Investors are selling utility stocks indiscriminately. But even though their stock prices are falling, most utilities will remain exactly what investors want them to be: Consistently profitable, and pumping out those quarterly dividends like clockwork. It's important to remember that regulated utilities are usually able to pass on regular rate increases. Plus, the underlying businesses -- providing electricity -- are virtually a matter of national security. Even if rates do rise, high-quality utilities aren't going anywhere.
But if anything, the dip in utility stock prices has offered investors a good buying opportunity. American Electric Power (NYSE: AEP) and Consolidated Edison (NYSE: ED) are two well-run utilities that have seen their stock prices drop, but now are more attractively valued and offer higher dividends than just a few weeks ago.
However, I'd recommend investors take a pass on Southern Company (NYSE: SO), which isn't as well-managed as its peers.
Two utilities to bank on
Investors prize their utility stocks for reliable profits and rock-solid dividends. American Electric Power and ConEd are the epitome of this. AEP has paid out dividends for more than 400 consecutive quarters, while ConEd has increased its dividend for 41 years in a row.
ConEd's earnings per share grew 2% in the first quarter, thanks to higher utility rates, as well as lower operating and maintenance expenses. ConEd also raised full-year guidance after first-quarter earnings. Meanwhile, AEP grew EPS by 14% in the first quarter, due to better performance in its regulated operations. Earnings in the vertically integrated utilities segment jumped 21% last quarter, year over year.
Since AEP's and ConEd's stock prices are dropping, their valuations are getting more attractive, and their dividend yields are rising. This is presenting a good buying opportunities for investors looking at modestly valued, high-yield dividend stocks. Shares of AEP and ConEd trade for 15 times earnings, which is a significant discount to the S&P 500 Index's 18 multiple. And AEP and ConEd offer 4% and 4.4% dividends, respectively.
One potential risk for investors to keep in mind is a utility's exposure to coal. For example, AEP has the highest percentage of its power generation from coal. As new Clean Air regulations are put in place, this results in a higher risk that AEP will have to spend drastically to remain in compliance. However, there is a mitigating factor to this, which is its high focus on regulated operations.
According to AEP's presentation at its May Investor Meeting, 96% of its capital spending through 2017 will be allocated toward its regulated operations. This is a smart strategy, since the regulated business is much steadier. AEP projects its regulated rate base to rise at a 7.5% compound annual rate through 2017. Because of this, management reiterated its long-term forecast for 4%-6% annual earnings growth, which should be enough to keep those dividends rolling.
Take a pass on Southern
Unfortunately, I don't believe investors can be as confident about Southern Company. Southern is widely regarded as a top utility stock, but it's struggling through a major managerial mishap in the form of its Kemper facility. The Kemper project is a massive undertaking that, at one point, promised to power Southern's future. Now, the project looks more and more like a total mess.
Excluding items, Southern earned $0.56 per share in the first quarter, down 15% year over year. Increased operating and maintenance expenses were largely attributed to the drop in profitability. First-quarter operating revenue declined approximately 10% year over year, which is surprising for a normally slow-and-steady utility. Residential and commercial energy sales fell 4% and 1%, respectively.
More broadly, the ongoing problems at Kemper are a big issue. At first, the Kemper facility held promise as a revolution in the way coal is converted into energy. Kemper is a 582-megawatt electric power plant that features a high-efficiency technology capable of utilizing lignite, which accounts for more than half of the world's coal reserves. The technology is called Transport Integrated Gasification, or TRIG.
Unfortunately, rampant cost overruns are weighing on Southern's profitability. Last year, the company booked $536 million in after-tax charges related to the increased cost estimates at Kemper. The year before, the extra costs totaled $729 million. In all, the the total price tag for the Kemper project has eclipsed $5 billion, which is significantly higher than the $2 billion initially anticipated.
Buy AEP and ConEd, pass on Southern
To be sure, Southern is a good dividend stock as well. It currently yields 5%, but the stock trades for 18 times earnings. Given its issues at Kemper and its falling profits, I don't believe Southern deserves its valuation premium. It has a higher dividend yield, but only because it distributes a higher percentage of its profits than its peers. Southern's earnings payout ratio stands at 92%. In comparison, AEP and ConEd distributed 61% and 69%, respectively, of their trailing-12 month earnings per share. Because of this, I believe AEP and ConEd will pass along higher dividend growth going forward.
Not all utilities are created equal. Southern offers a higher yield, but current yield isn't everything. Investors interested in total return should view AEP and ConEd more favorably than Southern.