The Little Sector That Could

6/27/2011


The 81 stocks in our Utility Update combine for about $500 billion in stock-market capitalization, roughly the size of Apple ($325; AAPL) and IBM ($166; IBM) together. Utilities account for just 3.6% of the capitalization-weighted S&P 1500 Index and exert little influence on broad market indexes. Yet they occupy an outsized place in the hearts of investors, for two primary reasons:

1) They average a yield of nearly 4%, versus 1.3% for the average S&P 1500 Index stock.

2) They hold a mostly well-deserved reputation for safety and dependability. Over the last 15 years, a period that included two serious market downturns, the S&P 1500 Utility Sector Index delivered a 7.4% return, higher than all but three of the market's 10 core sectors. During those 15 years, the utility index's monthly returns were less volatile than those of seven other sectors.

Individual utility stocks rarely satisfy our research criteria (high Quadrix® scores, attractive valuations, solid growth potential), and we don't like any single utility enough to warrant a Buy rating. Yet the sector as a whole does have appeal for income-oriented investors. With that in mind, we offer the Top 15 Utilities portfolio, listed below, an equal-weighted basket of 15 stocks designed to provide a yield roughly in line with the sector and superior total-return potential. Investors seeking utility exposure should purchase equal-dollar amounts of all 15 utilities.

TOP 15 PORTFOLIO
Our Top 15 Portfolio consists of eight electric utilities, five diversified utilities,one utility/energy hybrid and one natural-gas utility. We have concentrated our selections in industries with the best mix of valution and growth potential. From its inception at the start of 2007 through June 21, the portfolio has returned 29.6%, versus 11.7% for the S&P 1500 Utility Sector Index. So far in 2011, the Top 15 Utilities Portfolio has returned 12.2%, versus 8.2% for the index.
Sector-Specific
Scores *
Company (Price; Ticker)
Div.
($)
Yield
(%)
Trailing
P/E
Ratio
Quadrix
Overall
Score *
12-
Factor
Reranked
Overall
Industry
AGL Resources
($40; AGL)
1.80
4.5
14
53
75
60
Gas
Alliant Energy
($40; LNT)
1.70
4.2
14
72
79
89
Electric
Avista ($25; AVA)
1.10
4.4
13
83
86
98
Diversified
Cleco ($35; CNL)
1.12
3.2
16
36
59
29
Electric
DTE Energy
($50; DTE)
2.35
4.7
15
50
43
65
Diversified
Duke Energy
($19; DUK)
1.00
5.3
13
65
88
93
Electric
Energen ($56; EGN)
0.54
1.0
14
72
74
91
Hybrid
Entergy ($69; ETR)
3.32
4.8
10
79
99
96
Electric
Exelon ($42; EXC)
2.10
5.0
10
59
95
80
Diversified
NextEra Energy
($57; NEE)
2.20
3.9
13
54
80
55
Electric
PPL ($27; PPL)
1.40
5.1
9
86
100
100
Diversified
Public Service Ent.
($32; PEG)
1.37
4.3
10
53
94
76
Diversified
TECO Energy
($19; TE)
0.86
4.6
16
44
39
40
Electric
UniSource Energy
($37; UNS)
1.68
4.5
13
68
61
85
Electric
Westar Energy
($27; WR)
1.28
4.8
15
42
85
50
Electric
Portfolio Average
4.3
13
61
77
74
* Quadrix scores are percentile ranks,with 100 the best. The sector-specific scores are designed to compare stocks to others within the same sector.

Since its inception in January 2007, the Top 15 Utilities portfolio has returned 29.6%, versus 11.7% for the S&P 1500 Utility Sector Index. The Top 15 portfolio does not attempt to mirror the index's construction, instead looking for the individual stocks with the best potential. But while we don't establish target industry weightings for the portfolio, we do tend to find more opportunities in the groups with the strongest fundamentals.

Stocks belonging to different industries within the utility sector have quite different characteristics, as shown in the table below.

INDUSTRY ANALYSIS
All numbers except company count and market value represent averages for industry groups within our Utility Update. The independent power, natural gas, and water industries earn the lowest Quadrix Overall scores and have managed the weakest profit growth over the last year. Not surprisingly, our Top 15 Utilities portfolio contains only one stock from those three groups combined.
12-Month
Change
Est. EPS Growth
Industry (No. of Cos.)
Market Value,
in $Bil.
(% of Sector)
Div.
Yield
(%)
Sales
(%)
EPS
(%)
Curr.
Year
(%)
Next
Year
(%)
Next
5 Yrs.
(Ann.)
(%)
Trailing
P/E
Ratio
Quadrix
Overall
Score
Diversified (23)
175.8
(35)
4.0
4
17
3
10
6
15
53
Electric (33)
263.3
(52)
4.1
6
13
2
7
5
15
51
Energy/Utility
Hybrids (4)
20.8
(4)
2.0
4
5
(1)
16
8
22
52
Independent
Power (3)
14.0
(3)
0.9
(11)
(36)
(25)
(4)
4
12
29
Natural Gas (11)
25.3
(5)
3.8
0
4
0
8
4
17
40
Water (7)
5.5
(1)
3.4
8
5
(5)
5
6
18
43
Utility
Sector (81)
504.8
(1)
3.8
4
11
1
8
5
16
49
Notes: Averages exclude growth rates of more than 100%.  Quadrix scores are percentile ranks, with 100 the best.

