Why Do Utilities Pay Big Dividends?

By Arthur Pinkasovitch - March 2, 2012 | Tickers: AT, ETR, EXC, NEE, SO | 0 Comments

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Federal Reserve Chairman Ben Bernanke cautioned that the economic recovery has thus far been “uneven and modest.” Despite the fac that unemployment and consumer spending have been on the upswing, the chairman used a guarded tone as he addressed Congress regarding his sentiment of the overall economy. With the Fed forecasting economic growth of approximately 2.5% and a drop in unemployment to 8.2% through 2012, necessary measures must be promoted in order to ensure that the ongoing recovery process is not hindered. As a result, interest rate hikes will not be considered until around June 2014, “unless there is a substantial strengthening of the economy in the near term.”

Resulting low yields in the bond market deter many income seeking investors from purchasing risk-free fixed income securities. The utilities sector provides a feasible alternative for those willing to add a small amount of risk to their portfolios in exchange for substantial yield. With many well established utilities such as Atlantic Power Corp. (NYSE: AT) yielding over 7%, these investments are an ideal opportunity for dividend seekers. Although there are numerous sources which suggest particular picks in this industry (11 High Yield Utilities With A History Of Growing Dividends, The Most Promising Dividends in Electric Utilities), the question of “why” do utilities offer significant yields is normally not fully addressed.

Basically, the services provided by the utilities are inelastic goods, meaning that regardless of the state of the economy, people will always need to heat their homes and use electric devices (assuming no foreclosures and businesses remaining in business).

Many of the utilities in the U.S operate through a “cost plus” model by which regulated rates allow companies to recover their costs and earn a reasonable rate of return on investments. Southern Company (NYSE: SO) is perhaps the best known firm that falls under this category. Exelon (NYSE: EXC), on the other hand has both, regulated and liberalized operations. Regulation typically removes factors of cyclicality and thus the utilities generate a consistent level of cash flows which they are able to give back to their shareholders.

Large capital investments into transmission lines, smart meters and other business requirements pose a substantial ongoing cost to utilities. However, regulated rates ensure that these companies earn a sufficient rate of return on their invested capital; thus, cash flow from an expansion project is not as risky as for, say, a technology company. Naturally, if the utility firm becomes overly leveraged this will still have negative consequences on its future operations. As interest rates remain low, expenditure expenses will remain likewise; in such an environment regulated utilities can earn a reasonable return on their invested capital without lobbying regulators for higher rates.

Deregulated utilities are typically more sensitive to general market movements as they must manage their own costs and pricing strategies to ensure an optimal return. The basic argument still remains however, that residential properties and commercial businesses will always require heat and electricity to operate. Although large deregulated operations such as Entergy Corp. (NYSE: ETR) have greater risk exposure, the potential for capital gains is also more significant. The cost to such a business model is a lower dividend yield and lower payout ratio due to earnings and cash flow volatility.

Contrasting a deregulated and regulated utility could shed some more light on the difference between the two payout structures. Southern Company, an operator within the regulated universe, offers a payout ratio of around 73% based on dividends paid to common shareholders. Entergy, comparably, has a much smaller payout equivalent of only 50%. Looking at income payments as a percentage of operating cash flow yields a similar patters: Southern Company carries a dividend to operating CF multiple of 27% while Entergy’s respective metric is slightly under 15%. This sort of trend is consistent throughout comparisons of both universes – regulated and deregulated.

Compared to other blue chips, utilities are generally mature firms with relatively few growth opportunities. Yes, capital must be allocated to maintenance and geographic expansion projects to accommodate growing communities and even to build new facilities. However, these companies have a basic business model and unlike Apple, do not have to exert extensive financial resources for research & development and new product manufacturing costs. Once a new project is created, the corresponding cash flows are fairly easy to predict based on population size and the general pricing environment, whether regulated or not. Therefore, to entice investors into this slow growth industry, companies offer substantial yields.  

Of the 50 largest utilities listed on the New York Stock Exchange, all yield near or above 4%. NextEra (NYSE: NEE) offers the smallest dividend yield of only 4.02%, well above the rate on Treasuries. The utility sector offers a safe business model and income potential greater than that which can be obtained within the money markets.

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