The surge of inflation to a 40-year high has imparted a double hit on the stock market this year.
Inflation has greatly increased the costs of most companies and thus it has pressured their operating margins. In addition, it has reduced the present value of their future cash flows and as a result exerted great pressure on the valuation of most stocks.
Utility stocks can easily pass their increased costs to their customers and hence they are more resilient to inflation than most stocks. This helps explain why the Utilities Select Sector SPDR ETF (XLU) has outperformed the S&P 500 by a wide margin this year (-3% vs. -21%).
Let's discuss the prospects of three utility stocks that offer above-average dividend yields.
UGI Corp.
UGI Corp. (UGI) is a gas and electric utility that operates in Pennsylvania, in addition to a large energy distribution business that serves the entire U.S. and some international markets. It was founded in 1882 and has paid consecutive dividends since 1885. The company operates in four reporting segments: AmeriGas, UGI International, Midstream & Marketing and UGI Utilities.
UGI is different from most utilities due to its propane distribution business, which covers a wide geographic area. This business allows the company to expand faster than a typical utility but it also introduces some volatility in its business performance due to its sensitivity to weather conditions.
However, UGI is doing its best to mitigate the effect of the underlying weather conditions on its performance. To this end, it recently signed a five-year pilot program with regulatory authorities. According to this program, UGI is permitted to adjust the bills of its customers if the weather deviates more than 3% from the 15-year historical average. This is certainly a favorable development, which will render the cash flows of the company more reliable and predictable.
It is also important to note that UGI has exhibited a much more consistent growth record than most investors would expect. To be sure, the company has grown its earnings per share in eight of the last nine years, at a 10.9% average annual rate. As 2012 formed a relatively low comparison base, investors should note that UGI has grown its EPS at a 7.6% average annual rate over the last five years. This growth rate, which is more representative of the growth potential of UGI, is undoubtedly attractive, especially given the reliable growth trajectory of the company and its resilience to recessions.
In the fiscal third quarter, UGI enjoyed wide margins in its natural gas businesses, but its global LPG segment was negatively affected by warm weather and high cost inflation. Consequently, its EPS dipped from $0.13 in the prior year's quarter to $0.06. Given its performance in the first three quarters of its fiscal year and current business trends, UGI seems poised to incur a 2% decrease in its EPS this year.
On the other hand, the utility segment of the company, which has an 11% growth rate of its rate base, is on track to deploy a record level of capital for the expansion and improvement of infrastructure. In addition, UGI has added more than 11,000 residential heating commercial customers so far in 2022 and recently reiterated its commitment to meet its long-term financial target of 6%-10% growth of EPS and 4% dividend growth. Overall, it is reasonable to expect UGI to continue growing its EPS by about 7% per year, in line with its historical growth rate.
Moreover, UGI is a Dividend Aristocrat, with 35 consecutive years of dividend growth. The stock is currently offering a 10-year high dividend yield of 4.3%, with a solid payout ratio of 50%. Given its reliable growth trajectory and its resilience to recessions, UGI can easily continue raising its dividend at a mid-single-digit rate for many more years.
OGE Energy Corp.
OGE Energy (OGE) is the parent company of Oklahoma Gas and Electric Company (OG&E), a regulated electric utility that serves more than 860,000 customers in Oklahoma and western Arkansas. OGE Energy generates 80%-85% of its annual utility earnings in the second and third quarter.
OGE Energy does its best to maintain its electricity rates as low as possible. Its rates are significantly below the national average most of the time and thus they result in high customer satisfaction rates, which enable the company to grow its customer base. This is a major competitive advantage. The other competitive advantage of OGE Energy is the immense investment required from potential new entrants to build the infrastructure of the regulated business. The high barriers to entry protect OGE Energy from potential new competitors.
