Can Utilities Continue To Lead?
The S&P 1500 Utility Sector Index generated a negative annual total return of 3.4% over the last three years, a number that doesn’t sound good unless you consider that the broader index delivered a negative return of 7.1%. Only the consumer-staples sector outperformed the utility sector. Utilities have also outperformed the broader index over the last one, five, and 10 years.
Such outperformance during weak markets should not surprise investors, as utilities are known for their defensive characteristics. History suggests that if the broad indexes rise, utilities are not likely to lead the pack.
A year ago, the average utility stock in the S&P 1500 Utility Sector earned a Quadrix® Overall score of about 65. At only one other time since 1994 — the first half of 2001 — did utilities earn such high Overall scores. The average utility stock now earns a score of 53, roughly in line with the average since 1994.
The average Overall score of 53 bespeaks unimpressive fundamentals, while the average Value score of 64 suggests that the sector isn’t especially cheap, either. Utilities have averaged a Value score of 72 since 1994, reflecting that fact that utilities tend to trade at cheaper valuations than other stocks. The score of 64 suggests that while utilities remain cheaper than the average stock, their valuation advantage has narrowed.
The utility sector as a whole does not have impressive fundamentals, and we have not found any traditional utilities that warrant inclusion on our buy lists. We suggest that investors who like the income potential and defensive characteristics of utilities consider our Top 15 Utilities portfolio, shown in the table below. The portfolio contains a diversified group of utilities that in aggregate should yield close to the average utility, with substantially higher growth potential.
This week, we are making some changes to our Top 15 Utilities portfolio, as well as to our Utility Update supplement. In the Utility Update, we are adding four stocks: AES ($11; AES), NorthWestern ($28; NWE), Southwest Gas ($33; SWX), and Dynegy ($5; DYN). The additions do not represent buy ideas, rather an effort to further broaden our utility coverage universe.
In the Top 15 Utilities portfolio, Southern Union ($24; SUG) and TECO Energy ($17; TE) are replacing IDACORP ($35; IDA) and UGI ($28; UGI). In the following paragraphs, we explain the changes to the Top 15 portfolio. Utility investors may also want to check out the profile of Energen ($45; EGN) in Analysts Choice.
Southern Union ($24; SUG) operates natural-gas utilities in Missouri and Massachusetts, a gas transportation and storage business, and a unit that gathers and processes natural gas. The consensus projects per-share-profit growth of just 2% this year, followed by 10% next year. Southern Union topped the consensus by 13% in the June quarter and seems capable of exceeding near-term expectations.
The transportation and storage unit (34% of 2009 revenue) moves gas throughout the Midwest, Southwest, and Florida using about 15,000 miles of pipelines. This business generates strong cash flow through long-term transportation contracts and accounts for about three-fourths of the company’s profits. The gathering and processing segment collects gas from wells, treats it, and delivers both gas and its liquid byproducts to such customers as utilities, energy marketers, and manufacturers.
Southern Union’s gas utilities serve 550,000 customers, but its energy-related businesses should drive future growth. Southern Union yields 2.5% but pays out only 34% of its profits to cover that dividend, leaving plenty of flexibility to fund future increases. The stock earns an A rating in our Utility Update and is being added to the Top 15 Utilities portfolio.
TECO Energy’s ($17; TE) per-share operating profits have risen at least 20% in each of the last five quarters, lifted by widening profit margins. Sales rose in the last two quarters and are expected to increase 6% this year and 7% next year, supporting additional profit growth. Profit margins are on the rise, and TECO offers unusually high growth for a company that generates about 80% of revenue from regulated utilities.
TECO’s Tampa Electric provides electricity to about 667,000 customers in west central Florida and accounts for about two-thirds of company revenue. TECO also produces coal (20% of 2009 revenue) and operates a natural-gas utility (14%) with more than 334,000 customers.
Weakness in the Florida economy — and in particular the housing market — has limited customer growth in recent quarters. However, TECO says housing is starting to rebound. If the company is correct, current projections for profit growth of 24% this year and 6% next year could prove conservative. The company earns a Quadrix Overall score of 75 — unusually high for a utility — and scores above 80 in both of our sector-specific metrics for the utility sector. TECO, with a 4.8% yield, earns an A rating in our Utility Update and is being added to the Top 15 Utilities portfolio.
IDACORP ($35; IDA) managed a total return of 11% over the last year, well above the average utility stock’s return of 6%. But in the wake of those gains, the stock trades at a premium to its three- and five-year averages for price/sales and price/book ratio. Profit margins are trending lower, as are IDACORP’s Quadrix scores.
With a mediocre Overall score of 40, a worrisome Momentum score of 4, and sector-specific scores below 30, IDACORP’s fundamentals have eroded. We are taking our profits in IDACORP, which is being downgraded to B in the Utility Update and sold from the Top 15 Utilities portfolio.
UGI ($28; UGI) has a solid track record, with sales and per-share profits up in six of the last seven years. Trading in part on that history, the stock has returned 20% over the last year and is no longer cheap relative to historical norms.
Wall Street expects lower sales and profit this year, followed by modest growth in 2011. Sales and profits have fallen in each of the last five quarters. UGI is being downgraded to a B in our Utility Update and sold from the Top 15 Utilities portfolio.