The shareholder-owned electric utility industry extended its near-decade-long trend of widespread dividend increases during Q2. Nine of the 50 publicly traded companies tracked by the Edison Electric Institute raised their dividend, resulting in a total of 28 that either raised or reinstated their dividend during the first six months of the year. The period’s total mirrored that of last year and remained at the high end of the 23 to 28 range that has held since 2004.
The total of 37 companies that raised or reinstated their dividend during the full 2012 calendar year was also at the top end of the 32 to 37 range of the previous three years. While 2012’s total was a step down from 2007’s 43 companies, it remained well above the 27 companies that raised or reinstated their dividend in full-year 2003.
The percentage of companies that raised or reinstated their dividend in 2012 was 73%, up from 58% in 2011 and 60% in 2010. The 2012 result is the highest on record, based on data going back to 1988. The 15% dividend tax rate has supported the high number of increases in recent years.
At June 30, 2013, all 50 publicly traded companies in the EEI Index were paying a common stock dividend. Table I shows the industry’s dividend paying patterns over the past 13 years. Each company is limited to one action per year. For example, if a company raised its dividend twice during a year, that counts as one in the Raised column. Companies generally use the same quarter each year for dividend changes, typically the first quarter for electric utilities.
The industry’s average dividend increase during the first half of 2013 was 4.6%, with a range of 1.2% to 13.8% and a median increase of 3.6%. PNM Resources (+13.8% in Q1), NV Energy (+11.8% in Q1) and NextEra Energy (+10.0% in Q1) posted the largest percentage increases.
PNM Resources, based in Albuquerque, increased its quarterly dividend from $0.145 to $0.165 per share. The company said its board plans to review the dividend again later this year, and is considering a comparable increase in December to move the dividend into the company’s targeted 50% to 60% payout ratio range.
Headquartered in Las Vegas, NV Energy increased its quarterly dividend from $0.17 to $0.19 per share. The company led the industry with a 30.8% dividend increase in 2012. With the latest increase, NV Energy’s dividend has risen by 138% since reinstatement in July 2007 at $0.08 per share.
NextEra Energy, located in Juno Beach, Fla., raised its quarterly dividend from $0.60 to $0.66 per share. The dividend is consistent with the company’s plan, announced last year, to target a 55% payout ratio in 2014. The plan is premised on a continuing shift in the company’s portfolio mix toward more regulated and long-term contracted assets.
Chicago-based Exelon lowered its quarterly dividend by $0.215 per share, or 41.0%, from $0.525 to $0.31, effective in Q2. Exelon said the lower payout allows it to maintain its investment-grade credit rating. The company also said the decision to cut the dividend was driven, in part, by expectations that low U.S. power prices would continue longer than previously expected.
Payout Ratio & Dividend Yield
The industry’s dividend payout ratio was 62.8% for the 12 months ending March 31, 2013, surpassing all other U.S. business sectors. (The industry’s payout ratio was 61.1% when measured as an un-weighted average of individual company ratios; 62.8% represents an aggregate figure.)
While the industry’s net income has fluctuated from year to year, its payout ratio has remained relatively consistent after eliminating non-recurring and extraordinary items from earnings. From 2000 through 2012, the annual payout ratio ranged from 62.0% to 69.6%, with the highest result coming in 2009 due to the weak economy and the weather’s negative impact on earnings. We use the following approach when calculating the industry’s dividend payout ratio:
- Non-recurring and extraordinary items are eliminated from earnings.
- Companies with negative adjusted earnings are eliminated.
- Companies with a payout ratio in excess of 200% are eliminated.
The industry’s average dividend yield was 3.9% on June 30, 2013. This was higher than all other business sectors except the broader Utilities sector (consisting of electric, gas and water utilities), which yielded an average of 4.0%. The industry’s yield was 3.9% on March 31, 2013, 4.3% at year-end 2012, 4.1% at year-end 2011, 4.5% at year-ends 2010 and 2009, and 4.9% at year-end 2008. We calculate the industry’s aggregate dividend yield using an un-weighted average of the 50 publicly traded EEI Index companies’ yields.
The strong dividend yields prevalent among most electric utilities have helped support their share prices in recent years, especially given the period’s historically low interest rates. The EEI Index rose by a modest 2.1% in 2012, following returns of 20.0%, 7.0% and 10.7% in 2011, 2010 and 2009, respectively.
The Mostly Regulated company category had the highest dividend yield by category on June 30, 2013, at 4.0%, compared to the Regulated category’s 3.9% and the Diversified’s 2.7%. Note that Diversified category metrics have become less meaningful indicators of broad industry trends in recent years since category membership has fallen to a single publicly traded company, as industry business models migrate back to a Regulated emphasis.
