Not All Utility Dividends Are Alike

 | Jul 27, 2012 | 4:30 PM EDT
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For some investors who seek income, utility companies are becoming a confusing investment. In the old days, U.S. Treasuries were safe and provided income. Today, they remain safe, but they no longer provide much income. U.S. utilities appear to be a good alternative investment, particularly when looking at their history of dividends. But utilities come in different sizes and shapes; some offer safer havens for investors, while others pay a premium to investors to absorb various levels of risk.

It can be difficult to discern the difference between safe and risky utilities. Investors rely on reports, ratings and their own independent analysis. Often the data are confusing.

A good example is Duke Energy (DUK). Out of the blue, some commentators are talking up Duke but provide little context. Some say investors should buy Duke's dividend of 4.54%, others claim Duke's enterprise is as solid as the Rock of Gibraltar.

It's hogwash. Duke is a wounded stock. By knifing CEO Bill Johnson in the back, rolling Progress Energy's board of directors and secretly conspiring to modify its merger agreement, Duke lost credibility with the rating agencies, shareholders, regulators, executives and employees.

Three separate rating agencies, Standard & Poor's, UBS and Moody's, recently downgraded Duke. Duke's stock took an unexpected tumble. State regulators are upset with Duke's executive management. Duke's earnings are in jeopardy. Three senior executives recently left the company.

Let's put Duke in perspective. If an income investor were to buy Duke today, he or she would likely receive a dividend that yields about 4.54%. Some suggest that this yield is attractive enough for investors to ignore fundamentals, jump in, buy the stock and lock in income from Duke's juicy dividends.

But buying Duke just for the yield makes little sense. Duke's current yield should signal a problem and a concern. On one hand, the yield is too high; it's almost 15% higher than the average investor-owned utility's yield. When the market demands higher-than-average yields, it's signaling that it wants to be compensated for taking on higher-than-average risk. Therefore, investors should be warned: Duke's stock is signaling that it currently represents a level of risk that's higher than that of the average utility.

On the other hand, if utility yields are the sole investment objective, why pick a loser? Twelve other investor-owned utilities pay yields higher than Duke, and five of those top utilities are paying 5% percent or more. If yields are the only issue as some suggest, why not pick the "top 5-by-5" -- the five top utilities paying 5% or more?

The top 5-by-5 utilities are:

Compare the top 5-by-5 utilities with Duke and rock-solid Dominion Resources (D):

Like Duke, the top 5-by-5 utilities have earnings, they have positive cash flows, they own regulated assets and they own additional unregulated assets. Like Duke, all of the 5-by-5 companies introduce varying degrees of risk.

If investors can manage the risk, the top 5-by-5 utilities are attractive, particularly for those seeking income. However, among the top 5-by-5, the lower-risk members appear to be Exelon (EXC) and PPL (PPL); they are very large utilities that have multiple revenue streams, and their price/earnings ratios are half the industry average.

Duke's risk profile is obviously changing. Its merger with Progress Energy had the effect of adding a new state regulator and, for a variety of reasons, new regulatory risks. Since Duke's revenue depends on eight separate state regulatory agencies, and since its credibility with those regulators has been badly damaged, Duke's future revenue is less certain than it was just two months ago.

At best, investors should view Duke as a compromise. Its dividends appear safe for now. Their price/earnings ratio is average for the industry. Like most of the top 5-by-5 utilities, Duke is no longer one of the nation's most stable utilities. Investors risk losing principal if more bad news about Duke unfolds. The bet is that more bad news is forthcoming. But the company is big, it has strong financials, and it can weather more bad news. In the end, Duke will likely recover, but it's not guaranteed.

Investors seeking income have choices. Among those choices, investors need to put Duke in context. If investors seek yield, they should be prepared to manage risk by constantly monitoring their positions. If a situation dictates, investors should be willing to pull the trigger.

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