by Aaron Levitt | September 24, 2013 11:06 am
With the Fed announcing that it wasn’t planning on ending its quantitative easing programs just yet, investors have once again plowed head first into anything with yield. That means utility stocks are once again back on the menu for many retirees and those looking for a little safe dividend income.
After all, the sector is responsible for delivering essential services and even in times of duress, people need to heat/cool their homes and keep the water and electricity flowing. That fact has made utility companies a steady source of dividend income for decades. So it’s no wonder why they have been given the nod by many investors in the low rate environment.
Yet, not all utilities are created equally.
Sure, the bulk of their operations still are about producing power. However, over the last ten years or so, more and more utilities have moved into some other areas in order to generate returns. That’s included some very non-essential and varied services.
For investors, taking a look under the hood is key when buying into a utility.
When we tend to think about a utility company, power or water plants come to mind. And given that these facilities provide vital and fundamental needs for society, they often come with a heap of government regulation.
That regulation can come from environmental standards, but more commonly comes down to just how much that utility can charge per unit of water, natural gas or electricity to its customers. These regulated operations form the backbone of the industry and really make up the bulk of the sectors earnings — and therefore juicy dividends.
But sometimes this just isn’t enough.
To produce higher returns than what can be achieved via regulated power plants, some utilities have taken the plunge and have added non-related assets. This actually includes sectors like banking, retail operations and real estate development. These side businesses can be tucked within the company’s non-regulated assets. While they can provide a nice “boost” to profits — as they are outside the cold hand of regulators — they can be a huge drag if they don’t perform.
Utility stalwart Wisconsin Energy (WEC) slashed its dividend nearly in half in 2000 on that back-heavy capital investment resulting from some non-regulated assets. That cut took investors by surprise. Since then WEC has recovered, but it just goes to show that these other assets can hurt. They can also destroy, if investors aren’t careful.
Everybody’s favorite fraud ENRON technically was considered a utility. However, its generating and pipeline assets weren’t what got the firm into trouble. It was hidden losses from a side business — energy trading — that eventually did the firm in.
The lesson in all of this is to know what you own.
Paying a 5% dividend, Hawaiian Electric Industries (HE) is the state’s largest utility, providing electricity through renewable energy sources and fuel oil to more than 95% of the islands. That’s all well and good, until you consider that HE also operates in another, completely different sector.
The firm is also the owner and operator of the third-largest bank in the state. That opens shareholders up to a whole mess of different risks — underperforming commercial loans, Frank-Dodd regulations, debit card swipe fee rules etc. — than they were expecting by purchasing utility shares.
Perhaps more frightening is that the bank subsidiary has actually been the main driver of earnings in recent quarters. Lower electricity sales and high fuel oil prices coupled with regulators inability to grant a rate hike have hurt the generation business. With the bank now at the forefront of the utility, any financial issues could upset the balance and send dividends crashing.
Another example could be diversified utility Allete (ALE). The firm does it all and provides the trifecta of regulated utility services — electric, natural gas and water — through its various subsidiaries in Minnesota and Wisconsin. However, “doing it all” also extends towards many other businesses not even remotely related to providing essential services. Auto auctions? Check. Owning nearly 10,000 acres worth of real estate in Florida? Check. How about a coal mine? Allete has that, too.
Luckily for ALE investors, managers at Allete have been very successful at allocating capital towards these side businesses. Although, owning a coal mine comes with a different set of risks than transmission lines.
Finally, Missouri’s Laclede Group (LG) is technically a natural gas utility, and at first blush its non-regulated side businesses fit that mold: pipeline assets, liquid propane transportation as well as energy trading. What doesn’t fit is its 28.5% interest in LBP Partnership, a company which previously engaged in research and development of light beam profiling technology. Laclede also owns a real estate development arm as well as an investment group that makes commercial loans and owns other publicly traded stocks.
Now I’m not saying that these are overall bad stock bets. The lesson here is that investors looking at adding power and water firms to a portfolio for their dividends need to do some digging before they jump the gun. And keep in mind, that rule extends to broad sector plays as well — all three of these “utilities that aren’t just utilities” are found in the $1.7 billion Vanguard Utilities ETF (VPU).
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.
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