The yields for all three categories are below their levels at December 31, 2012, when the Regulated, Mostly Regulated and Diversified yields were 4.2%, 4.4% and 4.0%, respectively. The EEI Index gained 10.8% for the six months ended June 30, 2013, resulting in the lower yields.
The Mostly Regulated group recorded a dividend payout ratio of 68.3% for the 12 months ended March 31, 2013, compared to 58.7% for the Regulated group and 32.2% for the Diversified group. The Regulated group has typically produced the highest annual payout ratio, having done so in 2010 and 2011 and each year from 2003 through 2008. It was exceeded by the Mostly Regulated group in 2009 and again in 2012.
Fourteen of the industry’s publicly traded companies repurchased an aggregate $821 million of common shares during 2012 as an alternate way of returning cash to shareholders. Share repurchases were $1.8 billion in 2011 and ranged from $908 million to $2.7 billion over the 2008 through 2011 period, after falling sharply from $11.9 billion in 2007.
The 2007 repurchases were 90% higher than the $6.3 billion spent in 2006. The industry’s common share repurchases exceeded $6.0 billion in 2004, 2005 and 2006 after rising from only $120 million in 2003.
Free Cash Flow
The industry’s aggregate free cash flow deficit continued in early 2013, with negative $8.5 billion in Q1 compared to negative $7.9 billion in Q1 2012. Calendar-year free cash flow was negative $26.7 billion in 2012, down from the negative $13.5 billion in 2011, marking the eighth consecutive year of deficits.
The vast majority of the decline is due to an $11.9 billion, or 15.1%, increase in capital expenditures. Common dividends paid increased $1.2 billion, or 6.0%, while net cash provided by operations was nearly unchanged.
The industry’s capital spending remains historically high due to elevated levels of investment in environmental compliance, transmission and distribution upgrades, and new generation capacity. While some 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.
EEI’s latest projections for industry capex are $95.3 billion in 2013, $92.0 billion in 2014 and $85.0 billion in 2015. These figures are based on a review of the latest capex projections for our entire universe of companies.
Total aggregate industry-wide cash dividends paid to common shareholders rose by $227 million, or 4.5%, in Q1 2013 compared to the year-ago period. On a calendar year basis, dividends increased by $1.1 billion, or 6.0%, to $20.5 billion in 2012 from $19.3 billion in 2011. From 2003 through 2012, total industry-wide cash dividends rose 66%, to $20.5 billion from $12.3 billion.
Legislation & Dividend Tax Rates
On January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012, which forestalled imminent federal spending reductions commonly referred to as the “fiscal cliff.” As part of this legislation, dividend tax rates (which would have reverted to ordinary income tax levels in 2013) were kept low and permanently linked to tax rates for capital gains.
The top rate for dividends and capital gains is now 20% for couples earning more than $450,000 ($400,000 for singles). For taxpayers below these income thresholds, dividends and capital gains continue to be taxed at the current rates of 15% and 0%, depending on a filer’s income level. Starting in 2013, a 3.8% Medicare tax that was included in the 2010 health care legislation will be applied to all investment income for couples earning more than $250,000 ($200,000 singles).
Continued low dividend tax rates remain an important element of the industry’s ability to attract capital for investment in emissions reduction, new transmission lines, distribution upgrades, and new generation in the years ahead. Notably, parity between dividend and capital gains tax rates was preserved, thereby not creating a disadvantage for companies that rely on a strong dividend to attract investors.
The reduced dividend tax rate has certainly supported utility stock returns over the past decade. From July 1, 2003, through June 30, 2013, the EEI Index of U.S. shareholder-owned electric utilities generated a total return of 160% compared to 114% for the Dow Jones Industrial Average and 102% for the S&P 500.
There are many factors that influence utility stock performance and dividend tax policy is but one. Nevertheless, the numbers serve to highlight the importance of the 15% dividend tax rate to the industry’s ability to attract capital.
The EEI Index posted a solid 10.8% gain for the first half of 2013, a move that will make for a strong year if utility stocks can hold their ground during the second half. But it wasn’t enough to outperform the broad market, as the Dow Jones Industrials gained 15.2%, the S&P 500 climbed a slightly weaker 13.8% and the tech-heavy NASDAQ, held down by sluggish performance by technology shares, posted a 12.7% gain. This grouping of first half returns within a reasonably close band masked what proved to be the most volatile stretch for utility stocks since the financial crisis of 2008/2009 threw all markets into turmoil.
