3 Reasons To Consider This 5% Yield

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

It's no secret that I believe the utility industry is a prime example of a dividend bubble. I've called out companies like Duke Energy (NYSE: DUK), Southern Co. (NYSE: SO), and recently Exelon (NYSE: EXC) as companies that have unsustainable payout ratios. The worst part is many income hungry investors see utilities as “safe” investments. One company that I like in the industry is a lesser known utility Integrys (NYSE: TEG). The company's recent earnings showed at least three reasons investors need to give this less popular utility a second look.

It's no secret that utilities don't like mild weather. Unpredictable weather causes their earnings to fluctuate based on the temperature. In addition, in the last few years utilities across the country have had to deal with changes in the regulatory environment, and the huge change the price of natural gas. That being said, there are certain things that utilities can control. One of the things they can directly affect is their margins. This is just the first reason to consider Integrys over other stocks in the sector.

In the last few years, Integrys’ improvement in their Regulated Natural Gas gross margin has been nothing short of remarkable. In fact, just a few quarters ago their margin was 37.8%, and in the current quarter this same margin was over 67%. While the company's Regulated Electric division saw basically flat margins over last year, the company's Energy Services unit also saw a huge improvement. Integrys Energy Services saw its gross margin jump from 13.03% at a low last year to almost 23% in the current quarter. Integrys is investing toward future growth, but with two of the three major divisions showing huge improvements, it's nearly inevitable that future cash flow will be improved.

Many utilities are expected to see small improvements in earnings over the next few years, but this doesn't always directly equate to better free cash flow. Since most investors buy utilities for their yield, investors need to keep a close eye on the cash flow situation at the company they choose to invest in. This is one of the biggest problems with utilities as income producing investments; their free cash flow payout ratios are horrible. Just as an example, Duke Energy's free cash flow payout ratio was 143% in the current quarter, and this was the first time in the last year or so that free cash flow was even positive. When it comes to Exelon, the company has shown negative free cash flow in the last nine months. Even if you look at the last four quarters, Exelon had a 127% payout ratio. Southern Co is a rare exception in the industry with a 41.2% payout ratio in the current quarter. However, on average in the last four quarters, Southern Co shows a 457% payout ratio. While Integrys does show a high payout ratio in the current quarter of 251%, over the last couple of years their ratio has been 40% to 50%. The company's current ratio is more a function of investments for the future, whereas their competition has a consistent problem generating positive free cash flow. This difference in free cash flow directly affects each company's balance sheet.

Since utilities have to spend a lot of money to consistently upgrade their plants and equipment, a strong balance sheet is critical. This industry has to access the credit markets on a regular basis, and Exelon recently commented that they were concerned primarily about keeping their investment grade debt rating. In fact, Exelon's management said if the company had to choose between keeping an investment grade rating or the dividend that they would have to revisit the dividend policy. One way to compare companies balance sheets is by comparing their long-term debt to total assets. Integrys shows the strongest balance sheet of its competition with a debt-to-total assets ratio of 0.17. By comparison, Exelon's ratio is 0.23, and Duke and Southern Co show ratios of 0.32 and 0.31 respectively. This stronger balance sheet benefits Integrys shareholders through lower interest costs and a relatively safer dividend. In fact, though the dividend is safer, the yield is higher than their competition.

When it comes right down to it, Integrys' higher dividend and growth profile is among the better reasons to consider the stock. I know that some believe Exelon offers a better yield, but the market has already voted that this yield is going to be cut. There is virtually no way the stock would have dropped to where the yield is over 7% if the market believed this dividend was safe. In addition, analysts are calling for a double-digit decline in EPS over the next few years. If Exelon is already concerned about maintaining its dividend without improvements in pricing, if analysts are right this dividend is as good as cut. This leaves Integrys, Duke, and Southern Co as the three remaining competitors. Duke can be eliminated immediately because the company's yield is lower than Integrys' at 4.76% versus 5.09%. In addition, Duke is only expected to grow earnings by about 3% versus Integrys is expected to see 5.5% EPS growth in the next few years. While Southern Co comes in at a close second with a similar expected growth rate of 5.18%, there is no getting around the fact that Southern Co's yield is over a half a point lower than Integrys. With Integrys, investors get a utility with a higher yield, better expected growth rate, better balance sheet, and improving margins. As you can see, there are at least 3 good reasons to give Integrys a second look.

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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