Utilities have taken a beating this year. The normally lower-volatility stocks have been the opposite. They've plunged by 20% on average, with half that decline coming in the past week.
Surging long-term interest rates have weighed heavily on the sector. That's because utilities tend to borrow lots of money to fund their capital programs. Furthermore, they've lost value because lower-risk income investments like government bonds now offer higher yields. Investors now demand higher yields from utilities to compensate them for their higher risk profiles.
A silver lining to the sell-off in the utility sector is that several high-quality companies now trade at much lower valuations. That makes them look like bargain buys for long-term investors.
Growth on sale
Utilities have historically traded around 20 times forward earnings. However, many of the sector's largest players now trade well below that level.
NEE PE Ratio (Forward) data by YCharts
The biggest outlier is NextEra Energy(NYSE: NEE). The Florida-based utility has typically traded at a significant premium to its peers. That's mainly due to its higher growth rate, powered by its focus on the fast-growing Sunshine State and its renewable energy investments.
That premium has evaporated recently due to news that its affiliate, NextEra Energy Partners(NYSE: NEP), was slamming on the brakes by cutting its dividend growth rate roughly in half. It had to slow its growth because higher interest rates have made it too expensive to raise capital to fund acquisitions from NextEra.
However, while the partnership is slowing down, NextEra Energy doesn't expect to slow. It reaffirmed its outlook that its adjusted earnings will grow by 6% to 8% per share through 2026. The company said it would be disappointed if growth wasn't at or near the upper end of that range. It also expects to increase its dividend (currently yielding 3.7%) by around a 10% annual rate through next year. The company has increased its payout annually for over a quarter of a century.
One factor powering its confidence is that it's not completely reliant on NextEra Energy Partners to fund its growth. The company recently proved that by agreeing to sell its Florida City Gas utility for $923 million in cash. That will give it money to recycle into higher-returning capital projects. It could sell many other non-core assets to third parties to raise capital.
With a 4% dividend yield and a 6% to 8% earnings growth rate, NextEra Energy could generate total annual returns of 10% to 12% from here. That assumes no recovery in its trading multiple. Multiple expansion gives it even more upside potential.
High-quality dividend growth stocks
The sell-off in the utility space has driven up dividend yields. That has the sector offering some attractive payouts from companies with excellent track records of paying dividends.
Utility | Dividend Yield | Dividend Track Record |
|---|---|---|
Consolidated Edison(NYSE: ED) | 3.9% | 49 straight years of dividend increases |
Southern Company(NYSE: SO) | 4.4% | 22 consecutive years of dividend growth and 76 years of dividend stability and growth |
Duke Energy(NYSE: DUK) | 4.8% | 97 years of dividend payments |
Data source: Google Finance and company websites.
All three should continue increasing their dividends in the future despite the effect of higher rates. Powering that outlook is their heavy investments in clean energy, which should give them the fuel to grow their earnings.
For example, Duke Energy anticipates growing its earnings by 5% to 7% annually. That will give it the power to continue pushing its payout higher. It recently provided investors with a 2% raise. The company is combating higher rates by retaining more cash (increasing the dividend at a lower rate than earnings growth) and capital recycling.
It's also selling its commercial renewable energy business in separate deals valued at $2.8 billion (utility-scale business) and $364 million (distributed generation business). These initiatives will reduce its reliance on issuing debt to fund its investments in low-risk capital projects with attractive returns.
Consolidated Edison also recently cashed in on its commercial renewable energy business, selling it for $6.8 billion in cash. It will use those proceeds to invest in clean energy transmission projects, energy efficiency, building electrification, battery storage, electric vehicle infrastructure, and renewable power generation in New York. Those investments will grow its earnings. That should allow it to continue increasing its dividend.
Southern Company's earnings are about to get a big boost from the upcoming completion of a major capital project. Its Georgia Power subsidiary invested over $10 billion to build two new nuclear power generating units (Vogtle 3 and 4). The first unit is already producing power (and cash flow), while the second one will start commercial service by early next year at the latest. Once online, they'll supply Southern with $700 million of incremental operating cash flow. That will give it more money to pay dividends and invest in additional capital projects.
Attractive total return potential
Utilities are trading at their lowest valuation multiples in years. That's boosted their dividend yields. Because of that, they now offer very compelling value propositions. They should be able to grow their earnings and dividends at a low to mid-single-digit pace. That positions them to produce double-digit total returns when factoring in their higher-yielding dividends. Add in the potential additional upside from multiple expansion, and utilities look like great investment opportunities right now.
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Matthew DiLallo has positions in NextEra Energy and NextEra Energy Partners. The Motley Fool has positions in and recommends NextEra Energy. The Motley Fool recommends Duke Energy. The Motley Fool has a disclosure policy.
