Until about 10 years ago, U.S. electric and natural gas utilities have been quintessential "widow and orphan" stocks. Their profitability was highly regulated and, lacking any significant growth prospects, they paid out most of their cash flow in dividends. Their resulting high yield and steady share price made them attractive for investors looking for a stable return year in and year out. Their weakness, however, was that if interest rates started to rise, the shares might suffer if bond yields became more attractive.
Over the past decade, however, changes to utility regulations have subjected many electric power generators to competition and market prices, while a relaxation on merger restrictions has allowed "pure-play" utilities to expand into unregulated businesses that bring the potential for faster earnings growth. This new "growth-oriented" breed of utility company tends to offer investors a lower dividend yield, and, as a result, its share price is less sensitive to changing interest rates. For certain companies, this has proven to be beneficial.
With the yield on the benchmark 10-year U.S. Treasury note rising above 5% last week to its highest in five years, utility stocks have come under pressure from income-oriented investors who are attracted to the higher bond yields. Standard & Poor's Equity Strategy recently downgraded its recommended weighting of the S&P 500 utility sector to "underweight" from "marketweight" in anticipation that the sector will lag the broader index during the second half of 2006. However, several utility companies have growth prospects that make them attractive even if interest rates keep going up, according to S&P equity analysts.
"I would not expect utility stocks with profitable, non-regulated businesses to fall much in the foreseeable future," says Justin McCann, S&P equity analyst for electric utilities, in part because their current dividend yield isn't high enough to make them competitive with bond yields, and many utility companies now have growth prospects they once lacked.
"When utility companies have low dividend yields, their stocks generally are not trading on the dividend." McCann has buy recommendations on five electric utility stocks: PPL (PPL) , Constellation Energy Group (CEG) , Edison International (EIX) , Public Service Enterprise Group (PEG) , and Exelon (EXC) , all of which have significant unregulated businesses.
Utility dividend yields have been depressed by a three-year rally in utility stocks, which have been recovering from a rash of trading scandals, financial restatements, and bankruptcies, as well as a lack of dividend increases. As such, McCann believes that investors have been focused more on utilities with non-regulated businesses that show earnings growth than on their above-average dividend yields.
"Utilities are not the problems they once were," McCann says. "They've dramatically improved their balance sheets, become more financially stable, and investors see steady cash flow from them." Shares in American Electric Power Company (AEP) , one of the largest U.S. power generators and electric utilities, yielded more than 10% in March 2003, when Treasury yields were lower than they are now. AEP shares now yield just 3.38%. Over the same period, the yield on Public Service Enterprise Group fell from about 7% to 2.64% currently. Overall, the yield on the S&P 500 utilities index is currently just 2.97%, down from 3.91% in September 2003 and equal to the yield from telecommunication services shares.
Another reason utilities have become less sensitive to interest rates is they have diversified into other energy-related and non-energy-related businesses. For some companies, revenue and net income from regulated utility operations make up less than half of their total.
"There are only one or two companies that are pure-play natural gas distributors," which act like the traditional utility, says Christopher Muir, Standard & Poor's equity analyst for natural gas stocks. "The rest of them have natural gas transmission, exploration and production operations, and all sorts of other diversified businesses that make up half to two-thirds of their net income."
Muir raised his recommendation on several of natural gas stocks in the wake of their recent decline, including boosting his recommendation on shares of Nicor (GAS) to strong buy from buy. While operating profit from Nicor's regulated gas distribution business in suburban Chicago has fallen by an average of 10% annually from 2001 to 2006, the unregulated company's businesses--a Caribbean shipping business and energy marketing ventures--have grown by 23% and 40% respectively.
"With the earnings of the unregulated businesses rising substantially in relation to total earnings, they will become increasingly important in driving earnings growth at Nicor," Muir opines.