Can This Company Power Your Portfolio’s Yield Higher?

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Investors buy stock in certain industries with some built in expectations. The utility sector attracts a lot of attention because these companies offer high yields and relatively low risk. However, as investors learned over the last few years, not all yields are created equal. Some companies had to face the harsh reality that they couldn’t afford their payouts. Investors in Duke Energy (NYSE: DUK) have been rewarded handsomely in the last few years, and even today new buyers can enjoy a yield of about 4.6%. The question that begs to be asked is, can this run continue?

Investing 101: High Yields Are Rarely Safe
The lessons of 2008 and 2009 seem to be fading away a little too quickly. Investors who bought General Electric stock before the famous dividend cut couldn’t believe their luck when this great company carried a 10% yield. Banks with historic dividend runs like BB&T saw 30+ years of dividend increases come to an end. Investors saw BB&T with an 8% yield and thought they were getting the deal of a lifetime.

The similarity between these two companies and some utilities today is startling. These two companies had to protect their future survival by cutting their payouts. What’s ironic is, investors in Duke Energy seem to have forgotten a lesson from not long ago. Duke actually was forced to cut its dividend in 2007, and though this cut is only six years old, some investors have forgotten that it ever occurred.

A Duke Or A Commoner?
Before we get to what investors can expect from Duke’s dividend, we need to look at Duke’s competitive position. One way to compare Duke to their peers is by looking at their gross margin.

The utility business at its core is about providing a commodity (energy) to customers. In a commodity business, the company with the best gross margin should be a superior investment. On average in the last four quarters, Duke’s gross margin has been 20.53%. While it’s true that Duke has been trying to integrate acquisitions, this margin ranks dead last among their peers.

Some of Duke’s peers are companies like Consolidated Edison (NYSE: ED), Southern Co. (NYSE: SO), and Integrys (NYSE: TEG). When it comes to gross margin, Southern Co. is the clear leader with an average gross margin over the last four quarters of 39.97%. Consolidated Edison reported an average margin of 26.66%, and Integrys tied with Duke with an average margin of 20.53%. As you can see, Duke’s margins leaves something to be desired.

A second way to compare these companies is by looking at their core free cash flow (net income + depreciation – capital expenditures) versus their dividends. Take a look at how these companies compare over the last year:

<table> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>Core Free Cash Flow</strong></p> </th><th> <p><strong>Dividend Payments</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Duke Energy</p> </td> <td> <p>($227.75 million)</p> </td> <td> <p>$496.5 million</p> </td> </tr> <tr> <td> <p>Consolidated Edison</p> </td> <td> <p>($810.5 million)</p> </td> <td> <p>$178.5 million</p> </td> </tr> <tr> <td> <p>Southern Co.</p> </td> <td> <p>($115.75 million)</p> </td> <td> <p>$443.5 million</p> </td> </tr> <tr> <td> <p>Integrys</p> </td> <td> <p>$1.03 million</p> </td> <td> <p>$53.03 million</p> </td> </tr> </tbody> </table>

As you can see, Duke doesn’t appear to be in the worst position, as Consolidated Edison posted the largest negative core free cash flow. That being said, the company generated relatively more negative core free cash flow than Southern Co. or Integrys, and has the largest relative dividend burden. Of the four, it appears Integrys performed relatively better than the rest, with the only positive core free cash flow.

What About The Dividend?
Where Duke’s all important dividend is concerned, the company’s yield of about 4.6% is very close to the roughly 4.6% yields offered by Southern Co and Integrys, and better than the 4.2% yield available from Consolidated Edison.

When it comes to dividend growth, Duke’s dividend has been growing, albeit slowly, over the last few years, after the infamous dividend cut of 2007. You can see the trajectory over the last several years.

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Duke’s rate of dividend increase has declined from a 5% increase in 2008, to a 4% increase in 2009, and down to 3% and 2% prior to the 3% increase in 2013. In other industries, this rate of low single-digit increases would be unacceptable, but in the utility business it’s fairly commonplace.

What About Future Growth?
While a high yield is desirable, a growing dividend is maybe even more important. Given that analysts expect Duke to grow earnings by about 4% over the next few years, it seems reasonable to expect the dividend to grow by a slightly lesser amount of between 2% to 3%.

By comparison, Consolidated Edison is expected to grow more slowly at 1.71%, and already offers the lowest yield of the group. Southern Co. would seem to be a strong contender with a similar yield and slightly better expected growth rate of 4.67%. However, of the group, the best alternative to Duke might be Integrys.

With Integrys, investors get a similar yield to Duke, the company is expected to grow earnings by 5.5%, which is faster than Duke, and Integrys is the only company to generate positive core free cash flow over the last few years.

In the end, Duke provides a decent yield, and okay growth. The stock might not be a bad pick, but all things being equal, Integrys looks like a better deal. Duke should provide adequate returns to shareholders, but Integrys seems like it could power your portfolio to better returns.

Chad Henage owns shares of Integrys Energy Group. The Motley Fool recommends 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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