Tag Archives: utility

A Word Of Caution About New Purchases In The Utility Sector

My first purchase of an electric utility stock was 400 shares of Duke Energy (NYSE: DUK ) around 1978. Somewhere along the way, I sold those shares for reasons that I no longer recall. I am not expressing a word of caution about the long term benefits that have flowed through buying and holding quality utility stocks and reinvesting the dividends. The ten year annualized total return numbers for a number of electric utility stocks are superior to the 7.83% annualized total return of the S&P 500 ETF (NYSEARCA: SPY ) through 2/13/15. Some examples include the ten year annualized performance numbers of American Electric Power (NYSE: AEP ), Dominion Resources (NYSE: D ), Edison International (NYSE: EIX ), NextEra Energy (NYSE: NEE ) and Wisconsin Energy (NYSE: WEC ) Ten Year Annualized Total Returns Through 2/13/15 Computed by Morningstar: AEP +8.09% D + 9.93% EIX + 8.72% NEE +12.15% WEC +13.03% Several other well known “utility” stocks have come close to matching the S & P 500 ten year annualized total return without the same decree of drama. AT&T +7.69% SCANA +6.86% Southern Co +6.75% Verizon Communications +7.54% The question that I am addressing now is whether new buys can be justified based on current yields and valuations. I started to look at this question a few days ago when making a comment here at SA about the impact of rising rates on REIT and utility stocks. Both of those industry sectors have attracted a large number of investors searching for yield. For many investors, REITs and utility stocks are viewed as “bond substitutes”. I started an analysis simply be looking at the current yield of the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ), a low cost sector fund that owns primarily electric utility stocks. Yield: As of 2/12/15, the sponsor calculated the dividend yield at 3.28%. The attractiveness of that yield will depend on an investor’s view about the direction of interest rates. Notwithstanding the abundance of contradictory evidence, the Bond Ghouls have been predicting that a Japan Scenario will envelope the U.S. until the end of days, a slight exaggeration, based on the pricing of a thirty year treasury bond at a record low 2.25% yield recently. If an investor believes that deflation will alternate with periods of abnormally low inflation for the next 30 years, then the pricing of several long term sovereign bonds may at least appear to be rational rather than delusional. The current yields of a U.S. electric utility stock, with modest earnings and dividend growth, may even look good compared to those yields and the dire future predicted by those sovereign bond yields (U.S., Germany, Switzerland, Netherlands, Japan, etc.) The 30 year German government bond closed last Friday at a .92% yield. German Government Bonds – Bloomberg The average annual inflation rate in Germany between 1950-2015 was 2.46%. Just assume for a moment that the future will be similar to the past, with some hot and low inflation numbers and possibly a brief period of slight deflation. The .92% 30 year German government bond would produce a 1.54% negative annualized real rate of return before taxes. The average annual U.S. inflation rate between 1914-2015 was 3.32%. When the 30 year treasury hit a 2.25% earlier this year, and assuming the historical average annual rate of inflation, the total annualized return before taxes would be -1.07%. The first item for investors to consider is why are so many predicting the Japan Scenario given the recent U.S. economic numbers and the non-existence of a single annual deflation number since 1955 other than the understandable -.4% reported for 2009. Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis When looking a long term charts, it is hard to see the underlying support for what the Bond Ghouls are saying about the future. (click to enlarge) (click to enlarge) (click to enlarge) The DSR ratio highlights that U.S. households have more disposable income after debt service payments to pay down debt, to spend, or to save. I view this chart as bullish long term for stocks but not far bonds. I have been making the same point here at SA for over three years now without convincing a single bear of my point. An example of banging my head against the wall was a series of comments to this SA article published in February 2013: Sorry Bulls, But This Is Still A Secular Bear Market-Seeking Alpha It is interesting to go back and read some of those comments from other investors. Yes, I am referring to the bears here who were predicting a bear market starting in 2012 just before the S & P 500 took off on a 700 points move up, not down by the way. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) Links to some other relevant charts: Financial Stress-St. Louis Fed Household Financial Obligations as a percent of Disposable Personal Income-St. Louis Fed Mortgage Debt Service Payments as a Percent of Disposable Personal Income-St. Louis Fed Charge-Off Rate On All Loans, All Commercial Banks-St. Louis Fed Retail Sales: Total (Excluding Food Services)-St. Louis Fed E-Commerce Retail Sales-St. Louis Fed Light Weight Vehicle Sales: Autos & Light Trucks- St. Louis Fed Corporate Net Cash Flow with IVA -St. Louis Fed ISM Non-manufacturing-St. Louis Fed And what are the current economic statistics (not the ones generated through reality creations) that support the long term Japan Scenario prediction that underlies current intermediate and long term bond prices? I will just drag and drop here my recent