2 Utility Stocks to Buy, 1 to Watch

by Susan J. Aluise | August 3, 2012 10:00 am

Utility stocks were breakout performers in 2011, then market volatility settled down on hopes of a stronger global economy. Unfortunately, those great expectations soon faded when a slower China and scarier Europe pitched us back into the same stomach-churning wild ride.

That means now is a pretty good time to fall back in love with the high-yield, low-beta utility sector.

Utilities have a well-deserved reputation as the dull darlings of the investment world[1]: As regulated providers of essential services (you have to keep the lights on, after all) they have a stable ratepayer base and limited competition. Add to that the opportunity to enhance their size and market reach through consolidation, and the value proposition is readily apparent.

Although current 10-year Treasury yields of around 1.6% make high-dividend utility stocks look very attractive right now, the sector’s strong run has amped up valuations on these companies considerably. Many key players are trading at or near their 52-week highs, so take care not to chase dividends at any price[2].

Balancing the attractive dividend yields against current valuations and other factors, here are two utility stocks to buy and one that warrants the “wait-and-see” approach:

Buy Now

American Electric Power (NYSE:AEP[3]). This provider of electricity to customers in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia, boasts a current dividend yield of 4.5%.

With a market cap of $20.2 billion, AEP is trading around $41.50 and has a one-year return of nearly 18%. AEP’s high price-to-earnings growth (PEG) ratio of 3.2% is on low side for the typically high-PEG utility sector (a PEG of 1 is considered to be fairly valued). Its forward P/E of less than 14 is also better than most other large-cap electric utilities.

AEP announced this week that it has begun construction on an alternative energy project — the Prairie Wind Transmission joint venture — in Kansas. It’s participating with WestarEnergy (NYSE:WR[4]) and MidAmerican Energy Holdings. I think AEP is a great stock for long-term, stable, high yields. I like AEP with a price target of $44.

PEPCO Holdings (NYSE:POM[5]). This electric and natural gas utility, which provides service to customers in Washington, D.C., Maryland, Delaware and New Jersey, has a current dividend yield of nearly 5.5%. With a market cap of nearly $4.5 billion, POM is currently trading around $19.50 and has a one-year return of nearly 12%. POM’s PEG ratio of 2.7 is low for the utility sector. It has a forward P/E of 16.

The utility has done a good job of growing earnings, though it has struggled to reduce power outages[6] — and regulators and customers in D.C. and Maryland say it has a long way to go (InvestorPlace‘s Marc Bastow, for one, thinks the company’s performance in this regard has been so poor that it ought to be made to rescind its juicy dividend[7]).

Still, I think PEPCO’s market position is solid and its operational performance is improving, albeit slowly. The dividend is among the best in the sector, too. Buy POM with a price target of $21.

Wait and See

Duke Energy (NYSE:DUK[8]). Duke, which became the nation’s largest utility by completing its merger with Progress Energy last month, has a current dividend yield of 4.5%. Although it has struggled with earnings growth in the past, the merger presents new opportunities for the combined entity.

With a market cap of nearly $30 billion, DUK is trading around $67 and has a one-year return of more than 27%. The stock has a PEG ratio of 3.6 and a forward P/E of nearly 16.

On the positive side, DUK’s quarterly earnings beat the Street on Thursday with a 2% rise largely due to rate increases. Progress earnings, which were reported separately, slipped on maintenance issues that took three nuclear plants offline. Duke and Progress results will be reported together beginning next quarter.

While DUK is strong, stable and offers an attractive dividend yield, I don’t think now is the time to initiate a new position in the stock. Duke has come under fire from shareholders and regulators[9] for changing CEOs just one day after the DUK-PGN merger was completed last month.

To make matters worse, former Progress shareholders filed a class action lawsuit on Thursday, essentially alleging that Duke management lied when it said Progress chief Bill Johnson would serve as CEO of the merged company. Wait until the dust settles over the CEO snafu before you buy.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.

  1. dull darlings of the investment world: https://investorplace.com/2012/07/for-older-investors-dividends-trump-bonds/
  2. take care not to chase dividends at any price: https://investorplace.com/2012/07/3-things-you-must-know-about-dividend-investing/
  3. AEP: http://studio-5.financialcontent.com/investplace/quote?Symbol=AEP
  4. WR: http://studio-5.financialcontent.com/investplace/quote?Symbol=WR
  5. POM: http://studio-5.financialcontent.com/investplace/quote?Symbol=POM
  6. struggled to reduce power outages: http://www.washingtonpost.com/opinions/5-myths-about-pepco/2012/07/06/gJQAzrIASW_story.html
  7. rescind its juicy dividend: https://investorplace.com/2012/07/pepco-needs-the-hook-pom-duk-d-so/
  8. DUK: http://studio-5.financialcontent.com/investplace/quote?Symbol=DUK
  9. Duke has come under fire from shareholders and regulators: https://investorplace.com/2012/07/3-lessons-from-the-duke-progress-ceo-switcheroo/

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