Quest For Value
In the utility sector, value is king.
While most QuadrixÂ® scores have not been especially effective with utilities, high Value scorers tend to outperform. In rolling 12-month periods since 1994, the top one-fifth of S&P 1500 Index utilities as measured by Value score returned 15.3%, versus 12.2% for the average utility in the index.
Of course, we do not recommend that anyone purchase a stock based on Quadrix scores alone. But we do tend to favor utility stocks with high Value scores, as evidenced by our Top 15 portfolio. The average stock in that portfolio earns a Value score of 87 on a scale of 0 to 100.
Utilities tend to trade at valuations below the average for the market, in part because of their modest growth potential. While the sector has looked quite expensive at times â€” for example, the average utility in the S&P 1500 Index had a Value score below 50 at the end of 2008 â€” utilities have averaged Value scores of 72 since 1994. Today, the index's utilities average Value scores of 75, though some parts of the sector look better than others.
Among the stocks in our Utility Update, which contains all of the S&P 1500's 72 utilities plus another 11, independent power companies earn especially high Value scores. The industry contains only three stocks, and the valuation ratios reflect both recent market weakness and pessimism regarding profits over the next year or two.
The electric and diversified utility groups average Value scores of more than 75 â€” and are the only industries in the sector with average Overall scores above 50. Twelve of the companies in our Top 15 portfolio hail from the electric or diversified group.
Water utilities are by far the most expensive in the sector, averaging Value scores of 45. They also have the weakest fundamentals, averaging Overall scores of 39. Not surprisingly, our Top 15 Utilities portfolio contains no water utilities.
Below we make changes to the Top 15 portfolio and review two attractive utility values.
Adds to Top 15 Utilities
PPL ($26; PPL) is a diversified utility with a Value score of 93 and dividend yield of 5.4%. At nine times trailing earnings, the shares trade 43% below their three-year average and 38% below the average diversified utility in our Utility Update. In November, PPL gained 1.2 million electric and gas customers from a $7.6 billion acquisition that should smooth out a profit stream heavily dependent on the power-generation business. The acquisition boosted PPL's total customer base to 3.6 million.
Westar Energy ($25; WR) supplies electricity to 685,000 customers in east Kansas. Westar has managed six consecutive years of sales growth, despite a series of strategic divestitures. Sales rose 13% in the nine months ended September, and operating profit margins trended higher. Wall Street expects per-share profits to jump 46% this year, then fall 6% next year. Westar seems capable of exceeding the 2011 target.
Cuts from Top 15 Utilities
OGE Energy's ($46; OGE) shares have delivered a total return of 28% so far this year, and sales have risen by at least 33% in each of the last three quarters. But in the wake of the stock's run-up, the shares trade at nearly 15 times trailing earnings, an 18% premium to the three-year average price/earnings ratio and well above historical norms for price/book, price/sales, and price/cash flow. OGE Energy is being downgraded to a B in our Utility Update.
Oneok's ($55; OKE) revenue, up 31% in the nine months ended September, has rebounded from a dismal 2009. However, the shares now trade at 17 times trailing earnings, a premium of at least 14% to both their three-year average P/E and the average diversified utility in our Utility Update. The stock's 12-Factor Sector score has fallen to 6, while its Reranked Overall score is just 26. The 12-Factor Sector and Reranked Overall scores compare utilities to other utilities. Oneok is being downgraded to a B in our Utility Update.
At 10 times trailing earnings, Exelon's ($41; EXC) stock trades 24% below its three-year average and 32% below the average diversified utility in the Utility Update. The stock also trades at a deep discount to its historical norms for sales and book value. Yielding 5.1%, Exelon earns a Value score of 94.
Operating revenue rose 7% in the nine months ended September on growth at Exelon's two utilities. The largest U.S. producer of nuclear power, Exelon serves about 5.4 million electric customers and nearly 500,000 gas customers in Illinois and Pennsylvania. The company derives nearly half of its revenue from nonregulated ventures, such as power generation and marketing. Exelon, rated A (above average), is a component of our Top 15 Utilities portfolio.
Entergy ($71; ETR) yields 4.7%, above the 4.4% average for electric utilities in our Utility Update. The stock earns a Value score of 94.
The company issued 2011 per-share-earnings guidance with a midpoint of $6.60, implying a decline of nearly 6%. Entergy says regulated businesses, which provide electricity to 2.7 million customers across four southern states, are expected to generate 64% of projected profits. Power generation provides the rest.
In October, Entergy announced a $500 million share-buyback program, on top of $750 million repurchase plan expected to be completed by the end of 2010. Entergy has lowered its share count by 4% in the past year. Entergy, rated A in our quarterly Utility Update, is included in the Top 15 Utilities portfolio.