discussions of this data. Is that dire long term U.S. inflation and growth forecasts embedded in those historically abnormal yields justified by the 5% real Gross Domestic Product growth in the 3rd quarter perhaps slowing to 3% in the 2014 4th quarter with personal consumption expenditures accelerating; the lowest readings on record in the debt service payments to disposable income ratio (DSR) ; the decline in the unemployment rate to 5.7% with 257,000 jobs added in January with a 12 cent rise in average hourly earnings and a 147,000 upward revision for the prior two months; a decline in the 4-week moving of initial unemployment claims to the historical lows over the past four decades; the long term forecasts of benign inflation; a temporary decline in inflation caused by a precipitous drop in a commodity’s price, the consistent and long term movement in the ISM PMI indexes in expansion territory; capacity utilization returning to its long term average where business investment has traditionally increased by 8% , or perhaps some other “negative” data set. That kind of data has to be negative rather than positive, right? Even the government’s annual inflation numbers for 2014 showed a + 3.4% increase in food prices; a 2.4% increase in medical service costs, a 2.9% increase in shelter expenses, and a 4.8% increase in medical commodities. The BLS called the rise in food prices “a substantial increase” over the 1.1% rate for 2013. While I am not predicting here a return to $80+ crude, the price may have already bottomed and the disinflationary impact created by the 50%+ decline is consequently a temporary abnormality that will self correct with supply and demand moving back into balance. Consumer Price Index Summary While it is too early to know whether intermediate and long term rates have started to turn back up, the recent movement is certainly cautionary and resembles the lift off in interest rates that started in May 2013, when the ten year was at a 1.68% yield, and culminated in a rate spike to 3.04% for that note by year end. 7 to 30 Year Treasury Yields 2/2/15 to 2/13/15 Daily Treasury Yield Curve Rates When looking at that table, it is important to keep in mind that a ten year treasury yield of 2.00% is abnormally low by historical standards since 1962: (click to enlarge) 10-Year Treasury Constant Maturity Rate – FRED – St. Louis Fed And this brings me to my word of caution about utility stocks. A 3% dividend yield is not too hot using history as a guideline. To be justified, the investor will have to buy into most of the Bond Ghouls Japan Scenario unfolding in the U.S. rather than a gradual return to something close to normal inflation and GDP growth. Valuation: For me, valuation is the kicker. What S & P sector currently has the highest P.E.G. ratio? Back in the late 1990s, I would have said technology stocks without looking to verify the answer. I said utility stocks now and I took the time to verify that response. An investor can download the current E.P.S. estimates for the S & P 500 and the various sectors from S & P in the XLS format. I can not link the document here, but anyone interested can find it using the exact google search phrase “XLS S & P Dow Jones Indices”. It should be the first result. As of 2/12/15, the estimated forward 5 year estimated P.E.G. for the utility sector is a stunningly high 3.65, and this sector has traditionally been one of the slowest growing sectors. Technology is at a 1.27 P.E.G. The P/E based on estimated 2015 earnings is 17.12. The data given by the sponsor of XLU immediately set off alarm bells when I looked at it recently. In addition to the vulnerability of stock prices due to a rising interest rate environment, the sponsor calculated the forward P/E at 17.14, which is normally a non-GAAP ex-items number, a 7.23 multiple to cash flow, and a projected 3 to 5 year estimated E.P.S. growth rate of only 4.86%, or a similar P.E.G. to one calculated by S & P and mentioned above. The Vanguard Utilities ETF (NYSEARCA: VPU ) has another set of data that is even more concerning than the XLU valuation information: As of 1/31/15, this fund owned 78 stocks, with a P/E of 20.8 times and a 2% growth rate. Portfolio & Management Taking into consideration the possible or even probable rise in rates, the low starting yields for utility stock purchases now, the high P/E and abnormally high P.E.G. ratio, I am just saying be careful out there. I will be discussing in my next blog a reduction in my position in the Duff & Phelps Global Utility Income Fund Inc. (NYSE: DPG ), a closed end fund that has performed well for me since my purchases. I may not start writing that blog until Monday after taking the time to write this one in my usual stream of consciousness writing mode. CEFConnect Page for DPG According to Morningstar, the Utilities Select Sector ETF ( XLU ) had a 2014 total return based on price of 28.73%, much better than SPY, and was up YTD 2.33% through 1/31/15. The tide has turned with the recent rise in rates since the end of last month. The total return for XLU is now at -4.34% YTD through 2/12/15. Just as a reminder, I only have cash accounts and consequently do not short stocks. I do not borrow money to buy anything. I have never bought an option or a futures contract. I am not paid anything to write these SA Instablogs or SA articles or any of my almost 2000 blogs written since early October 2008, mostly very long ones, published at Stocks, Bonds & Politics . I do not own any of those short ETFs. I am currently substantially underweighted in the Utility sector.