In the second quarter of the year, OGE Energy saw its EPS dip from $0.56 in the prior year's quarter to $0.36 but mostly due to a decrease in the value of its stake in Energy Transfer (ET) . OG&E grew its EPS from $0.42 to $0.50, mostly thanks to favorable weather. The company reiterated its guidance for EPS of $1.87-$1.97 for the utility segment in the full year, implying 7% growth at the mid-point, but stated that it expects results at the top half of this range.
It is also important to note that OGE Energy has divested most of its shares in Energy Transfer this year and hence it currently owns less than 1% of Energy Transfer. This divestment is in line with the goal of the company to become a pure regulated utility, with much more predictable earnings.
OGE Energy has exhibited an uninspiring performance record, as it has grown its EPS by only 3.1% per year on average over the last decade. However, its outlook seems much brighter than its past. The company has invested $3.3 billion in growth projects in the last five years. As this amount is nearly half of the market capitalization of the stock, it is evident that management is heavily investing in future growth.
Moreover, the strong economy in Oklahoma and Arkansas are likely to drive significant organic growth for OGE Energy in the upcoming years. Thanks to the recent completion of some growth projects and the focus of management in growing the utility business, OGE Energy can grow its EPS by 5.0% per year on average over the next five years. This is in line with the long-term guidance of management for 5%-7% annual growth of EPS in the utility segment. Management also recently reaffirmed that it will continue raising the dividend while keeping a healthy balance sheet and a flat share count.
OGE Energy has raised its dividend for 15 consecutive years and is currently offering a dividend yield of 4.4%. Given its decent payout ratio (for a utility) of 75% and its strong balance sheet, which has a BBB+ credit rating, the company can keep raising its dividend for many more years.
FirstEnergy Corp.
FirstEnergy (FE) generates, transmits and distributes electricity in the U.S. via its subsidiaries. The company owns and manages hydroelectric, coal-fired, nuclear, natural gas and renewable power generating facilities. Its 10 electric distribution companies form one of the largest publicly traded electric utilities in the U.S. FirstEnergy serves approximately six million customers in Ohio, Pennsylvania, New Jersey, West Virginia, Maryland and New York.
In the second quarter, FirstEnergy grew its revenues 7% over the prior year's quarter, mostly thanks to increased demand from commercial customers. However, its EPS decreased 12.5%, primarily due to increased planned expenses and the issuance of new shares. On the bright side, management reiterated its guidance for annual EPS of $2.30-$2.50. At the mid-point, this guidance implies 2% growth over last year.
A key difference of FirstEnergy from most utilities is its exceptionally volatile performance record. The company has made some unsuccessful investments and thus it has incurred hefty losses in some years. This unreliable performance is in sharp contrast to the vast majority of utilities, which are characterized by a reliable performance.
Fortunately, FirstEnergy has finally turned around and thus its outlook seems more promising than the past. Thanks to its capital plan, the company expects to grow its EPS by 6%-8% per year on average. Given the choppy performance of FirstEnergy, we advise investors to keep their expectations towards the low end of the guidance of management.
It is also worth noting that FirstEnergy has a markedly poor dividend record for a utility stock. It cut its dividend in 2014 and froze the reduced dividend for five years. Then, it slightly raised its dividend but it has frozen its dividend again in the last three years.
The stock is currently offering a 4.1% dividend yield with a payout ratio of 65% and hence its dividend appears safe in the absence of a severe downturn. On the other hand, given the high debt load of the company and its somewhat unreliable performance, its dividend is not as safe as the dividends of UGI and OGE Energy. Moreover, investors should not expect meaningful dividend raises going forward. This is an important issue to consider, particularly given the highly inflationary environment prevailing right now.
Final Thoughts
The stock market is going through a painful bear market this year due to the impact of inflation on the earnings of most companies, the effect of inflation on the valuation of stocks and fears of an upcoming recession. All these headwinds have formed a perfect storm for investors.
Utilities have proved much more resilient than most stocks during such fierce downturns. The above three utilities are currently offering attractive dividend yields and are likely to outperform the broader stock market as long as the ongoing bear market remains in place.
