wondering how much gas is left in the tank.

Utilities tend to perform well when investors want safety and dividends, especially with interest rates so low. But concerns that the Federal Reserve will soon raise rates has hurt the group. Utilities have slumped 5% so far in the third quarter, behind only the 7% decline for the telecom sector. The real estate sector has too little history for comparison.

UTILITIES GROWING BUT PRICEY VERSUS HISTORY
Utility stocks have delivered solid returns so far in 2016 but retreated in recent months. On average, utilities are expected to deliver decent relative profit growth this year, but the stocks look expensive versus historical norms and in Quadrix.
Avg.
Estimated
EPS Growth,
Curr. Yr.
(%)
---------- P/E Ratio ----------
----- Avg. Quadrix Scores -----
S&P 1500 Sector
(No. Of Companies)
Average
Start
Of 2016
20-Year
Norm
Value
12-Year
Norm For
Value
Overall
Cons. discret. (246)
7.7
19.4
19.7
20.0
68
61
69
Consumer staples (68)
6.0
23.2
23.0
20.9
48
55
54
Energy (87)
(32.9)
19.5
17.0
20.7
41
60
24
Financials (309)
2.7
17.3
21.3
19.3
68
58
69
Health care (161)
8.3
27.5
28.3
25.3
49
47
60
Industrials (230)
2.8
20.3
19.0
20.5
61
59
62
Materials (93)
4.9
21.3
18.5
20.4
58
62
56
Technology (234)
7.1
27.8
25.1
27.8
50
46
58
Telecom (15)
(3.2)
28.2
25.5
23.0
60
61
49
Utilities (57)
4.1
20.9
18.1
17.0
51
68
45
S&P 1500 stocks
4.2
22.5
21.6
21.4
56
57
59

Another concern: Yield-hungry investors pushed up prices and valuations. Today, S&P 1500 utilities earn an average price/earnings ratio of 20.9, up from 18.1 at the start of the year and 23% above the 20-year average — the largest premium across the 10 broad sectors. In Quadrix, utilities earn an average Value score of 51, versus the long-term norm of 68. At 45, the Overall score is second-lowest among the 10 sectors and below the norm of 53.

Finally, utilities are expected to report only middling profit growth. Based on estimated current-year earnings, analysts expect utilities to grow profits 4.1% — in line with the broad market, but below the index average of 5.4% growth excluding downtrodden energy stocks. In 2017, utility earnings are expected to climb 5.4%, versus 12.7% for all S&P 1500 stocks.

Still, we can make a case for select utilities. For investors looking to add a few to a portfolio, the tables below A-rated stocks (the Forecasts' favorites are highlighted in bold) that appeal on three fronts:

Dividend growers. Over the last five years, all five stocks increased their per-share dividend faster than the sector average of an annualized 4.8%. In addition, all five have delivered at least five consecutive years of dividend hikes.

DIVIDEND GROWERS
Company (Price; Ticker)
Div.
($)
Yield
(%)
5-Year
Annual.
Growth
(%)
Consecutive
Years
Increased
Quadrix
Overall
Score
Eversource Energy ($55; ES)
1.78
3.2
10
5
43
South Jersey Ind. ($30; SJI)
1.06
3.5
8
17
45
Star Gas Partners ($10; SGU)
0.41
4.3
6
8
78
UGI ($48; UGI)
0.95
2.0
7
29
78
WEC Energy ($63; WEC)
1.98
3.2
14
13
60
Notes: Quadrix scores are percentile ranks, with 100 the best.     Stocks in our Top 15 Utilities portfolio listed in bold.

Profit leaders. All five stocks are expected to outpace the sector's average earnings growth in the current year and deliver superior long-term growth.

PROFIT GROWERS
--- Est. EPS Growth ---
Company (Price; Ticker)
Div.
($)
Yield
(%)
Curr.
Year
(%)
3-5 Years
(Annual.)
(%)
Quadrix
Overall
Score
Atmos Energy ($77; ATO)
1.68
2.2
7.9
7.0
48
Entergy ($81; ETR)
3.40
4.2
10.2
5.5
48
Eversource Energy ($55; ES)
1.78
3.2
5.6
5.8
43
SCANA ($74; SCG)
2.30
3.1
5.0
6.0
46
WEC Energy ($63; WEC)
1.98
3.2
7.6
6.0
60

Value plays. Based on estimated P/Es using projected current-year earnings, all five utilities trade at a sizable discount to the sector average of 20. All five earn Value scores of at least 55, well above the sector average.

