Avoid These Utility Stocks

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

While investors may have flocked to utilities due to macro uncertainty, they are likely to do just the opposite in a full recovery. Combined with the implications of a dividend tax hike (more than double the current rate), the potential for losses is substantial. Unfortunately, growth opportunities to offset the impact are few and far between. Accordingly, I generally recommend avoiding the industry and especially these producers...

Too Little Free Cash Flow From PPL (NYSE: PPL)

Over the last 52 weeks, PPL has proved itself to be a very stable and reliably stock.  While it is not too much above its 52-week low, it has inched upwards towards the 52-week high. The beta of 0.39 further indicates limited volatility and is well complemented by a 4.9% dividend yield. Multiples are also quite cheap at a respective 9.9x and 12x past and forward earnings.

But they are also cheap, because earnings are expected to decline over the next half decade. That's a pretty big deal for several reasons. First, we are entering a full recovery where investors will no longer seek safe stocks but will instead go towards higher risk / higher reward plays generally outside of utilities. Second, the Obama administration's planned 164% dividend tax hike will have to cause share prices to decline in order to return yields to their equilibrium after-tax level. Third, PPL generates very little free cash flow that it can use to reinvest in profitable growth opportunities. Over the last 19 quarters, the most the company has generated on a TTM-basis is $917 million. Yet the company is worth $16.9 billion, so, at best, the company is generating a 5.4% free cash flow yield. And a weak credit rating and debt-to-equity ratio of 1.8x complicate financing alternatives when free cash flow comes out short.

On the positive side, the company has consistently bested expectations by an average of 11.2% over the last five quarters. Business is well diversified across generation, transmission, and distribution of electricity, serving around 10 million consumers. But, again, this won't be compelling to investors a year from now when bullish trends pick up. Accordingly, I recommend avoiding an investment.

FirstEnergy (NYSE: FE)

And then there's an expensive version of PPL. FirstEnergy trades high at 16.3x past earnings without even the growth necessary to justify an investment. Assuming it meets analysts' expectations for 4% annual EPS growth over the next half decade, 2016 will come out to $3.07. At a multiple of 15x, this translates to a future stock value of $46.50, right around the current price. At an 8% discount rate, the stock would be priced at $31.34.

Moreover, FirstEnergy lacks the excellent performance that PPL has produced. Over the last five quarters, FirstEnergy has underperformed three. In addition, the company has been hit by Hurricane Sandy. Assessments are now being made as to whether the transmission system will have to be rebuilt. Over the twelve trailing months, return on invested capital has also been weak at 4.1%, which is down 120 bps from its 5-year average. While this is partly explainable by a tougher pricing market, what isn't explainable to shareholders is why performance has been so weak.

Moreover, it is concerning that the payer ratio stands high at 80%. This will limit investor excitement over a dividend hike. Accordingly, I recommend at least buying stock in a larger producer, such as Duke Energy (NYSE: DUK). Like many of its utility peers, Duke is also quite expensive at 19.3x past earnings, but it at least has the potential to increase an already high 4.7% dividend yield, as evidenced by the debt-to-equity ratio of 0.95x and top gross margins of 40.3% The company has also grown EPS at a rate of 7.1% in recent years--far better than competitors. Accordingly, if there is one utility that is best hedged against the Obama administration's proposed tax hikes, it's Duke.


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