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The utility sector has been struggling in recent months.  Between April 30 and September 17 (the day before the September 18 FOMC announcement), the total return for the Dow Utility index was off 7.5%.  The rise in 10 year treasury yields and fear of Fed QE taper weighed on this interest rate sensitive sector.  The S&P 500‘s total return was up 7.6% over the same time period. The difference between the two total returns underscores the lagging nature of the utility sector.

The yield spread is attractive for utilities:

Although the utility sector has been a soft performer, the sector continues to provide a favorable yield alternative to the 10 year treasury and Baa corporate bond yield.  The yield on the Zacks Utility Sector index was about 3.65% against a 10 year yield near 2.70% and a Baa corporate yield below 5.50%.  A Baa corporate is a medium grade debt instrument which is neither highly protected nor poorly secured.  The spread between the utility dividend yield and the fixed income alternatives remains near the upper end of the 15 year range.  The first graphic displays the spread without the impact of taxes.  The price of the utility index is plotted on the second y-axis and inverted.  Loosely speaking, it shows drop in the utility less 10 year treasury and utility less Baa corporate spreads leading to higher utility sector prices and rising spreads leading to lower utility sector prices.

Through much of the period between the mid 1990’s and mid 2000’s period, utilities carried a yield below that of treasuries.  The sector also carried a spread less than 2.50% to the Baa corporate.  The chart suggests the spreads are not overly elevated compared to the post Great Recession period, but high compared to most of the time frame in the graphic.  Utilities look cheap to fixed income, especially if dividends in the sector can rise over time.   To some extent, it looks like the sector is taking some protection against higher corporate and treasury rates.

Spreads with taxes:

Beyond a straight yield spread, it might be worth looking at tax implications.  Qualified dividends are taxed at a lower rate than ordinary income (coupon payments) for a large number of investors.  Dividends are taxed at 15%, while ordinary income is taxed at 25% or more for joint filers with incomes over $72,500, and individuals making more than $36,250 per year.   The dividend tax jumps to 20% and the tax on interest income surges to 39.6% for high income earners.  The graphic displays the difference in yields on an after tax basis.  The highest dividend tax of 20% is applied to utilities, while the top marginal tax rate of 39.6% is applied to the treasury and the Baa corporate.  The new Medicare tax of 3.8% on investment returns was left out, but is present for both dividends and interest income for individuals and families over $200,000 and $250,000 respectively.  

The general conclusion on relative value is about unchanged looking at the spreads with and without taxes, but there is more return pick up in the utility sector due to the favorable tax treatment of dividends.

The Fed Factors:

Given that the Fed has surprised the markets by keeping its asset purchase program in place at full level, investors are likely to warm toward yield grabbing.  A recent survey by a major broker indicated that investors were underweight the bond sector by the largest amount since 2006.  Investors may up their allocation to fixed income and debt linked investments.

In his press conference on September 18, the Fed Chairman seemed to suggest that the Fed will keep rates low for a long period and would not box the Fed into the timing of tapering.  This type of statement may support the search for yield and put utilities on the investment table. Carry or the opportunity cost of holding cash, remains favorable for dividend investment. 

Ways to play with ETFS:

In order to earn yield in the utility sector, investors could put money in a utility based ETF.  There are a number available. Here are a few choices:

The SPDR Utility Select Sector ETF (XLU - Free Report) offers exposure. It is a market capitalization weighted ETF.  It has a heavy concentration in Duke Energy (DUK - Free Report) , Southern (SO - Free Report) , Nextra Energy (NEE - Free Report) , and Dominion Resources (D - Free Report) – over 30%.  There is not much focus on earnings in this ETF, and it is a slice of the S&P 500.

PowerShares has a Dynamic Utility ETF (PUI - Free Report) .  This is a “smart” ETF in that its weights are based on price momentum, earnings momentum, management action, and value.  However, this name spreads holdings outside of the pure utility sector with DISH Networks (DISH), Sprint (S) and Comcast (CMCSA) a few untraditional utility names in the portfolio. It classifies communications related stocks as utilities.

Guggenheim has an S&P 500 equal weighted utility index (RYU - Free Report) . This provides a broader exposure to the utility sector - less concentration.

Vanguard has a utility ETF (VPU - Free Report) . It is concentrated in large cap names like the XLU, but to a lesser extent. 

Ways to Play with Stocks:

Utilities tend to be yield plays, but there are a number of companies which are a Zacks Rank #2 (Buy).  Utilities can benefit from growth trends and operational efficiency, and the Zacks #2 rank implies there are utility stocks seeing their EPS projections revised higher.  Thus, it may be possible to get some growth and yield for a healthy total return. 

The table following displays a list of Zack Rank #2 utility stocks, their dividend yields, and the trend in their earnings estimate revisions.  Notice that Integrys Energy and UNS Energy have the highest dividend yields and relatively high payout ratios for fiscal year 2013.

(click table to enlarge)

It seems like Idacorp (IDA - Free Report) and PNM Resources (PNM) have the largest room to lift their dividends based on their payout ratio.  As a refresher, the payout ratio is equal to the dividends per share paid divided by earnings per share.  It is a simple measure of dividend sustainability.  Dividends paid relative to free cash flow may be a better read of payout stability, but shifts in capital spending can make this a volatile and sometimes a not meaningful indicator.

There have not been a great number of earnings revisions in the sector. The table highlights that NV Energy has seen the only upward revision in the last 30 days.  

The next table highlights valuation in the sector. Notice that Integrys Energy and UNS Energy are trading closest to their long term PEG ratio.  TEG looks marginally cheap to the group, but valuations would be more attractive if the names were trading at a discount to their longer term PEG ratios.

(click table to enlarge)

Like the PEG ratio, most of the names are trading at a premium to their median tangible book value per share value.  Idacorp was trading equal to its median and looked relatively cheap to the group.  Northwest was next with a small 4.2% premium.

Given the general search for yield and a cautious view toward the equity market by the public, it seems like utility valuations are firm – the sector is does not look cheap relative to its historical earnings and book value measures.  The value seems to rest in the dividend yield levels relative to treasuries and corporate debt.

In terms of relative value and dividend yield, the table following highlights a matrix of values and averages for each name.  A value of 1 was given to the company with the most bullish fundamental measure, while a value of 5 was given to the company with the most bearish fundamental measure.  In this case, a low PEG ratio, low price to book value, and low payout ratio were seen as bullish. In contrast, a high dividend yield was viewed a bullish.

(click table to enlarge)

Based on this simplistic approach, which is arguable as a stock picking tool, Idacorp and Integrys Energy scored strongest in terms of the mix of value and yield.  The table helps to provide some clarity on the mixture of measures examined and helps draw a conclusion.

Concluding thoughts:

Utilities remain attractive relative treasuries and corporate debt.  Those looking for broad exposure may want to choose an ETF, but for those looking for some growth and income and like individual names, Idacorp and Integrys Energy are worth examining.  These are Zacks Rank #2 shares which pay yield and appear attractively valued relative to their peers. Let utilities power up you portfolio.