Low interest rates were the order of the day following the financial crisis of 2008, which made high-yielding utilities an attractive investment option for income-seeking investors. Utilities are low-beta businesses and offer good risk adjusted returns. Investors chased yields following the financial crises, which led to above-market average price multiples for utilities. Historically, utilities have traded at premium valuations when the 10-year Treasury yield has remained under 3%. A low interest rate environment is expected to prevail in the remainder 2013, with the 10-year yield currently around 2.8%.
However, moving into 2014 and beyond, Treasury yields are expected to rise, which could make utilities less attractive for investors. Hence, a rise in Treasury yields remains a headwind for the utility sector. There are some utilities that may outperform, however, given cheaper valuations and above-average dividend growth.
High yield and attractive valuation
PPL Corp. (NYSE:PPL) is a utility company that offers a high dividend yield of 4.9%, making it an attractive stock for income-seeking investors. The company has a solid dividend history, and has been paying quarterly dividends for more than 260 consecutive quarters. Dividends offered by the company are expected to grow in future, in line with earnings growth; analysts are estimating five-year earnings growth of 5% per year for PPL Corp. In the last twelve years, PPL Corp. has increased dividends eleven times. PPL is also trading on a cheaper forward P/E of 13.85x, in comparison to a forward P/E of 15.45x for the utility sector as a whole.
Capital expenditure (capex) incurred by any regulated utility company is recovered through rate case increases, which result in sales and earnings growth for a company. PPL Corp. anticipates its regulated rate base to grow by 7.9% from 2013–2017, which will have a positive impact on its future sales, earnings, and stock price.
Solid earnings and dividend growth
NextEra Energy (NYSE:NEE) is involved in the generation, transmission and distribution of electricity in the U.S. and Canada. The company has a generational capacity of approximately 41,000 MW and serves electricity to 8.9 million people in Florida. High growth prospects, strong cash flows and limited regulatory risks make NextEra Energy likely to outperform the utility sector.
Analysts have estimated an attractive five years growth rate of 6.5% for the company. Currently, the company offers a decent dividend yield of 3.3% with a payout ratio of 62%, which is lower than the industry average of almost 70%. The dividend offered is expected to grow along with earnings growth; also, the payout ratio can be increased to achieve dividend growth higher than future earnings. NextEra also has healthy cash flows, evident from its high operating cash flow yield of 13%. Dividends offered by the company are sustainable, as the company has a lower payout ratio of 62%, and dividends are backed by a healthy operating cash flow yield of 13%.
Moreover, the company is exposed to limited regulatory risk, as it has acquired approval of a multiyear rate deal with permission of several rate case increases for the next four years, and there are no significant pending rate cases. Due to the factors mentioned above, NextEra is expected to deliver superior performance in comparison to its peers, and remains a good investment option.
Attractive valuations and growth = Opportunity
Through its subsidiaries, Xcel Energy (NASDAQ:XEL) is engaged in the generation, purchase, distribution, and sale of electricity in the U.S. Xcel Energy has a potential to post above-industry average growth and returns in the future, as it has been aggressively undertaking capex, which will allow it to enjoy rate base growth. This will result in future sales and earnings growth.
There are several pending rate cases requests filed by the company, amounting to more than $350 million, which are likely to fuel its future earnings-per-share growth. Pending rate cases are expected to conclude by year-end and new rates are likely to be effective from the first quarter of 2014. Earnings for the company are expected to grow by 5% per annum in the upcoming five years.
Given the company's attractive growth prospects, its forward P/E of 13.8x appears to be cheap in comparison to the utility sector's forward P/E of 15.25x. A positive outcome of pending rate cases will result in multiple expansions for Xcel, which will likely result in stock price appreciation. This makes Xcel a good investment opportunity.
Other than attractive valuations and potential growth prospects, Xcel pays a decent dividend yield of 4.1%, accompanied with a low payout ratio of 55% and a solid operating cash flow yield of 16%. As the company shows growth prospects, dividends are likely to grow along earnings in the upcoming years. Also, the company can increase dividends by pushing its payout ratio up, as it currently has a moderate payout ratio of 55%.
The utility sector provides investors a continuous and less risky income stream, as it offers a high yield on average. The 10-year Treasury yield is currently below 3%, which makes utilities an attractive investment option for income-seeking investors. However, Treasury yields are anticipated to rise from next year onwards, creating a headwind for utilities. Despite the projected rise in yields, the three above-mentioned companies are expected to outperform their peers due to their high growth prospects and/or cheaper valuations.
Syed Shah has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.