Our Top 15 portfolio contains stocks from four of the six industry groups, and one from each group is reviewed below.

We are also making a change to the Top 15 portfolio. Southern Union Group ($34; SUG) agreed to be purchased by Energy Transfer Equity ($46; ETE), a master limited partnership. The partnership will pay $4.2 billion ($33 per share) in equity units for Southern Union, plus the assumption of $3.7 billion in debt, to create the largest U.S. natural-gas pipeline company. Last year, Southern Union's natural-gas utility accounted for just 28% of revenue, with the rest coming from transportation, storage, and processing businesses. Subscribers should sell Southern Union, which is being dropped from coverage in our Utility Update.


Alliant Energy ($40; LNT) is replacing Southern Union Group in our Top 15 Utilities portfolio. In 2010, Alliant served 984,000 electric customers and 412,000 natural-gas customers in four Midwest states, mostly Wisconsin and Iowa. Cash flow from operations jumped nearly 50% in 2010. And in the 12 months ended March, Alliant managed per-share-profit growth of 47%. While such growth is not sustainable, consensus estimates seem too conservative, given Alliant's operating momentum and stronger-than-expected results for the March quarter.

Wall Street projects per-share-profit growth of about 6% this year and less than 3% next year. At less than 14 times trailing earnings, Alliant trades at a discount of 8% to its five-year average P/E ratio and a 9% discount to the average electric utility. Alliant earns an A rating in our Utility Update.

And now we present top selections in four utility industries:

Natural gas

Yielding 4.5%, AGL Resources ($40; AGL) has increased its quarterly dividend at an annualized rate of 6% over the past five years, keeping its payout ratio near 60% of earnings. AGL, a regulated utility with nonregulated marketing operations, is expected to earn $3.13 per share this year, up 3% on 4% higher revenue. Shares trade at less than 14 times projected 2011 earnings, a 20% discount to the average gas-utility stock.

Looking ahead, AGL should get a boost from its pending acquisition of gas utility Nicor ($55; GAS) for $2.4 billion in cash and stock plus the assumption of about $700 million in debt. The deal, announced in December and still under regulatory review, should close in the second half of the year. The Nicor acquisition will more than double annual revenue while paving the way for aggressive cost cuts. AGL, a component of our Top 15 Utilities portfolio, earns an A rating in our Utility Update.

Energy/utility hybrids

Energen ($56; EGN) shares have returned 17% this year, versus an average of 9% for stocks in our Utility Update. At 14 times trailing earnings, Energen trades 11% above its five-year average but at a 38% discount to the average hybrid.

Energen owns a natural gas-utility in Alabama (39% of 2010 revenue) and also produces natural gas and oil (61%). Growth could prove tough to come by in 2011, though analyst estimates are rising. Energen targets per-share profits of $3.35 to $3.75, versus $4.38 earned last year. But based on the recent outlook for commodity prices, management says per-share earnings could exceed its stated range by $0.38. The consensus calls for per-share profits of $3.85.

Energen's hedging strategy smoothes over some of the volatility inherent to energy prices. Energen expects production to grow 9% in 2011 and has hedged 69% of the year's output. Natural gas should account for 59% of production, with oil and other liquids comprising the remainder. Proved reserves rose 17% in 2010. The company boasts 29 straight years of higher dividends, including a 4% bump earlier this year. Energen is rated A (above average) and is a component of our Top 15 Utilities portfolio.

Electric

Entergy ($69; ETR), the second-largest nuclear-power generator in the U.S., operates in an industry facing intense scrutiny following the earthquake and resulting nuclear meltdown in Japan. In April, Entergy sued the state of Vermont to keep its nuclear power plant open past March 2012. Federal regulators said Entergy could run the plant for another 20 years, but Vermont officials are reluctant to grant an extension. New York lawmakers are also debating whether to renew licenses for two of Entergy's nuclear reactors located within 50 miles of New York City. The original 40-year licenses expire in 2013 and 2015.

States must balance the possibility of a nuclear disaster with initiatives for cleaner energy, and the unpopularity currently plaguing Entergy could subside in time. Entergy also owns electric utilities that serve about 2.7 million customers in Arkansas, Mississippi, Louisiana, and Texas.

The shares already reflect plenty of pessimism, trading at less than 10 times trailing earnings, about 33% below both their own five-year average and the average electric utility. The payout ratio hovers near 50% of earnings, yet the dividend yield of 4.8% is high by historical standards. Earning a Quadrix Value score of 88, Entergy is a component of our Top 15 Utilities portfolio and earns an A rating in our Utility Update.

Diversified

Until recently, PPL ($27; PPL) relied on nonregulated power generation for the majority of its revenue. But weak electricity prices and rising coal costs have lowered the industry's profit margins, prompting PPL to purchase two regulated electric utilities in Kentucky and a utility in the U.K. during the past year. By 2013, roughly 75% of cash flow should come from regulated businesses, compared to just 27% last year. PPL believes the reliable nature of regulated businesses will backstop the growth of its dividend, currently yielding 5.1%.

PPL forecasts per-share profits of $2.50 to $2.75 in 2011, down from $3.13 last year. But the $2.61 consensus leaves room for upside. PPL has exceeded Wall Street's target by at least 15% in the last two quarters. The stock earns an Overall score of 86 — second-highest in the sector — and maximum ranks of 100 in our two sector-specific scores. A member of our Top 15 Utilities portfolio, PPL is rated A in our Utility Update.


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