Dividend Increases Hit the Mark

EEI’s latest projections (as of August 2012) for industry capital expenditures are $94.7 billion in 2012, $83.6 billion in 2013 and $80.0 billion in 2014. These figures are based on a review of the latest capex projections for our entire universe of companies. Although there is a visible spike in 2012, the average projected spending for 2012-2014 is in line with industry averages over the past several years. The increase in 2012 is due to accelerations of various projects, a higher volume of near-term renewable projects (primarily solar and wind), and an expanded range of projects related to environmental compliance.

While many analysts define free cash flow as the difference between cash flow from operations and capital expenditures, we also deduct common dividends due to the utility industry’s strong tradition of dividend payments. Aggregate pre-dividend free cash flow remained in positive territory during 2011, at $5.1 billion, following a positive $3.5 billion in 2010. This metric was a negative $21.5 billion in 2008 and a negative $13.0 billion in 2007 (the industry’s first deficit year since 2001).

Total aggregate industry-wide cash dividends paid to common shareholders rose by $189 million, or 4.0%, in Q1 2012 when compared to the year-ago period. On a calendar year basis, dividends rose by $1.4 billion, or 7.7%, to $19.3 billion in 2011 from $18.0 billion in 2010. From 2003 through 2011, total industry-wide annual cash dividends rose 57%, to $19.3 billion from $12.3 billion, supported by the lower dividend tax rates. 

Stock Performance

The market’s bullish spirits faded to a worried caution in Q2, deflated by the recognition — as has often followed the bouts of optimism since the crisis of 2008/2009 — that central banks can supply economies with easy money but cannot make them grow. The EEI Index returned 6.6% in the second quarter, considerably outperforming the -2% to -3% losses produced by the Dow and S&P 500 and the Nasdaq’s -5.1% decline. 

Another trend evident in the EEI Index’s performance during the year’s first half is the relative similarity of returns among the constituent groups. The market now perceives most utilities — whether they are fully or only mostly regulated — as essentially stable businesses with strong dividends, offering a safe harbor in turbulent times from exposure to the riskier, more competitively exposed and more economically leveraged earnings streams found in other economic industries.

Low Interest Rates

The 10-year Treasury yield (an adequate, albeit imperfect, proxy for market interest rates) has declined from the 5% to 6% range during 2006-2007 to under 2% in the second quarter of 2012. During the second quarter of 2012, the 10-year Treasury yield fell from a high of about 2.4% in late March to below 1.5% by mid-June, firming at quarter end up to 1.7%. 

Historically low interest rates have unquestionably offered an important source of support for utility shares in recent years by reducing the significant interest expense component of utilities’ cost structure and elevating the value of the dividend stream for investors.

Tax Rates 

The 15% tax rate on dividends for individuals is set to expire at the end of 2012 unless Congress takes action. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Tax Relief Act of 2010), passed in December of 2010, extended the 15% individual tax rate on dividends and capital gains through 2012. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced individual tax rates on dividends to 15% for most tax brackets. 

The 15% dividend tax rate remains important to the industry’s ability to attract capital for investment in emissions reduction, new transmission lines, distribution upgrades and new generation in many power markets in the years ahead. A key argument for preserving the rate has been the need for parity between dividend and capital gains tax rates, so as not to disadvantage dividend-paying companies in their capital raising efforts. EEI and the industry continue to work to extend the 15% dividend tax rate beyond 2012.

Stable Fundamentals

General business conditions in the industry at mid-year 2012 remain reasonably strong, with the big picture narrative little changed from that of recent years. Utilities are undertaking sizeable and wide-ranging capital investment programs that include distribution network upgrades, Smart Grid investments, a significant boost in the pace of transmission investment, rising emissions-related capex driven by the need to comply with EPA regulations, and generation investments in select power markets. All told, the construction cycle has supported mid-single digit earnings growth for much of the industry over the past six or seven years. 

Despite the prospects for only tepid electricity demand growth going forward (due in part to energy efficiency technologies and wider use of demand side management programs), estimated at 0% to 1% annual gains nationwide, analysts expect the industry’s ongoing capital spending to drive mid single-digit earnings growth for many utilities over the next several years. Much of this investment is going into rate base, with a state regulatory backdrop that most analysts say is constructive and supportive of the need for such investment.

The value to investors of such a predictable, if not placid, business environment is that an investment in the EEI Index made at the end of 2007 and indexed to 100 would have outperformed both the S&P 500 and the Dow Jones Industrial Average if held through June 30, 2012. This period includes the severe decline and wild volatility of the 2008/9 financial crisis, the strong subsequent market recovery and recent sideways progression of the markets since early 2011 — offering a diverse macroeconomic and market backdrop in which to evaluate the industry’s emphasis on core regulated and competitive electricity businesses.

Valuations

Despite trailing the broad market averages during the first half of 2012, the EEI Index outperformed all major market sectors over the 12-month period ending June 30. This was due less to any change in the industry’s prospects than to the industry’s status as a safe-harbor during macroeconomic turbulence. The broad market fell more than 10% during Q3 2011 as the spectacle of the U.S. fiscal debt limit debate (and Standard & Poor’s August 5, 2011 downgrade of U.S. debt from AAA to AA+) along with European leaders’ equally contentious response to a flare-up of market stress over their continents’ sovereign debt woes rattled investors.

By late June 2012, most analysts observed that utility price/earnings ratios were near historical highs relative to the broad market, suggesting that the group’s strength may be nearing an end. Conversely, given today’s extraordinarily low interest rates, utility shares receive powerful support from the industry’s roughly 4% dividend yield, double that of the S&P 500’s dividend yield. When viewed as a bond substitute (offering bond-like yields with dividend growth potential), analysts observed that utility stocks could have room to rise given the very low yields available most everywhere else. 

To the extent that utility dividends remain perceived as stable and safe, and if interest rates remain very low, utility shares will likely receive an ongoing strong bid from investors. However if rates were to rise or if industry fundamentals were to worsen — such as the perception of difficulty executing capital investment programs or renewed fuel cost increases pressuring end-user rates, fostering a more contentious environment in rate cases — the group’s stock market fortunes may take a turn for the worse. 

Recent years have delivered many tailwinds for the industry, independent of the hard work by companies to reform themselves around the traditional utility business model while implementing the strong public good aspect of their mission — that of ensuring safe, reliable and increasingly environmentally clean electricity within regulated service territories. 

It’s likely that the values of utility shares in the immediate future will continue to be driven more by global macroeconomic issues outside of the industry’s control than by changes in business strategies or fundamentals that managements can control. That is not to say that the month-to-month and year-to-year challenges that come with the management of shareholder-owned utilities are not significant, it’s just that they are largely under control for now.