Rising Interest Rates Make Utilities Risky

 | Jul 31, 2013 | 2:00 PM EDT  | Comments
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Stock quotes in this article:

ed

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aep

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duk

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d

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wec

Utilities are often a lynchpin of any dividend strategy. Investors like them for their consistent, regulated earnings. While regulation often inhibits utilities from rapid growth, it also often acts as a guarantee for profits.

Unfortunately, rising interest rates pose a big, continuous threat to utilities stocks. Rising bond yields usually mean that dividend yields for utilities must rise as well. Utilities basically trade along with bonds.

Bonds are still historically expensive, despite having come down a bit. And we will see that there is still a lot more room to the downside. In this environment, we therefore have to be skeptical of utilities. When in doubt it is probably best to stay away for the moment. Today, I am going to look at four big U.S. utilities with attention to historical valuations and yields.

 By Dividend Yield

Source: YCharts

Let's start with two of my personal favorites, Consolidated Edison (ED) and AEP (AEP). One thing that stands out is just how far yields are still depressed. Since the 2009 intergenerational low, prices have gone up pretty smoothly, and hence rates have come down. At barely 4 percent, how much lower can rates realistically go? If history is any guide, they sure can go a lot higher. We really shouldn't be getting into Con Ed or AEP until the yield is closer to five percent than it is to four.

 Source: YCharts

Two other big, important utilities are Duke (DUK) and Dominion (D). Duke's yield is higher than the rest, perhaps because of its reliance on coal and the lack of industrial strength (something its coal-reliant cohort AEP does have). Unfortunately, it shows the same big downside possibility. With Duke, it's best to wait for a yield of over five. Dominion is a fundamentally strong company and is trading at a premium to the rest. The low four percent range would be a good place to grab this Virginia utility.

 By Forward P/E Ratio

Consolidated Edison (ED)             15.6x (vs. average of 14.6 for past fifteen years)

American Electric Power (AEP)      14.9x (vs. average of 13.2 for past fifteen years.)

Duke (DUK)                                    16.3x (vs. 15.8 historically)

Dominion Resources (D)                19.1x (vs. 16.5 historically)

 Source: FAST Graphs

Looking at historical price-to-earnings ratios really drives the point home. Despite the drop in "dividend equivalents" such as utilities, they are still pretty expensive relative to where they used to be. Staying away from utilities, at this point, seems a no-brainer. Because of utilities' stability and lack of growth, they will trade in lockstep with bonds. Many are still relatively expensive and will go down as rates continue to go higher.

If you really like utilities, however, there is one that does have reasonable growth, is growing its payout faster than its peers and therefore might be immune to jumping rates. That company is Wisconsin Energy (WEC). Wisconsin Energy is in the process of increasing its dividend payout target ratio from 35% to 70% of earnings by 2017. Their current payout ratio sits at 51%. There is plenty of room for dividend growth here. With 4-6% earnings per share growth expected to 2017, management believes they can grow dividends by seven to 10%. Although the yield seems low at 3.5%, it's the steady growth that will get you through until 2017. Some things are worth paying the premium for.

 Conclusion

Despite the recent drop, utilities are still expensive. As rates finally start to go higher, utilities suddenly become a risky sector. Investors must adjust to this reality and stop categorically thinking of utilities as "safe." A 10% drop in any of these, which is entirely possible, would erase dividend gains for years. If you are going to wade into utilities, look for the ones that offer some growth and expansion of the payout ratio. I think Wisconsin Energy is a good choice.

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