If President Bush gets his way, investors will soon be receiving their dividends tax-free. You’d figure that one sector to benefit would be gas and electric utilities, which through the years have offered consistently high dividends.
Right now, the average yield on utility stocks is 4.5%. Compare that with the 2.9% yield on the five-year Treasury note. Now, imagine that the utility’s dividends, which historically have risen a bit each year, aren’t taxed. Investors in an average tax bracket will be able to put about 2 1/2 times as much money in their pockets with the utility as with the Treasury security.
“The timing of a dividend tax change could not be better for the utility sector,” Steven I. Fleischman of Merrill Lynch wrote in a letter to clients two weeks ago. There’s no guarantee Bush’s proposal will pass Congress, but, even so, utility stocks ought to be soaring.
They’re not.
Consider FPL Group (FPL), a solid company whose main subsidiary, Florida Power & Light, generates electricity for 3.9 million customers. FPL has been increasing its sales and profits at a steady pace, and Dow Theory Forecasts, in a recent review of utility stocks, gives the company an “A” rating, noting its relatively low risk.
FPL pays a dividend of $2.32 a year. The stock recently closed at $57.96 a share, so its yield is 4%. In other words, an investment of $10,000 in FPL currently pays an annual dividend of $400. If you’re in a 30% tax bracket (including both state and federal taxes), you now pocket $280. If the Bush plan passes, you’ll keep all $400 — for an increase of $120, or 43%. That’s a huge jump.
But since Jan. 6, when the president’s tax proposal became public, FPL’s price hasn’t soared. Instead, it’s fallen 5%. And FPL is not alone.
Franklin Utilities (FKUTX), a mutual fund that invests mainly in U.S. electric companies, is down 2% this year. Exelon (EXC) of Chicago, the only midwestern or eastern utility that’s rated above average by the Value Line Investment Survey, has dropped 4%, and Dominion Resources (D) of Virginia, the only utility among the 43 stocks in Morgan Stanley’s U.S. model portfolio (and a favorite, as well, of Fleischman’s), is down a few cents.
What’s wrong with utilities? A lot. Many investors view them as downright toxic, and even the prospect of tax-free dividends doesn’t seem to help. But it is the very fact that utilities are being shunned that makes them attractive. It’s no accident, for example, that Berkshire Hathaway (BRK), chaired by super-investor Warren Buffett, has purchased Mid-American Energy, with 5 million gas and electric customers. Berkshire has added a pipeline and generating facilities in the United States and has become the No. 2 electric utility in Britain.
But most investors want nothing to do with such companies — and for apparently sound reasons. The main problem is that utilities are no longer safe, defensive stocks, producing a secure stream of income. They are something else, but no one is quite sure what.
In the past, utilities accepted strict regulation in return for geographic monopoly franchises. They generated not just electricity but a delightful flow of cash, dispensing about 80% of their profits to shareholders. When the economy was good, demand for power increased, so profits rose; when the economy was poor, demand fell, but, since borrowing costs dropped as well, utilities maintained decent profits. Tampa-based Teco Energy (TE), for example, increased its cash flow every year from 1986 to 1996, not bothered at all by the 1990-91 recession. Dividends per share rose from 62 cents to $1.11.
Tough times also benefited utilities, both because people still need to keep the lights and heat on and because a poor economy usually means low interest rates, which increase the appeal of utilities’ robust dividend yields.
But in the early 1990s, this cozy little world began to change with deregulation. Ending monopolies, allowing utilities to expand beyond local borders and into new businesses, and reducing price controls — all of those steps are ultimately good for consumers and the economy. But the steps also threw this conservative industry into turmoil.
Suddenly, as Vincent Muscolino wrote in a recent letter to clients at the Cambridge, Mass., investment firm David L. Babson & Co., companies gained the authority to “unbundle and repackage the three basic components of service: power generation, transmission and distribution.” Especially with a rash of mergers, it became hard for investors to determine the strategic direction each utility company would take — or the competition and continuing regulatory obstacles it would meet along the way.
In addition, utilities lost much of their financial security. Instead of being content to disgorge their profits as dividends, they were pressured to reinvest them in new plants and equipment, in an attempt to achieve the double-digit earnings increases that investors were now expecting from a transforming industry that had gained sex appeal. “The utility sector’s new drive for growth,” wrote Muscolino, “swapped its traditionally ample free cash flow for hope of greater shareholder returns.”
Despite these uncertainties (or maybe because of them), utility stocks started to rise powerfully in the mid-1990s. They were behaving almost like technology stocks. The Dow Jones utility average rose 129% between the start of 1995 and the end of 2000 but then lost all of its gains by October 2002. The stocks rallied over the next three months, but they have since leveled off or dipped. The utility average today remains nearly 50% below its high.
Here’s what happened: In the early years of deregulation, Wall Street was impressed. New capital arrived, and — not surprisingly — the industry became overbuilt. Supply exceeded demand; profits dried up. Old-fashioned managements couldn’t handle the changes. As Fleischman says, the industry is “still digging out of excess leverage, a difficult credit environment and a spending binge on power plants.”