Calpine Corp.: A Different Kind Of Utility

Summary Operates diversified, modern natural gas-fired power plants. Company pays no dividend yield, only share repurchases. Management exercises prudent control of debt and input costs. Calpine Corp. (NYSE: CPN ) has a portfolio (including partnership interest) of over 88 power plants generating in excess of 26,000 megawatts of power in North America, primarily in California, Texas, and the Eastern seaboard. As an added benefit, these are modern, clean energy plants using natural gas and geothermal to produce power, resulting in lower carbon emissions – 95% of the company’s power generation was done with natural gas. This marks it as an industry leader going forward as natural gas is expected to be a leading generator of power in the United States in the coming years, as coal continues its decline and natural gas is discovered in shale plays. While the company consumed 793 billion cubic feet of natural gas in 2014 (10% of all natural gas used for power generation), the EIA estimates the US has over 350 trillion cubic feet of proven natural gas reserves at the end of 2013. Prior Bankruptcy, Current Cost Control In 2005, Calpine filed for bankruptcy protection in one of the largest bankruptcies in US history as natural gas prices had soared, a new glut of competing power plants came online, and the company’s debt load of $22B became unmanageable due to poor structure. Calpine’s prior leadership team was poor and mismanaged the company in its debt and hedging practices. The company emerged from bankruptcy to begin trading again in 2008. I think it is important to note that the market today is much different than it was then – Calpine’s current outstanding debt is half of what it was, has been financed at lower interest rates, and the natural gas market has fundamentally changed. (click to enlarge) As noted, the company has done a great job in recent years of paying down and refinancing debt. Total interest expense has fallen from $813M in 2010 to $645M in 2014, a decrease of 20%, as total revenue has grown 22% in that same time frame. Long-Term Outlook, Coal to Gas Switching Depending on the fluctuating spot prices of coal and natural gas, power plants using one or the other frequently set the price of wholesale energy. Most often in the past decade, but as natural gas prices have fallen it has become more commonplace that natural gas sets the price. When this switching occurs, demand and total generation volumes increase for Calpine. If you look back to 2012 when this occurred often, you’ll find elevated levels of operating income. Forward markets for natural gas prices suggest this may happen again in 2015. Fundamentally, in the intermediate/long term, coal to gas switching may become even more prevalent as environmental regulations and political pressures force coal-fired power generation to reduce levels of pollutants like sulfur dioxide and nitrogen monoxide through expensive retrofits. Costs will increase for these market participants and natural gas power plants may overtake coal as the primary form of energy generation in the United States. Wait, No Dividend? Utilities are known for and sought out by income investors for the income that their dividend payouts provide. Retail investors frequently screen stocks by dividend yield and history to choose stocks. CPN does not pay one – but not for lack of profitability or cash flow. Thad Hill, CEO, stated in the Q4 2014 Earnings Release , 2014 wrapped up in a fine year for Calpine, we are proud to report adjusted EBITDA of $1.949 billion, adjusted free cash flow of $830 million and adjusted free cash flow per share of $2.03. So what gives? CPN provides returns to shareholders in the form of share buybacks solely. Thad Hill further states, Finally, we have continued to return money to our shareholders by completing $277 million of buyback since the last quarterly call in November. As our stock price moved down with the recent commodity price sell off, we took advantage of it and stepped up our share repurchase program. Since beginning the program in 2011, we have repurchased approximately 25% of our outstanding shares for $2.4 billion. $1.1B of those share repurchases have been done in the last year. Operating using a model of only share repurchases gives management added flexibility in deploying capital. Who better to know when the shares are undervalued than management? Or when that capital may best be used to fund a timely acquisition that has a greater expected NPV than through shareholder returns? Ownership/Short Interest CPN also has high institutional ownership (95%). This ratio is one of the highest I could find among utilities – only El Paso Electric (NYSE: EE ) and ITC Holdings (NYSE: ITC ) have higher rates, at 98.9% and 95.1%, respectively. Institutional ownership here is key – considering the vast amount of resources, talent, and research that these institutions provide their researchers, their investment decisions generally carry great weight with retail investors. In this case, retail investors have not followed, most likely due to the earlier highlighted issues of the lack of a dividend and prior bankruptcy. Analysts have a similar opinion to institutions. 75% of analysts rate the stock a strong buy/buy, with none rating it as underperform/sell. The average target price is $25.00 – nearly 20% upside from current prices. *Sourced from Yahoo! Finance Short interest in CPN (4% shares held short) is within the top quintile of utilities. Its short interest is similar to utilities that have no free cash flow or those with higher P/E ratios and lower growth prospects. Having no dividend is a double edged sword – no short wants to get stuck covering a dividend over ex-date, so short interest in the sector is usually mild even when the sector trades overvalued. The company’s lack of a dividend yield gives shorts the advantage of not being forced to cover at high prices before ex-date or feeling the sting of that negative dividend payment hit their account. 2015 Guidance (click to enlarge) The company guides $2.10-$2.60 a share in free cash flow/share – 3.5% increase over 2014 on the low end and 28% on the high end. This is forecast to be a record year in cash flow availability for the company, with plenty of available cash for repurchases and acquisitions. As of the February earnings release, the company had already repurchased $125M in shares in 2015 – on pace for another year of over $1B in repurchases – which would retire 12% of the float at the current share price. As the current share price sits below the average share price of repurchases in 2014, so I expect these buybacks to continue as management continues to believe current prices are an excellent investment opportunity. Conclusion A purchase in Calpine is a purchase of a company with a historical stigma and no steady income stream to shareholders. But it is also a purchase in a company that analysts and institutions have committed big to and one that is set to benefit strongly from a coming shift in energy production from coal to natural gas on the heels of the American resurgence of power in oil and natural gas production. I see fair value today at $26.00/share – more than 20% upside from current prices. Disclosure: The author is long CPN. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Dominion Resources Is Boosting Returns To Shareholders, But Is It A Buy?

