1 Utility To Buy, 2 To Avoid

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

If you are looking to hedge against economic uncertainty, you may consider buying utilities. However, there are more than dividends that go into making a top utility. These producers should have compelling multiples, reasonable growth prospects, and strong operational execution. Below, I review 3 utilities by these points.

Avoid The Southern Company (NYSE: SO), Buy SCANA Corporation (NYSE: SCG)

At a respective 16.9x and 15.3x past and forward earnings, Southern looks quite expensive even amongst utilities. Analysts rate it closer to a "sell" than a "buy," which also reflects my outlook. Return on invested capital stands at around 7%, which is far below the S&P 500's 15.6%. It is only forecasted for 3.7% annual EPS growth over the next 3-5 years. At these prices and at that rate, you might just move faster starting your own company!

To its credit, management has put in a good faith effort to deal with mild climate headwinds. It has cut back on maintenance expense and other non-fuel operations. Moreover, Southern ranks in the top quartile of utilities in customer satisfaction. The installation of 4.4 million Smart Meters in Florida, Alabama, and Georgia, and this came under budget and before expected. Meanwhile, considerable progress is being made in the construction projects. A third of the production has been completed for Vogtle 3 and 4. Catalysts ahead include the pouring of the Unit 3 Nuclear Island basemat and the Unit 3 reactor pressure vessel.

If you are looking for stronger upside in electric utilities, SCANA (NYSE: SCG) is preferable. It trades at only 13.6x forward earnings and is forecasted for 5% annual EPS growth. Assuming SCANA meets expectations, 2016 EPS will come out to $3.88. At a multiple of 15x, this translates to a future stock value of $58.20. While the stock may not be undervalued (the PEG ratio stands at 2.91x), investors can expect an average return of 10.3% based on this trajectory when factoring in dividends.

American Electric Power (NYSE: AEP) Preferable To Some But Still Avoidable

Analysts are even more bullish about AEP. It trades at only 13.9x past earnings--right around where SCANA trades on forward earnings basis. It offers a dividend yield that is also 20 bps higher at 4.54%. The stock has less than half the volatility of the broader market and generates a 7.7% return on invested capital, which is 83 bps than the industry average.

In the last 5 quarters, performance was mostly in-line with two beats in 3Q11 (2.6%) and 2Q12 (6.9%). But during the recent quarter, industrial load fell 3.1%--the first drop in 9 quarters. Although commercial customer growth is helping, the load growth profile is still expected to be flat for the year. 

AEP, however, has seen free cash flow dip from a peak of $1.7 billion in 3Q11 to $356 million today. This puts the yield at less than 2%--much lower than the 10% I say is required to generate outperformance. It is also forecasted for 1.3% negative EPS growth over the next 5 years. This is even worse than the 3.3% growth rate expected for the conventional electricity industry. For this reason, I recommend avoiding the stock.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend 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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