Plugging Into Utilities

 | Dec 19, 2011 | 10:30 AM EST
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Utility stocks often receive only small helpings of affection by Wall Street. I have never been sure why that is the case. My hypothesis is that utilities tend to trade on premium multiples relative to the broad market and offer a profile of boring (though steady) earnings growth.

Companies such as Xcel Energy (XEL), Southern Co. (SO) and Duke Energy (DUK) lack the earnings growth rates that would attract growth investors. They also skew too expensive for value investors, and given their sleepy investment theses and associated low betas, they fail to attract momentum traders.

However, lo and behold, utilities have been a darn good place to hide in 2011 as U.S. politicians accomplish nothing but making riveting public arguments and Europe's hell-in-a-hand-basket story plays out daily. The mood on the Street regarding 2012 is that the S&P 500 stands to gain at least 10%, and that utilities, once again, are a sector to be avoided. Naturally, that type of groupthink leads me to believe otherwise.

Here's what we can say in utilities' favor:

  • They are monopolies. We cannot shop for electric on Amazon (AMZN) (not yet at least)!
  • Much could be said for domestic businesses that offer consistent earnings in an inconsistent world setting.
  • They offer juicy dividend yields.

The S&P 500 dividend payout ratio is at an all-time low, and the 10-year Treasury note is yielding less than 2%. The Federal Reserve's strategy of keeping interest rates low will go unchanged in 2012 (this hurts rates on savings accounts and CDs, for example), so utilities stand out with their steadily growing and sustainable dividends (the average yield for a utility is north of 4%). Moreover, I believe the earnings power of utilities is still underappreciated by the market.

This is not just a grab at dividend growth. There is room for further multiple expansion, because more stuff is getting plugged in. Utilities give a portfolio strong exposure to the technological innovation from Apple (AAPL), Microsoft (MSFT), Intel (INTC) and other technology companies, without the risk of a product miss harming quarterly sales and earnings.

These statements may sound too straightforward, but think about them. The top-selling gifts this holiday season, and for all of 2011, have been anything that requires a recharge. Many people interact with handheld devices all day long, and these devices are likely to be plugged in even when they're not in use. At auto shows, carmakers are touting their electric cars. New businesses continue to sprout up, and they need electric in formerly unused office space. This trend extends to the new home office known as Starbucks (SBUX). I continue to be amazed by how many people have devices plugged into the outlets at Starbucks. The company should link up with Staples (SPLS) and dedicate specific areas in its stores where people can work.

The stock I have selected incorporates these factors and one other. I want to be where the median household income is sufficiently above the national average, because this would suggest more tech gear consumption and greater power usage. Obviously, that place is New York. The company is none other than Consolidated Edison (ED), which so happens to have raised its rates in the middle of this year.

Con Edison distributes close to 70% of its free cash flow in the form of a dividend; its yield is 4%. The company has recently entered a credit agreement that extends to 2016. It has improved its capital structure through debt repayment and less reliance on commercial paper for funding. And it is coming off a quarter in which it hiked the low end of its earnings guidance by $0.10 a share.

Con Edison distributes electric, gas and steam power to an area that has a sub-9% unemployment rate and where monthly job gains have picked up. And its service area has seen a surge in the number of people re-entering the job market, and they will undoubtedly consume more power in their pursuit of employment.

Going back to my view that utilities garner no love from Wall Street, only one of 19 analysts covering the stock have a buy rating on Con Ed. Where have they been? The stock is up 21% year to date.

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