Meanwhile, the angry political reaction to electricity shortages and manipulation in California in 2000 and the Enron scandal in 2001 (which involved a pipeline company that decided to make a living trading energy futures and anything else it could get its hands on) added still more regulatory uncertainty.
Over the past five years, mutual funds specializing in utilities have posted the worst returns of all sector funds, according to Value Line — a total loss of about 5%, compared, for instance, with a slight gain for technology funds. Profits dropped again last year. David Reimer, a Value Line analyst, notes that the eastern utilities he covers remained in the bottom fifth of the research firm’s rankings for most of 2002 and says that “prospects for 2003 are not much better.” Eastern utilities rank 85th among the 98 Value Line sectors; central utilities are 91st; western, 88th.
It’s a miserable situation, but that’s precisely why you should pay attention. Many of these stocks are absurdly cheap. In its review, Dow Theory Forecasts found that 14 of 62 electric utilities had price-to-earnings (P/E) ratios of 9 or less. The average was 12, or slightly more than half the P/E of the Dow Jones industrial average.
Of course, many of these companies richly deserve their low valuations. Aquila (ILA), for example, earned $2.35 in 2001 but trades today at just $2.10 (down from $37.80) after a horrible year. The dividend is still quoted at 70 cents a year (for a nice yield of 32%), but it’s been suspended. That’s quite a blow to a company that increased its payout in every year from 1986 to 1998 and then sustained it at $1.20 through 2001.
The problem was that Aquila, like Enron, got into the energy-trading business, with horrifying results. Some of its unprofitable marketing agreements, notes Paul Debbas of Value Line, run for as long as 20 years, “so they are difficult to unwind.” The firm has a huge debt burden. Still, some analysts project earnings of 30 cents in 2003, so technically, anyway, the P/E, based on estimated 2003 profits, is 7. But stay away.
On the other hand, Wendell Perkins, who manages the JohnsonFamily Small-Cap Value Fund (JFSCX), which has returned an annual average of 8% over the past three years (whipping the S&P 500 by 22 points), has lately been buying shares of Alliant Energy (LNT), a utility that also suffered a big drop in earnings last year. Alliant made what Perkins calls “some dumb, dumb international purchases” — particularly in Brazil — but the company, with a solid midwest franchise, is returning to its senses.
The stock fell by half in 12 months and now trades at a P/E of 12. The dividend was recently cut from $2 to $1, but Alliant is expected to maintain that level, which means its current yield is over 6%.
For total return (dividend plus potential price appreciation), Dow Theory Forecasts recommends Duke Energy (DUK), a battered North Carolina-based electric utility yielding 6.3%; KeySpan (KSE), a Brooklyn-based gas utility with a yield of 5.2%; Questar (STR), a solid company whose stock has actually doubled over the past three years; and Vectren (VVC), which distributes natural gas in Indiana and Ohio and yields 5%.
Merrill Lynch’s Fleischman warns investors that the industry is likely to have a rough time this year but says that “stocks that we continue to favor from a fundamental perspective and that also have attractive dividend yields” include Dominion, yielding 4.7%; Public Service Enterprise Group (PEG), 6%; and Pepco Holdings (POM), the Washington area utility, 5.1%.
The wretched state of the industry is reflected in the composition of Value Line’s model dividend-oriented portfolio: Only one of the 20 stocks is an electric utility. It’s Atlanta-based Southern Co. (SO), a solid citizen, with a P/E of 16 and a yield of 4.7%.
With the potential for so much volatility among the 80-plus electric and gas utilities, diversification is essential. Unfortunately, most mutual funds with “utilities” in their names are loaded with telecommunications stocks — another sector entirely. Franklin may be the best pure play. The “A” shares carry a 4.25% load but have annual expenses of only 0.8%. Average annual return for the five years ending Dec. 31, 2002, was 1.5%, about two points ahead of the S&P.
Its top five holdings are FPL, Exelon, Southern, New Orleans-based Entergy (ETR), and Cincinnati-based Cinergy (CIN).
Another good choice, the top utility pick of Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, is Gabelli Utilities AAA (GABUX), which is only three years old but carries a five-star (tops) rating from Morningstar. About 85% of the holdings are gas and electric utilities, the rest energy and telecom stocks. One drawback is the expense ratio — a lofty 2%.
The top asset is Allegheny Energy (AYE), based in Hagerstown, Md. Because of serious debt problems and accounting concerns, shares crashed from $54 in 2001 to $3 at last year’s depths, but they closed Friday at $8.58. Analysts estimate earnings of between $1 and $2 a share in 2003. If those guesses work out, this is one cheap stock. But, as Reimer of Value Line warns, “We advise all but the most speculative of investors to avoid commitments to this untimely, risky stock.”
No, utilities aren’t what they used to be. The idea of sitting back and enjoying a tax-free dividend of 5% really isn’t in the cards. These companies, undergoing massive changes, carry major risks. But where there are major risks, there are often major rewards.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.