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.