Switched on utility dividends

Some electric utilities have cut their yields, making some investors wonder if the lights are going out on the sector.

By Mina Kimes, reporter

NEW YORK (Fortune) -- Investing in an electric utility is a lot like buying the Electric Company in Monopoly. Neither has huge growth potential, but both offer steady payouts: a reliable source of income during a recession or the beginning of a long game.

In 2009 alone, however, three large utilities have chopped their dividends, dimming the prospects for the traditionally safe sector. Since Constellation Energy (CEG, Fortune 500), Great Plains Energy (GXP), and Ameren (AEE, Fortune 500) cut their payouts, their stocks have sunk an average of 31%.

"Now that we've already seen three dividend cuts this year - the most in one year since 2003 - there's more investor anxiety," says David Burks, an analyst at Hilliard Lyons. "People are wondering, is this the start of a trend?"

For now, most utility dividends look secure. While three operators have made cuts over the last year, 36 raised their dividends, and 19 haven't made changes. JP Morgan analyst Andrew Smith told investors in a note that Great Plains and Ameren's decreases "were driven by company specific issues and do not point to systemic financial weakness in the industry."

But that doesn't mean that more dividends cuts won't happen, says Ryan McLean, a Morningstar analyst. "For the most part, they're safe. But they're less safe than they used to be," he says.

Over the last few years, electric utilities have amped up their spending on new power plants to spur growth, driving them deeper into debt. John Kohli, the manager of Franklin Utilities Fund, says the companies that cut their dividends were probably hesitant to tap unfriendly credit markets - bonds of Great Plains for example, are trading with 10.5% yields.

They were also anxious because of slowing sales. Great Plains blamed its dividend cut in part on reduced consumer demand and the weak economy.

Investors typically view electricity as a recession-proof product, but operators have reported a drop in consumption and a rise in delinquent accounts, particularly in hard-hit regions like the Southeast and Midwest.

"Most of the companies we follow are forecasting flat to negative sales in 2009," says Burks. "People think of electric utilities as defensive investments, but recessions do impact them."

But while operators with weaker balance sheets will struggle to raise or keep their dividends steady amidst such pressures, stronger companies will outperform the market, wrote Smith. "We continue to believe that utilities offer investors stable, attractive earnings and cash flow."

A steady earnings current

Electric utilities come in three flavors: regulated, partially regulated, or completely unregulated. A company is "regulated" if it dominates a region. The government dictates how much the utility can raise its rates, which is supposed to protect consumers from wild swings. Because a regulated utility doesn't have to lower its rates when power prices drop, it's typically less sensitive to economic volatility - but it also misses out on fat margins in boom times because it has to wait in line for rate increases.

"Companies across the world have been cutting their dividends, but a bright spot has been regulated utilities," says Thomas Forsha, co-manager of Aston/River Road's Dividend All Cap Value Fund. None of the operators that cut their rates this year are purely regulated.

Because regulated utilities must appeal to their state governments for rate increases, it's possible that a populist outcry might cause regulators to turn down requests for bumps. Burks doesn't think this will happen. He notes that Florida just granted its first rate increase in 16 years to Tampa Electric, part of Teco Energy (TE).

If the regulatory environment stays friendly, all regulated operators will benefit. But some, says McLean, still won't achieve the level of profits they're permitted to earn each quarter. "A few regulated utilities are under-earners, like Hawaiian Electric (HE)," he says. McLean projects that Hawaiian Electric, along with diversified utility PNM Resources (PNM), may sacrifice its dividend this year.

Most regulated utilities, however, are unlikely to cut their payouts, says Kohli. One operator he likes is Southern Company (SO, Fortune 500), which is currently trading at about 13 times estimated earnings. "Picking up that company and its 6% dividend yield makes tremendous sense no matter what direction the economy is going in," he says.

For value hunters, Burks prefers CMS Energy (CMS, Fortune 500), a smaller Michigan outfit that has improved its balance sheet over the last few years and recently boosted its dividend by 40%. "Their debt was downgraded to junk seven years ago, but now it's back at investment grade," he says. Nevertheless, the company's price to earnings ratio is just 7.5, a significant discount to its competitors.

Higher voltage stocks

If the economy rebounds, integrated operators stand to benefit more than regulated utilities. They sell both regulated and unregulated, or merchant, power, so they're more sensitive to variables like demand and commodities prices. "As an investor, you need to be aware that their earnings will move up and down," says McLean.

Merchant utilities suffered last year because of decreases in the price of power, says McLean. He thinks that will reverse this year. "Power prices hinge on natural gas, and we're forecasting an increase."

One integrated utility on a number of buy lists is FPL Group (FPL, Fortune 500). Its stock has taken a 17% hit over the last year, due in part to its location in recession-ravaged Florida. But McLean says FPL's geography is actually a boon. "They have a highly residential customer base, and individuals are far less likely to resist rate increases," he says. While just 0.3% of residential customers cut back on consumption last year, 2.6% of industrial users decreased their usage.

Other analysts like FPL for its diverse holdings. "They're the largest generator of wind power in the U.S.," says Burks. "They have growth potential."

Electric utilities face potential political headwinds in the form of proposed cap and trade restrictions, which would force them to purchase credits for higher emissions. While regulated operators might be able to pass along those costs to customers, integrated utilities with diverse holdings are better positioned to withstand widespread environmental legislation.

One such operator is Entergy (ETR, Fortune 500), which has a large nuclear portfolio. "Entergy was impacted by lower power prices, and now it looks attractive on a valuation basis," says Burks.

Another integrated standout is Sempra (SRE, Fortune 500), a California utility that also builds pipelines and trades commodities. "They have the best balance sheet in the industry - a 55% equity to capital ratio, which is much higher than the industry average," says Kohli. The company recently raised its dividend by 11%, and how offers a 4% yield.

"For the most part, utilities are in a good position," says Kohli. "The vast majority are well-capitalized, and should be able to withstand the credit cycle." For less flush operators, a continued downturn could be challenging - and put the lights out on dividends. To top of page

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