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Morningstar's Josh Peters and Travis Miller examine why utilities stocks look attractive for dividend investors today.
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Investing in Utilities for a Higher Yield
Dividend Investing with Josh Peters
Josh Peters: Hello I’m Josh Peters Editor of Morningstar Dividend Investor. You’ve been looking at the markets lately you might see that utilities have been running kind of hot. Why don’t we take a little opportunity to shed some light on the subject? Here with me today is Morningstar’s Senior Utilities analyst Travis Miller.
Travis Miller: Hi Josh.
Josh: Hi Travis. How is that for the bad pun of they year award?
Travis: Yeah we do think there someone dragged to the opportunities in utilities right now especially for income, investors if you look at the spreads right now between dividend yields about 4-1/2% right now across the regulated utility industry and you look at where interest rates are these days. So get a 10 year the 30 year treasury the spreads are at historic highs almost 200 bibs on the 10 year treasury so we think if you’re looking at relative yield plays that you utility is still are a good place to go.
Josh: Well obviously the relative yield spread is very interesting but what about absolute returns if we’re looking at dividend yields for utilities relative to long term treasury yields right now we’ll just be seeing that idea that treasuries are over valued and under yielding?
Travis: Yeah that’s certainly possible but we want to look for in a good high yielding utility is the opportunity for growth investments so the utilities that we like right now are the ones that don’t depend on inflation. They don’t depend on the economy to rebound. These are utilities that are projects that are economically in sensitive. Their projects such as environmental capital expenditures such as infrastructure rebuilding that don’t need an economic rebounds to produce growth for dividend investors.
Josh: What’s your favorite example of this phenomenon?
Travis: We’re like West Star. I think we’re WR right now is one of our best pics. It’s a Kansas based utility, a couple of things that we like about them. One if we go back to growth projects that don’t need an economic rebounds West Star has about 90% of its generation from Coal fired power plants given the environmental regulations that are coming out even excluding carbon regulations. They’re going to have to put billions of dollars in capital into those coal plants to clean up all of the non-carbon emission, sulfur dioxide and nitrous oxide. Kansas also as everyone knows is the Saudi Arabia of winds so as other utilities build wind projects in Kansas the transmission lines to get that power from the middle of Kansas to demand centers are very high return types of projects for West Star should produce 6 to 8% dividend growth in earnings growth we think.
Josh: Wow well I do have to ask you about the environmental capital expenditures I mean does it sound like they’re just going to pour a lot more money into just stay where they are at already?
Travis: Well yes they do need to upgrade those plans to keep that generation available for the customers but they’re also a high return projects for the utility and share holder investors.
Josh: Also they’re aloud to earn a return on those investments?
Travis: Absolutely, they have as long the environmental CAP programs go through the regulatory structure which we think they will in Kansas and there’s a fairly supportive and constructive regulatory environment there and it should produce the 6-day % earnings growth that we see.
Josh: Okay well backing out to look at the whole sector again are there any dividends that you think are at risk of being cut?
Travis: Certainly those utilities that have less attractive growth prospects out there could be cut so we look at the Florida Utilities as an example of this and Florida Utilities progress energies PGN and the portion of Next Era Energy NEE just located in Florida. Now these are utilities that saw great, growth opportunities over the last decade as population boomed down there as demand grew down there as the housing market created more customer opportunities down there.
Since then the economy is tanked and regulators have been reluctant to give rate increases there so all of the sudden the Florida Utilities are seeing reduced amends, reduced customer accounts and a less constructive regulatory environment.
Josh: Do you think this might actually put their dividends at risk of being cut or is it more just a no growth scenario?
Travis: We don’t think they’ll be cut we think there’s plenty of cash flow available for dividends but we do see a much slower growth profile so perhaps you get a six or seven even percent yield on some of these names but the growth prospects are very, very small for the few next few years.
Josh: Well let’s take one more look at the question for the industry kind of coming up here recently on merger in acquisition activity. What’s going on?
Travis: Sure there’s been quite a bit on both sides of the utility industry one is the merchant space and also merchant generation space in the other side as the fully regulated space that we’re more familiar with as dividend investors. The latest is the Northeast Utilities and InStar to very similarly sized utilities in the northeast U.S have decided to combine so what it does is it reduces utility that’s about 9-1/2 billion market cap to very good sized utility with one of the largest customer bases in the northeast.
What we like for InStar is the opportunity to access the growth projects at Northeast Utilities has in transmission projects, in infrastructure upgrades for Northeast Utilities we like the cash flow profile then InStar contributes so instead of Northeast Utilities facing a financing requirement over the next few years InStar’s cash flow and strong cash flows and operating structure should improve the profile for Northeast Utilities.
Josh: And I understand that the combined entity thinks that it could grow earnings and dividends that is 6 to 9% annual rate that really sounds high by utility standards do you think they can do it?
Travis: Yeah I think they can, yeah we certainly are pricing that into our fair value estimates and projections. Where we think that comes from mostly the Northeast states in the US have very strict renewable portfolios standards. To get all the wind and hydro power that they’ll need into that region. These utilities are going to have to build very large transmission lines accessing either Canadian hydro or Wind projects. And main solar projects even off shore wind projects that are contemplating right now so all of these transmission projects require a lot of capital and produce high returns for shareholders.
Josh: It certainly sounds like a pretty good story. I don’t see any treasury bonds out there offering 6 to 9% types of growth rates. Well thank you very much Travis for joining us very good to get a little bit of an update on the utility industry. I might mention also that dividend investor has a pair of modeled portfolios are builder and harvest model portfolios that invest in dividend paying stocks and two of the stocks that we’ve been discussing are InStar, NST and West Star Energy WR are part of those two portfolios so you maybe in checking those out. I also own InStar in my own personal accounts a little bit of disclosure there and with that I would like to thank you very mach for watching for Travis Miller I’m Josh Peters Editor of Morningstar Dividend Investor.