Arch Resources Inc (ARCH) Q1 2021 Earnings Call Transcript
ARCH earnings call for the period ending March 31, 2021.
Utilities provide electricity, natural gas, and water and wastewater services to residential, commercial, industrial, and government customers.
The steady demand for these services has helped utility stocks generate relatively stable earnings over the years. Meanwhile, the rates they charge for delivering these services are either regulated (approved by a government entity) or contractually guaranteed (nonregulated). Utilities’ reliable earnings enable these companies to pay dividends with above-average yields. That combination of predictable profitability and income generation makes utility stocks lower-risk options for investors.
However, not all utility stocks deliver competitive investment returns. The best utilities share additional noteworthy characteristics that give them the power to outperform.
The best utility investments are companies with a top-notch financial profile and visible growth prospects. Each of the companies below meets those criteria and has the potential to produce above-average total stock returns -- dividend yield plus stock price appreciation.
Here is a list of standout companies, followed by our assessment of each investment:
American Water Works (NYSE:AWK) is the largest publicly traded water and wastewater utility in the U.S. It makes most of its money by providing regulated water and wastewater services, with the rest coming from less predictable market-based activities, including providing services to homeowners and the military.
American Water Works expects to increase its earnings per share (EPS) at a compound annual rate of 7% to 10% between 2020 and 2024, which would make it one of the fastest-growing utilities in the country. The main driver of its outlook is a multibillion-dollar investment program to expand its regulated operations. That investment level remains consistent with its pre-COVID view because people still need access to clean water.
The water utility has the financial flexibility to support its expansion plan thanks to its top-tier financial profile. It's one of the two utilities rated highest by credit rating agency S&P Global (NYSE:SPGI). Meanwhile it has a very conservative dividend payout ratio (it has targeted an average between 50% to 60% of its adjusted EPS). That strong financial profile leads American Water Works to foresee that its dividends will grow 7% to 10% per year through 2024 and that it will maintain a conservative payout ratio
Brookfield Infrastructure operates several utilities and utility-like businesses that generate predictable cash flow. It expects this portfolio to deliver 5% to 9% annual FFO growth over the long term. While the company did experience some headwinds in its transportation businesses because of COVID-19, it expects them to bounce back in 2021 as the global economy improves. On top of that organic growth, Brookfield anticipates that acquisitions could boost its FFO by an additional 1% to 5% per year.
Supporting Brookfield Infrastructure's long-term growth outlook is its top-notch financial profile. It has historically targeted a payout ratio of 60% to 70% of its cash flow. Further, it has a high credit rating for a company in the utility sector. Because of those factors, the company believes it can increase its dividend by a 5% to 9% annual rate over the long term.
NextEra Energy (NYSE:NEE) operates regulated electric utilities in Florida. It also owns a nonregulated competitive energy business that operates natural gas pipelines and renewable energy projects that generate predictable income backed by long-term fixed-rate contracts. NextEra expects these businesses to increase its EPS at a 6% to 8% compound annual rate through 2023, despite the economic slowdown from COVID-19, because businesses and consumers need access to reliable electricity. That’s faster than the EPS growth rate projections of its largest peers in the electric utilities sector, which are in the low-to-middle single digits.
Powering that above-average growth is NextEra’s ability to fund high-return expansion opportunities thanks to its strong financial profile. That profile includes one of the highest credit ratings among the large rate-regulated electric utility companies and a dividend payout ratio that’s historically been below the sector average. Because of its lower payout ratio, NextEra plans to increase its dividend by roughly 10% per year through at least 2022.
Utility infrastructure is costly to build and maintain. Because of that, a utility needs a strong financial profile to invest in maintaining and expanding its infrastructure while also paying an attractive dividend. Three metrics can help you gauge utilities’ financial strength.
A bond rating or credit rating for a company is like a credit score for an individual. Companies with higher, “investment-grade” bond ratings can borrow money at lower rates and on easier terms. That's important for utilities, since they routinely need to borrow money to help fund maintenance and expansion projects. So investors should seek out companies with high bond ratings, since they can more easily finance their operations, which helps them grow their earnings and dividends.
While utilities need to borrow money to finance their operations, too much debt limits their ability to grow. Because of that, investors should look for utilities with conservative leverage metrics for the sector. Two notable ones are debt to EBITDA (debt in relation to income) and debt to total capital (debt in relation to total value). Good targets for the sector are a debt-to-EBITDA ratio of less than 4.5 times and a debt-to-capital value of less than 60%.
A dividend payout ratio is the percentage of a company's profits that it pays out to investors via its dividends. Utilities traditionally have higher dividend payout ratios than other companies; the average was 65% for the sector in 2019 versus 36% for the average company in the S&P 500, but utilities with below-average payout ratios for the sector retain more cash to reinvest in expansion projects. As a result they don't need to borrow as much money (which would lower their credit rating) or issue as many new shares (which would dilute existing investors’ shares of their profits) to finance growth.
Utilities with stronger financial profiles have the flexibility to invest in expansion projects and make acquisitions that grow their earnings at an above-average rate. The extra fiscal strength also gives them more power to increase their dividends.
These utility companies all have top-tier financial profiles. Because of that, they have the flexibility to invest in expanding their operations while also growing their dividends. Those dual growth drivers should give these utilities the power to produce attractive total returns for investors over the long term.
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