2 utility stocks with big return potential

The sector is up 15% this year, but it's signaling a weak market ahead. Here are solid dividend payers that can ride out the weakness.

By StreetAuthority May 8, 2014 8:43AM
Electricity pylons © Digital Vision., Photodisc, Getty ImagesBy Adam Fischbaum

One claim that scientists make is that part of what distinguishes humans from animals is that humans have the ability to recognize patterns.

The reason I call it a claim is that my 8-year-old yellow lab knows when things are out of order -- mainly at feeding time (especially if the cat's food dish has been moved) and when it's time to come in to go to bed. If things are askew, she'll let you know (as only labs can).

In my research for an article on value-priced utility stocks, I recognized an undeniable historical pattern:

In every instance, a sideways pattern, or underperformance of that particular group of stocks, in the Dow Jones Utility Average Total Return index occurred during a relatively strong, broader equity market period was followed by a flat broader market or even a correction.

Now, in times of uncertainty in the economy and the markets, nervous investors will gravitate toward utility company stocks for their large and reliable dividends. So far this year, that scenario seems to be playing out. Utility stocks are outperforming the S&P 500 Index handily: $DJUTR is up 15 percent compared with a meager 1.8 percent gain for the broader average.
So, with that healthy, market-leading run, does it still make sense to buy utilities? Yes, but with one caveat: You have to pay attention to valuations and yields.

Widely held utility names -- such as Southern Co. (SO), American Electric Power (AEP) and Duke Energy (DUK) -- have seen their forward price-to-earnings (P/E) ratios rise to 15 or 16 and their dividend yields shrink to under 5 percent.

When selecting utility stocks, I want a forward P/E below 15 and a yield close to 5 percent. This provides above-average compensation at a cheaper price with room for the stock price to expand. Here are two utility names that fit these criteria.

Hawaiian Electric (HE)
Forward P/E: 13.8
Dividend yield: 5.3 percent

Besides powering the majority of the Hawaiian islands, Hawaiian Electric has large long-term services contracts in place with the many large U.S. military installations throughout the islands. In addition to the electric power generation business, the company also owns banking subsidiaries American Savings Bank and American Savings Holdings.

Hawaiian Electric's numbers are compelling. Utilities are usually steady but low-growth businesses -- but Hawaiian Electric has averaged respectable growth of 8.5 percent in earnings per share (EPS) over the past four years. Compare this with Southern Co., whose earnings have actually shrunk by an average rate of 4 percent -- and yet investors are willing to pay a premium for Southern.

Hawaiian Electric trades near $23.50, a 17 percent discount to its 52-week high and close to its tangible book value of $21.30 a share. This stock clearly offers utility investors much more value than better-known names.

Entergy Corp. (ETR)
Forward P/E: 14.5
Dividend yield: 4.5 percent

As a rookie, I remember the veteran broker in the office next to me touting a new preferred stock to a client. In his Southern drawl, the issuer was "the ol' Looziana Power," better known as Entergy Corp. Entergy provides electrical service to 2.8 million customers across Arkansas, Louisiana, Mississippi and Texas. Its retail and wholesale electrical-generation business own over 24,000 megawatts of capacity, including more than 5,000 megawatts of nuclear-generating capacity, making it one of the nation's largest nuclear power generators.

Entergy is positioned right in the sweet spot of shale fracking between the Eagle Ford shale play in South Texas and the Haynesville-Bossier shale play on the Texas- Louisiana border. As energy extraction activity ramps up in the region, so goes overall economic activity, so the demand for Entergy's electricity should continue to climb steadily. Earnings per share are projected to grow by a strong 33 percent in 2014, to $5.34 a share.

While ETR's dividend yield is slightly below my 5 percent benchmark at 4.5 percent, Entergy is an excellent bargain in its peer group. At about $73 a share, the stock trades at just 1.3 times its tangible book value.

Risks to consider: The biggest risk facing both stocks is rising interest rates. Utility stocks always take it on the chin as rates rise due to their reliance on debt financing. Rising interest costs can squeeze margins and shrink dividends. Entergy has increased risk of regulatory exposure due to its status as a major producer of nuclear power.

Action to take:
Based on the solid earnings momentum behind both Hawaiian Electric and Entergy, expansion of their P/E's to 17 in the next 12 to 18 months is plausible. This would result in a total return in excess of 30 percent. Not too shabby for utility stocks.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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2Comments
May 8, 2014 9:22AM
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This from the same group of people saying how great Duke was just last year.
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