The year-to-date period has been quite unusual, as market gains through May—fueled by massive support from the Federal Reserve’s quantitative easing program and augmented by Japan’s even more vigorous experiment with exceedingly loose monetary policy under new Prime Minister Shinzo Abe—were led by defensive, dividend-paying sectors such as utilities, healthcare, consumer staples and telecom services. Strong market advances are usually led by economically sensitive cyclical sectors, as investors anticipate that strengthened economic activity will lead to broad-based earnings gains.
Indeed, utility shares surged 20% from the start of the year through mid-May, then sharply dropped 13% through late June when talk by Federal Reserve officials hinted the central bank may “taper” its quantitative easing program if economic data improves. While Fed statements indicated no substantive policy change, the mere thought of a reduction in monetary support for markets was enough to cause a spike in interest rates, as the yield on the 10-year Treasury bond jumped from 1.6% in early May to 2.6% by late June.
The EEI Index’s quarterly results convey a similar pattern—returning 13.3% in Q1 then -2.2% in Q2—but the data alone doesn’t reveal the considerable volatility during the period.
The first half of 2013 amplified a theme that has characterized utility stock performance since the financial crisis: Broad-based global macroeconomic trends, such as changes in commodity fuel prices, interest rates and the pace of economic growth, have governed the movement of share prices more than any significant change in industry fundamentals, which are fairly slow to evolve given the industry’s focus on regulated business models and the mostly predictable nature of electricity demand growth.
Indeed, the industry’s multi-year migration to an increasingly regulated structure continued in 2012. At year-end, EEI’s group of regulated companies (where more than 80% of assets are regulated) totaled 37 of a total 56 companies, while the Mostly Regulated group (50% to 80% assets are regulated) totaled 17. The Diversified group (less than 50% of assets are regulated) fell to only two companies, one of which (Energy Futures Holdings) is privately held. The figures at year end 2005 were Regulated (33 of 68), Mostly Regulated (24 of 68) and Diversified (11 of 68), illustrating both the magnitude of structural change in the industry over the past eight years as well as the impact of M&A and buyout activity on the total number of companies.
The reduction in the number of Diversified companies to only one publicly traded stock makes category returns less indicative of trends within the industry than they used to be. During the first half of 2013, the Regulated and Mostly Regulated categories showed fairly similar returns of 13.0% and 15.8%, respectively, in Q1 and 0.4% and -3.4% in Q2, while the Diversified’s two positive returns, 15.0% and 7.6%, were all derived from sole constituent MDU Resources. The company’s oil business benefitted from increased production at its Baaken and Paradox basin properties and its construction services business grew its contract backlog. Both developments prompted stock upgrades by Wall Street analysts and supported a rally through quarter-end that defied late-quarter weakness among most other utilities.
The first half of the year brought an extension of another key industry trend—slow end-user electricity demand growth. While a cold March, when heating degree days were 11% above the historical average, helped power a 3.3% rise in electric output during Q1 (for the lower 48 states), output fell 2.2% in Q2, bringing growth during the year’s first half to just 0.5% year-to-year. Due to a combination of energy efficiency measures, the decline in industrial output as a contributor to U.S. economic growth and a slow-growth economy, nationwide power demand has shown no growth since 2007, when U.S. electric output was 4,100,611 gigawatt hours.
Output has declined slightly in each of the past three years, falling to 3,995,885 gigawatt hours in 2012 from 4,065,051 in 2011 and 4,090,200 in 2010. The industry’s forward looking expectation is only a modest 0% to 1% overall growth rate, with variations across different regions of the country tied to local economic trends and weather, a marked slowdown from the higher-single-digit growth that characterized much of the last several decades.
Natural gas spot prices, an important factor that has shaped power prices and industry fortunes in recent years, showed some strength during Q1, rising from $3 per million British thermal units to near $4 per million BTU by quarter end, but then held around $4 through the end of Q2. And the natural gas futures curve showed no net change from yearend 2012 to the end of June. There was little relief for competitive generators, who are suffering from a multi-year decline in natural gas prices that has eroded power prices in many competitive markets.
Combined with stagnant demand and generally adequate reserve margins nationwide (with the exception of the Texas market, where analysts see demand growth and opportunities for generators with a footprint there), the year’s first half brought no evidence of impending change in competitive market trends. The bearishness was reinforced by weak capacity auction pricing in the PJM Regional Transmission Organization (RTO) auction in May, where pricing for some locations fell by more than 50%, driven down by weak demand and significant new natural gas plant additions in recent years.
A strong rise in wind power production has also had an impact, pushing off-peak capacity needs and pricing down as wind production is strongest at night and is supported by the production tax credit. The weak PJM auction was cited by many analysts as a factor that compounded the June sell-off in utility shares, weighing on those with merchant exposure to the region.