VALUE PLAYS
Estimated
Current-
Year P/E
---- Quadrix Scores ----
Company (Price; Ticker)
Div.
($)
Yield
(%)
Value
Overall
AES ($13; AES)
0.44
3.4
13
71
57
Entergy ($81; ETR)
3.40
4.2
13
83
48
Eversource Energy ($55; ES)
1.78
3.2
19
55
43
Public Service Ent. ($44; PEG)
1.64
3.8
15
68
48
Star Gas Partners ($10; SGU)
0.41
4.3
12
87
78

In the table below, we list our Top 15 Utilities portfolio — the cream of the crop in our view. In the following paragraphs, we highlight four Top 15 picks.

Entergy ($81; ETR) earns a weak Quadrix Overall rank of 48, hurt by below-average scores for Momentum, Quality, and Earnings Estimates. But the industry as a whole has weak fundamentals, and both of Entergy's sector-specific scores exceed 80. Shares trade at just 10 times trailing earnings, 19% below their five-year median and 50% below the median S&P 1500 electric utility.

Entergy operates both an electric utility (82% of 2015 sales) and wholesale commodities business (18%), the latter powered by five nuclear plants. Lower costs for natural gas have made Entergy's commodities unit less competitive, and the company has been reducing exposure to this business. Entergy plans to shutter two nuclear plants by 2019, while relicensing negotiations with a third plant have met strong political opposition.

In August, Entergy cited tax benefits as a reason for raising its full-year per-share-profit guidance to $6.60 to $7.40, implying 10% to 23% growth. Although analyst estimates have risen, the current consensus is just $6.61, allowing plenty of room for upside. Entergy raised its dividend 2% in December, its first hike since the June 2010 quarter. Management says it wants to offer investors steady, annual dividend growth, ultimately targeting a payout ratio of 65% to 75%. Entergy currently devotes just 43% of earnings to its dividend, allowing sufficient flexibility for future growth. The stock yields 4.2%.


Otter Tail ($36; OTTR) shares have returned 35% including dividends this year, about four times the average total return for S&P 1500 Index stocks. That rally has pushed Otter Tail's trailing P/E ratio to 22, in line with its 10-year median and 9% above the median S&P 1500 diversified utility. However, Otter Tail is one of few utilities generating decent operating momentum. The company has increased earnings per share 7% (versus flat growth for its industry) on sales growth of 2% (versus a 3% decline) for 12 months ended June.

Otter Tail's electric utility accounts for about half of its sales, with the remainder coming from manufacturing machine parts (about 30%) and PVC pipe and other plastic products (about 20%). All three units grew revenue in the first half of 2016. Otter Tail's per-share profits are projected to hold flat for the September quarter, though analyst estimates are rising. Looking further out, management expects to hear from regulators in 2017 concerning its application to raise electric rates 10%. Otter Tail yields 3.5%.


Star Gas Partners ($10; SGU) offers investors the highly desirable combination of strong share-price action (its year-to-date return is 33% including dividends) and a fat dividend yield (4.3%). Shares still look cheap at 12 times estimated 2016 profits and 11 times the 2017 target, below the industry median by 48% and 50%, respectively. Dividend hikes have ranged from 6% to 9% in each of the past four years.

A master limited partnership (MLP), Star Gas distributes heating oil and propane (81% of sales for the first nine months of fiscal 2016), while also offering installation and repair services for heating and cooling systems in homes (19%). Unseasonably warm weather has hurt demand for heating oil and propane, causing the unit's nine-month sales to slump 39%; sales of services rose 3%.

The 2017 Farmer's Almanac forecasts an especially cold winter this year. Of course, it made similar claims last year that never came to fruition. The single-analyst estimate calls for Star Gas to grow earnings per share 11% in fiscal 2017 on 14% higher revenue.


UGI ($48; UGI) is best known as the largest retail propane marketer in the U.S. But it also operates gas and electric utilities (14% of sales in the first nine months of fiscal 2016 ending September), a midstream and marketing unit (14%), and international operations (32%). U.S. propane distribution accounts for the remaining 40% of UGI's revenue.

