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The Dividend Bubble Is Real In This Industry

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There has been a lot of talk about whether there is a dividend bubble in the stock market. Proponents of this theory say that investors are blindly piling into stocks that pay good yields without paying attention to valuation. Income hungry investors are looking at CDs and other accounts with very low rates. For people used to getting 4% or 5% yields, looking at a seemingly safe utility dividend looks like a good way to get the yield they want.

Utilities Are Seen As Safe Investments:

There are two huge problems with this idea. First, utilities are not CDs or money market accounts. Though utilities are seen as safe, they do face risks and their dividends are not guaranteed in any way. Investors seem to have forgotten that no stock can be counted on the way an FDIC insured account could be. A perfect example of this potential bubble at work is Southern Company (NYSE: SO). Though the company is considered as safe and has a long history of paying and increasing its dividend, there are problems that investors seem to be turning a blind eye to. This strong utility that investors have counted on for income is on the edge of a problem. The really sad part is anyone who looks at the numbers knows what's probably coming, and should be able to spot it a mile away.

Southern Company's Recent Earnings:

Before we get to the consistent problem facing the utility industry, let's first look at how Southern Company performed in the last few months. Revenues decreased by 7%, but through cost controls EPS increased by 3.74%. The real problem was revenue was down across the board. Southern Company gets about one-third of its revenues from residential, commercial, and industrial sales. While this split of revenue should argue that weakness in one division might offset another, each of these units showed a decline. Residential sales decreased the most with a 7.2% decline. While commercial and industrial sales were slightly less of a problem, they both declined by 2.4% and 1.9% respectively. The company blamed milder weather this year and warmer weather last year as a primarily culprit for these declines. While this explanation does make sense, what is unfortunately lacking is a good explanation for why Southern Company and other utilities are unable to manage their cash flow to cover their dividends.

The Free Cash Flow Payout Ratio Tells A Story:

If you are looking for signs of trouble with a company's dividend, look at the company's free cash flow payout ratio. Investors regularly question the stability of a dividend from any other company when the payout ratio gets above 70% or 80%, but when a utility routinely pays out more than that, it's a non-issue. While this makes some sense as utilities are regulated and generally have to survive to provide services to customers, this does not include any dividend guarantee. Multiple of Southern Company's competitors seem to have the same problem of paying out more than they make. Competitors like Duke Energy (NYSE: DUK), Exelon (NYSE: EXC), and Integrys (NYSE: TEG) consistently pay out more than they report in free cash flow. In fact, look at how each of these companies payout ratio has trended over the last four quarters:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Free Cash Flow Payout Current Quarter</strong></p> </td> <td> <p><strong>Free Cash Flow Payout Avg. Last 4 Quarters</strong></p> </td> </tr> <tr> <td> <p>Duke</p> </td> <td> <p>143.00%</p> </td> <td> <p>Negative</p> </td> </tr> <tr> <td> <p>Exelon</p> </td> <td> <p>90.78%</p> </td> <td> <p>127.23%</p> </td> </tr> <tr> <td> <p>Integrys</p> </td> <td> <p>Negative</p> </td> <td> <p>251.31%</p> </td> </tr> <tr> <td> <p>Southern Co.</p> </td> <td> <p>270.78%</p> </td> <td> <p>710.00% </p> </td> </tr> </tbody> </table>

As you can see, each of these companies would seem to have challenges generating enough free cash flow to cover its dividend. What is interesting is one of these companies has already mentioned the possibility of having to, “revisit its dividend policy”. What is really ironic is the company that questioned its dividend's sustainability is the one that compared to the rest, looks like it's in the best shape. Exelon's CEO Christopher Crane recently said, “it is possible that power prices will not recover as completely or as rapidly as our fundamental views suggest...if they do not play out favorably in the next 6 months, revisiting our dividend policy will be in the range of options...”. Given the fact that Southern Company had three times the payout ratio of Exelon in the most recent quarter, you have to wonder about the sustainability of Southern's dividend. In addition, this isn't a one quarter phenomenon as Southern has paid out much more in dividends compared to their free cash flow over the last four quarters, versus all of their competitors except Duke. Since one of the challenges that Exelon mentioned in its concern about their dividend was the company's balance sheet, let's see how Southern Company stacks up on this score as well.

A Weaker Balance Sheet Is A Worry Too:

The best way to compare the balance sheets of companies that are different sizes is, by looking at their debt-to-equity ratio. Generally speaking, a company with a lower debt-to-equity ratio is less at risk of lower ratings from the debt rating agencies. Since many utilities regularly carry a lot of long-term debt, their ability to keep as high of an investment grade possible is important to keeping their interest costs in line. Using this measure, the company with the highest debt-to-equity ratio is Southern Company at 1.02. Duke Energy comes in second at 0.88, Exelon has a ratio of 0.83, and Integrys carries a ratio of 0.56. Though some would suggest that these debt-to-equity ratios are not equivalent because of government guaranteed projects, this higher ratio of long-term debt just adds another risk factor.


With investors looking for yield, each of these companies could be considered overvalued. In fact, each company is expected to see no greater than 5.5% growth in earnings over the next few years. With these stocks selling for between 11.4 times and 15.35 times earnings, this means investors are willing to pay between two and three times earnings growth for the shares. Since Exelon has already questioned the sustainability of its dividend, investors need to keep a close eye on the remainder of these utilities for signs of trouble. Southern Company looks to be in the weakest position on an overall basis relative to its competition. Income hungry investors that bought Southern Company looking for safety might instead find out just how different CDs and stocks really are.  

MHenage owns shares of Integrys Energy Group. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Exelon and Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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