Pros & Cons Of 3 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.

If you are looking for some of the safer investments, utilities are an obvious choice. They offer leading dividends, albeit because of weak growth prospects and low price-to-book multiples. That said, there have been numerous shortcomings in the past along with headwinds in the future that could result in poor stock returns. Below, I review my outlook on 3 utilities below.

Duke Energy (NYSE: DUK): Pros & Cons

Over the last 6 months, Duke has slid 6%, which is a few percentage points below the median return. At this point, however, the large electric utility is very cheap compared to the competition. It trades at 1.3x book value veers an industry average of 3.2x, and it trades at 6.9x cash flow versus 10.4x. Deutsche Bank essentially noted this in its upgrade from a "hold" to a "buy" with a $69 price target. While return on invested capital of 5.3% is 60 bps below the competition and not enough to meaningfully create value, there are multiple reasons why you should be optimistic about the stock other than low multiples…

The company has a steeper growth curve ahead with minimal regulatory risk. Earnings are expected to rise by a rate of 3.7%, which is 450 bps greater than the multi-utilities industry and 80 bps greater than the utilities sector. It has also settled the political battle with North Carolina regulators over succession plans--part of the reason why Barclays upgraded to "overweight". This has been an overblown concern for some time. After the merger with Progress, Bill Johnson took a short-lived tenure as CEO until he was fired from poor relations with employees. It doesn't reflect at all on the underlying business, so it now presents a positive catalyst for the market to eventually pick up on. Overall, the integration of Progress has added meaningfully to the company's diversification and pricing power.

But operations have also been challenged. Repairs in the Florida Crystal River nuclear plant may ultimately come out to a bill of $3.43 billion--enough that the company is considering between repairing it or just shutting it down. In addition, Duke's Progress Energy Carolinas subsidiary has officially retired two coal power plants, and the upside of the shift towards fleet-modernization won't be seen for some time. Growth rates are still slow and revenue expectations have come out below expectations.

The Street Giving Thumbs Down To Southern Company (NYSE: SO), Exelon (NYSE: EXC)

Southern trades at a respective 17.1x and 15.5x past and forward earnings versus 16x and 11x for Exelon. However, Exelon is expected to see EPS erode by a rate of 3.9% over the next 5 years, so I recommend ignoring despite the 7% dividend, which is unsustainable anyway at a 139% payout ratio. Southern, by contrast, is forecasted for 5.1% annual EPS growth and offers a 4.5% dividend yield. This provides for a 9.6% average annual return without margin expansion, which I think will happen in light of the company's stability and unreasonable current discount.

Assuming expectations are met, 2016 EPS will come out to $3.23. At a multiple of 18x, this translates to a future stock value of $58.14. This provides for a 11.4% average annual return--not bad, especially when you consider that the stock is 83% less volatile than the broader market. Return on invested capital of 7% is also at a slight premium to peers while leverage is lower. Even still, analysts are more bearish than bullish on the stock. 12 of the 15 reporting analysts rate the stock a "hold". They share this pessimism for Exelon with a rating of 2.8 out of 5 where "5" is a "sell".

The reason for the bearish outlook stems from poor performance. In the third quarter, revenue of $5.05 billion fell 7% y-o-y and missed expectations by an incredible $920 million. However, much of this was due to milder than usual weather and an unclear economy that overshadows all--not just Southern Co.'s--near-term future. I recommend buying some shares to take advantage of this low.


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 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!

blog comments powered by Disqus