At first glance, UGI's dividend, yielding 2.0%, hardly stands out in the S&P 1500 utility sector, which averages a 3.0% yield. But UGI has paid a dividend without interruption since 1885 and increased its distribution every year since 1988. Of the 57 utility stocks in the S&P 1500 Index, just eight have a longer track record of dividend growth. Management targets annual dividend growth of about 4%, while keeping its payout ratio between 35% to 45% of profits. UGI's current payout ratio stands at 45%, versus an average of 64% for S&P 1500 utilities.

UGI's sales fell 16% in the first nine months of fiscal 2016, hurt by an unusually warm winter in the U.S. and Europe. However, earnings per share climbed 5%, helped by an overseas acquisition and lower operating expenses. Encouragingly, UGI plans to increase utility rates in October. Although analysts expect UGI to lose $0.03 per share in the seasonally light September quarter, estimates are rising for fiscal 2017, with the consensus projecting 16% higher profits on 9% revenue growth.


TOP 15 REGAINS LEAD

So far this year, the Top 15 Utilities portfolio has returned 23.0%, versus 17.9% for the S&P 1500 Utility Sector Index. The benchmark index led our Top 15 earlier in the year, helped by a rising tide that lifted all utilities, including the low-quality, low-growth types we typically eschew. However, the utility sector index has lagged the broad market over the last three months, while our focus on nontraditional utilities and inclusion of pipeline companies has supported the Top 15's returns.

Our portfolio, designed to provide a yield similar to that of the average utility with superior growth potential, has returned 202.6% since its 2007 inception versus 106.4% for the benchmark index, winning in seven of the last nine full calendar years. We credit much of our outperformance to a willingness to invest in nontraditional utilities, as well as companies in energy businesses that impact utilities.

Today we're making no changes in the Top 15 Utilities portfolio.

TOP 15 UTILITIES
----------------------- Dividend -----------------------
---- P/E Ratio ---
-- Est. Current Year --
Quadrix Scores
Company (Price; Ticker)
Per-
Share
($)
Yield
(%)
Payout
Ratio
(%)
5-Year
Annual.
Growth
(%)
Consecutive
Years
Increased
Recent
5-Year
Average
EPS
($)
%
Chg.
P/E
Value
Overall
Allete ($62; ALE)
2.08
3.3
59
3
6
17.7
17.5
3.12
2
20
68
52
Atmos Energy
($77; ATO)
1.68
2.2
51
4
33
23.4
18.3
3.35
8
23
38
48
Avista ($43; AVA)
1.37
3.2
66
4
14
20.8
17.5
2.06
9
21
51
49
Entergy ($81; ETR)
3.40
4.2
43
0
2
10.3
12.2
6.62
10
13
83
48
EQT Midstream Part.
($77; EQM)
3.12
4.0
62
NA
4
14.1
20.7
5.10
2
15
78
98
Otter Tail ($36; OTTR)
1.25
3.5
77
1
4
22.1
23.8
1.60
3
22
47
68
Portland General
($44; POR)
1.28
2.9
62
4
11
21.3
16.7
2.12
4
21
53
48
Public Service Ent.
($44; PEG)
1.64
3.8
59
4
5
15.7
13.0
2.87
(1)
15
68
48
Scana ($74; SCG)
2.30
3.1
64
3
16
20.6
15.4
4.00
5
18
44
46
SJW ($45; SJW)
0.81
1.8
38
3
48
21.1
20.9
1.57
(3)
29
45
75
Spectra Energy Part.
($44; SEP)
2.65
6.1
77
8
9
12.8
14.9
3.20
(23)
14
72
67
Star Gas Partners
($10; SGU)
0.41
4.3
38
6
8
12.4
14.4
0.81
37
12
87
78
UGI ($48; UGI)
0.95
2.0
45
7
29
22.4
18.1
2.06
2
23
55
78
Unitil ($40; UTL)
1.42
3.6
81
1
2
22.7
19.8
1.81
(4)
22
55
50
Vectren ($51; VVC)
1.60
3.1
71
3
56
23.0
19.4
2.47
3
21
54
55
Note: Quadrix scores are percentile ranks, with 100 the best.     NA Not available.

 


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