The utility sector is generally known as a collection of high yield, slow growth companies. Dominion Resources has been a top performer in the sector with an attractive growth rate and dividend yield. Dominion Resources recently announced a boost to the dividend and guided for a higher payout ratio going forward. This article will discuss the current valuation levels for the company and determine if it is worth adding to my dividend growth portfolio. As an avid reader of the dividend growth investing strategy on Seeking Alpha, it’s apparent that many investors using this method have a fond appreciation for utility companies in their portfolios. The consistency of earnings and reliable nature of a long-term, slow and steady growth rate make these companies a great cornerstone for long-term buy and hold investors. One utility that is a great example of this slow and steady growth is Dominion Resources (NYSE: D ). Here is the company description from Dominion’s website: Dominion is one of the nation’s largest producers and transporters of energy, with a portfolio of approximately 24,600 megawatts of generation, 12,400 miles of natural gas transmission, gathering and storage pipeline and 6,455 miles of electric transmission lines. Dominion operates one of the nation’s largest natural gas storage systems with 949 billion cubic feet of storage capacity and serves utility and retail energy customers in 12 states. Dominion has a long history of providing outstanding total returns for investors. The company has a 10-year dividend growth rate of 6.3%, a 10-year earnings growth rate of 4.5%, and during that time has provided investors with 12.4% annual total returns with dividends reinvested. While the past has been great, the future may be even better. On February 9th, the company announced an 8% increase in the quarterly dividend from $0.60 to $0.6475 per share, and stated its intentions to increase the dividend payout ratio from a range of 65-70% of earnings to 70-75% through the end of the decade. Dominion also held its Investor and Analyst Meeting on February 9th, with management providing an overview of operations and expectations for the future. During this meeting presentation, management provided guidance for 6-7% earnings growth and 8% dividend growth through 2020, both of which exceed rates seen over the last decade. With a current yield of around 3.55%, investors buying for the long term can lock in an attractive yield growing at a high rate for a utility company. However, in the short term, the stock appears to be trading at a rich valuation compared to historical levels. (click to enlarge) Compared to a normal PE of 16.2 over the last decade, the current ratio of 21.3 would indicate that shares are trading at a 30% premium to normal values. The current yield shown has not yet updated to the newly announced dividend rate, but the 3.55% yield at that payout is still low compared to historical levels. Much of this premium being paid by the market is due to U.S. Treasuries trading at historically low levels, which is driving income seeking investors into equities as they search for yield. I discussed this in a recent article covering the utility sector , and a similar situation is being seen in the REIT sector as well. This trend has been reversing in recent weeks, as the Treasury rate has rebounded and the utility sector, as shown by the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ), has sold off. 10 Year Treasury Rate data by YCharts Circling back to Dominion, it appears that the share price was driven up by macro factors, as the sector traded higher on the weaker Treasury rate. With that rate appearing to be normalizing, there could be some continued short-term pain for Dominion investors. Dominion is a great company with multiple drivers leading to continued growth. I think it deserves a spot in my portfolio as a core holding, but the valuation appears stretched at current prices. This is a company I hope to own, and it has been added to my watch list for my dividend growth portfolio . I will be looking for an entry point at around $65, which would provide a dividend yield of 4% that would pair quite nicely with an 8% dividend growth rate going forward. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I am a Civil Engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.