Feel The Electricity, But Don't Drink The Water
As a group, utilities look pretty good.
The 80 stocks in our Utility Update average Quadrix Overall scores of 60 and Value scores of 78, high relative to historical norms. But that doesn’t mean every utility is fair game. Industry groups within the utility sector have delivered drastically divergent returns in recent years. Don’t expect them to move in lockstep going forward, either.
S&P 1500 UTILITY INDEXES
Among the large industry groups (independent power and water combine to account for just five of the S&P 1500 Index’s 71 utilities), the natural-gas and diversified utility indexes have delivered the best returns over the last year. All of the industry groups except gas and independent power trade at a discount to their three-year average P/E ratios.
While utility stocks in general are cheap, a look beyond valuation further isolates the sweet spots in the sector. The table below provides averages for stocks in our Utility Update supplement, which runs in the last issue of every quarter. Electric utilities and utility/energy hybrids score well on Overall and also earn decent sector-specific Quadrix scores, which rank utilities relative to other utilities. Gas and water earn the lowest sector scores, and we have found few attractive options in those industry groups. Our Top 15 Utilities portfolio contains only one natural-gas utility and no water utilities.
We divide our utilities into six groups, while Standard & Poor’s uses only five delineations. We separated hybrids — companies that operate both traditional utilities and energy-production units — into their own category. Historically, S&P has classified most of these hybrids as gas utilities. Such hybrids account for most of the Natural Gas Utility Industry Index’s outperformance over the last year. We include three hybrids in our Top 15 Utilities portfolio, listed in the table below.
How to play the sector
The Top 15 Utilities portfolio was initiated in 2007 to address the thorny issue of how our growth-at-a-good-price approach should treat stocks with high yields but slow growth. Few traditional utilities qualify for our buy lists because of their subpar total-return potential. We do recommend two hybrids — Energen ($45; EGN) and Questar ($43; STR) — but neither pays a yield of more than 1.2%, and most utility investors seek more income.
Our solution: Create a diversified mix of utilities that generates a yield nearly as high as that of the average utility, coupled with substantially higher capital-gains potential. Taken as a whole, the portfolio offers investors a piece of most of the segments of the utility sector, limiting risk through diversification. Investors seeking broad exposure to traditional utilities should purchase equal-dollar amounts in all 15 stocks.
Utilities make up less than 4% of the total stock market’s value. While you may want to overweight the sector based on your evaluation of its risk-return potential, don’t bet your portfolio on a single sector just because it pays a high yield.
Subscribers have asked us questions along this line: “Do you really expect me to buy 25 shares of this stock and 50 shares of that stock and follow all 15?” Our answer: Why not?
These days, online discount brokers make it cheaper than ever to trade stocks. For all but the smallest accounts, the benefits of diversification within the utility sector should outweigh the extra commissions. And don’t worry about following 15 extra stocks. We will advise you when to make changes.
Below, we review our two favorite utility stocks:
Energen ($45; EGN) boasts a solid growth outlook, with Wall Street projecting 20% higher per-share earnings in 2010. Yet the shares trade at 11 times projected 2010 earnings, 37% below the average for utility/energy hybrids.
Natural gas averaged $2.92 per thousand cubic feet in September, the lowest monthly average in more than seven years. Since then, the price has increased 88%, helped by lower inventories and frigid weather forecasts for February and March. Energen hedges much of its production but does benefit from high gas prices. Energen has hedged 72% of expected 2010 energy production at levels well above current spot prices.
On average, Energen has hedged its 2010 natural gas at $8.03 per thousand cubic feet, up 47% from today’s $5.48. The company’s oil is hedged at $84.98 per barrel, 10% above the current spot price of $77.23. After taking the hedges into account, the company estimates that changes of $0.10 in natural-gas prices per thousand cubic feet or $1 in per-barrel oil prices will increase or decrease 2010 profits by $0.01 per share.
Energen’s regulated utility, Alagasco (43% of 2009 revenue, 18% of profits), reported 6% lower revenue last year. Sales for the exploration-and-production business (57%, 82%) slid 10% in 2009. Natural gas represented 65% of production, followed by 24% for oil, and 11% for natural-gas liquids. Energen is a Long-Term Buy.
Questar ($43; STR) has rallied 26% over the last year, outperforming the S&P 500 Utility Sector Index’s 4% gain. Weak natural-gas prices weighed on sales, down 18% in the first nine months of 2009. But during that time, Questar aggressively cut costs, widening operating margins and boosting free cash flow. Reductions in spending on capital projects resulted in positive free cash flow in each of the first three quarters of 2009, ending a seven-quarter stretch of negative flows. Despite that cutback in capital spending, Questar managed production growth of 7% in the nine months ended September.
Anticipating higher natural-gas prices, Questar boosted spending in the December quarter and said it planned to raise production by at least 13% in 2010. Management believes it can increase production at a 12% to 15% annualized rate over the next five years, excluding the effects of acquisitions. Questar will report December-quarter results Feb. 10. The consensus projects earnings of $0.70 per share, down 29%. But estimates have been rising. Questar is a Long-Term Buy.