Rate Base Growth
Slow demand growth and adequate capacity across most of the country is taking a toll on the industry’s formerly torrid pace of capital expenditure and rate base growth. EEI’s latest projections for industry capex anticipate a slowing from $95.3 billion in 2013 to $92.0 billion in 2014 and to $85.0 billion in 2015. Many analysts have ratcheted down slightly their expectation for earnings growth by regulated utilities, although they still expect that many are capable of low- to mid-single-digit gains in both earnings and dividends.
A review of consensus analyst estimates for the 50 publicly traded EEI Index companies confirms that general outlook. The average revenue growth across the industry (calculated as an arithmetical average of analyst projections, not accounting for market capitalization) shows projected growth of 4.6% in 2013 slowing to 3.0% in 2014. The average projected five-year earnings growth rate for the industry is 4.3% as of mid-July, ranging from small single-digit declines for some utilities exposed to weak prices for competitive generation to as high as 7% to 8% for companies undertaking relatively strong capital investment programs and/or benefitting from supportive regulatory outcomes in recent rate cases.
In recent years, there has been a general expectation across the industry that widespread public and political concern over global warming would eventually lead to some form of nationwide CO2 regulation, and President Obama made this a second-term priority with a policy speech delivered in late June in which he called on the Environmental Protection Agency (EPA) to develop measures to reduce greenhouse gas emissions under the authorization provided by the Clean Air Act.
It’s possible that a future carbon remediation regime will eventually require significant investment in carbon capture and storage technologies, but it will take several years before mandated requirements are clear. The president’s directive sets a time frame of June 2014 for the EPA to develop proposed standards for existing plants, with finalization of standards targeted for June 2015 (a goal was set to propose rules for new plants by September of this year).
There appeared to be little about the president’s plan that wasn’t consistent with general expectations on the part of the industry and Wall Street analysts. And it is not until late in the decade that final rules—in whatever form they ultimately take—would go into effect. As a result, the speech had little impact on the current or even medium-term outlooks for utility stocks; other forces impacting industry fortunes will likely have a far stronger role in shaping stock price changes over the next few years.
Yet it’s fair to note that the financial burden of longer-term investment stemming from carbon regulation will fall most heavily on competitive coal generators, which cannot finance capital spending in regulated rate base and run the risk that market forces could make such investment un-economic. And given the myriad forces at play—from economic growth, fuel price changes, technological change that may affect electricity usage patterns, movement of interest rates, to name just a few—any predictions as to the ultimate impact of CO2 regulation on the industry’s stock prices would be speculation.
The Federal Reserve’s relentless support of the financial system through near-zero short-term interest rates and its suppression of long-term yields through the purchase of Treasury bonds and mortgage-backed securities have held interest rates at multi-decade lows since the financial crisis. Whether the May-June rate spike marks the first stage of an inevitable bear market for bonds, with a prolonged period of rising rates, remains to be seen. But there’s no doubt that historically low market yields have distorted traditional regulated utility valuation metrics.
Analysts observed that the 20% jump in utility share prices through early May brought utility price-to-equity (or PE) ratios, based on 2014 earnings, to their highest premium relative to the S&P 500 since the 1960s—a rich 25%. And when the utility industry’s approximate 4% dividend yield is compared against the S&P 500’s 2% yield, utilities also look pricey; analysts note utility dividend yields would have to climb to 5% (meaning share prices would have to fall) to bring the difference back to its historical average.
Of course, such metrics aren’t precise indications of fair value at any point in time—market trends can take stocks away from fair or historically average values for extended periods—but they do serve as rough indicia of valuation patterns. On the other hand, compared to today’s very low corporate bond yields, utilities are decidedly cheap, with dividend yields only 1.5% below BBB corporate bond yields versus a historical average of about 3%. This means either utility shares can rise (reducing yields and increasing the gap to more normal levels) or bond yields can rise (meaning dividend yields and utility stock prices might remain stable even in an environment of rising rates).
Industry balance sheets are sound, dividends appear to be generally safe and supported by healthy business fundamentals, and the industry’s regulated focus offers long-term stability in an uncertain economy. Utility investors get dividend growth potential in addition to favorable tax treatment relative to bonds, an attractive mix for investors willing to assume the share price risk.
Utility stock price trends in the immediate future will probably mirror those of the past few years. Utilities will likely do better than the broad market if economic growth stalls, interest rates fall and the fears that stalk markets return—whether in the form of instability in Europe, slowdown in China, or eruption of geopolitical risks in emerging markets such as Brazil, Turkey or in the Middle East.
Conversely, if all is quiet on the risk front and confidence in economic growth strengthens, interest rates will likely continue to rise. Whether that means utility shares fall remains to be seen, but they will probably lag the performance of other sectors when bullish sentiments dominate markets.