More Juice Than Usual
Historically, the Forecasts has not put many utilities on our Buy List. The reasons are simple:
• Utilities tend to deliver less sales and profit growth than we like.
• Most utilities carry quite a bit of debt and pay out much of their profits in dividends, limiting their growth potential and financial flexibility.
• Historically, utility stocks have underperformed the broader market. Over the last 25 years, the S&P 500 Utility Sector Index has delivered an annualized total return of 4.5%, versus 7.8% for the broader S&P 500 Index.
• In part because of the above points, utilities tend to earn unimpressive Quadrix® Overall scores.
All of the points above represent legitimate reasons for investors seeking high total returns to avoid utilities. However, no trend lasts forever. On average, utilities still carry more debt and pay out more of their profits in dividends than does the rest of the market, and they are still expected to deliver less profit growth, as shown in the table below. But as measured by stock-price performance and Quadrix scores, the situation has changed.
The average utility stock in the S&P 1500 Index earns an Overall score of 64 and Value score of 78, both of which have been trending higher this year. In contrast, the rest of the stocks in the S&P 1500 Index average Overall scores of 57 and Value scores of 56.
The S&P 1500 Utility Sector Index has outperformed the broader S&P 1500 over the last five and 10 years. Utilities have lagged this year, as expected during a strong upward market move. But the utility index outperformed the broader index in each of the last five calendar years before 2009.
We’re not ready to entirely overlook utilities’ weak balance sheets and modest growth potential, but the sector looks pretty good right now. We currently recommend two utilities — Energen ($48; EGN) and Questar ($42; STR), both energy/utility hybrids — as Long-Term Buys. Investors seeking exposure to traditional utilities should consider the Top 15 Utilities portfolio, discussed below. In the following paragraphs, we discuss our favorite utility, Energen.
Energen’s ($48; EGN) stock has returned 64% so far this year. Brighter prospects could push the shares still higher. Earlier this month, Energen raised its 2010 per-share-profit guidance to $4.20 to $4.60, implying growth of 19% to 30%. Wall Street expects earnings of $4.26 per share. Energen’s hedging efforts contributed to the higher outlook, as the company has locked in prices for about 70% of estimated production at prices well above market rates. The oil hedges average prices 14% above the current spot price, while natural-gas hedges are 44% above the market price. Energen expects production to rise 3% next year.
Alagasco, Energen’s natural-gas utility serving 400,000 customers in Alabama, also acts in some ways as a hedge, in that its results are far less dependent on volatile energy prices. Alagasco’s sales (44% of 12-month revenue) have climbed 3% in the past year, while revenue from the production business (56% of revenue) fell 12%.
Oil accounted for about 25% of production volumes over the past 12 months. But in the wake of a slump in natural-gas prices, Energen has become more optimistic about oil prices and shifted more of its resources to developing oil reserves. Energen plans to sink 75% of 2010 capital spending into the Permian Basin, which holds 98% of the company’s proved oil reserves. Trading at 13 times trailing earnings, 31% below the average for energy/utility hybrids, Energen is a Long-Term Buy.
The Top 15 Utilities portfolio has shown some power this year, gaining 16.0% as of Dec. 22, while its benchmark, the S&P 1500 Utilities Sector Index, rose 8.3%.
Our strategy of focusing on utilities with growth kickers appears to have paid off. Two of our energy/utility hybrids — companies that both operate traditional utilities and produce natural gas — are up more than 60%. Many of our other top performers generate much of their revenue and profits from nonregulated operations.
Individual utility stocks, even those that mainly operate regulated businesses, are riskier than many investors perceive. Rather than take on the risk of buying just one or two traditional utilities, we think income-oriented investors are better off spreading their bets, purchasing equal-dollar amounts of all 15 of the stocks in the table below. The portfolio is fairly well diversified within the utility sector.
While most of the stocks in the Top 15 Utilities portfolio are not on the Forecasts’ Monitored List and are not recommended for purchase on their own merits, as a group the stocks offer investors the chance to earn a dividend yield in line with the average utility stock, yet with superior capital-gains potential. Most of the stocks pay strong yields, and the portfolio as a whole yields 3.5%, only slightly below the average of 4.0% for all utilities in the S&P 1500.
Today, we are making a change to the Top 15 Utilities portfolio, dropping CenterPoint Energy ($15; CNP) in favor of Sempra Energy ($56; SRE). CenterPoint has performed fairly well this year, generating a total return of 24% despite weak operating performance. In the wake of those gains, at 15 times trailing earnings, the stock is no longer cheap. CenterPoint’s sector-specific Quadrix scores have deteriorated, and the stock is no longer among our favorites in the sector.
Sempra operates traditional electric and gas utilities as well as an attractive portfolio of nonregulated businesses (power generation, pipelines, and natural gas liquids) with solid growth potential. Wall Street expects per-share-profit growth of 13% in 2010 on a sales increase of nearly 14%, and estimates are trending higher. Sempra earns an Overall score of 73 and a Value score of 83. Sempra is being upgraded to an A in our Utility Update, while CenterPoint is being downgraded to a B.