In a brutal market environment, where even the most staid and established blue-chip companies have been forced to either cut or reduce their dividends, there seems to be few sectors that are safe from the economic fallout of the coronavirus pandemic that is ravaging companies' earnings.
The carnage continues, this time in the energy services sector with Schlumberger (SLB) announcing yesterday an unprecedented — albeit necessary — 75% slashing of its dividend. For the moment, Chevron (CVX) remains unbowed in the face of unrelenting downward pressure on oil prices in a world where the supply is now so abundant that storage facilities will soon be full. The current payout at other companies could be in jeopardy as well, dependent on the duration of the lockdown and how soon a beleaguered and traumatized economy can bounce back.
Utilities are one sector in the economy where regulation could be a dividend or yield-starved investor's best friend during these perilous and uncertain times. The government allows utilities by statute, a specified reasonable rate of return, regardless of changes in the economy.
The sector overall has dropped much less than the S&P 500, showing its resilience in the face of challenging conditions. The Utilities Select Sector SPDR Exchange-Traded Fund (XLU, Financial) has lost approximately 12% since the S&P 500’s Feb. 19 peak, compared to the 18% precipitous drop for the broader market. The dividend yields, after the panic selloff, remain alluring. The ETF’s recent yield is 3.5%, which is favorable compared to the 2.2% of the S&P 500.
The 2020 FactSet consensus earnings projections for the Utilities Select Sector SPDR is $3.23 a share, a slight decrease from $3.26 as of the end of February. That compares with $3.18 for the same period last year.
Some analysts argue that shares in the utility sector, as well as consumer staples, have been bid up over the past six months and are now overvalued. Nonetheless, the benefit of the relatively abundant current yields available far outweighs any premium investors would have to pay. It should be noted as well that the average utility yield of 3% or greater far exceeds the meager 0.73% current rate on the 10-year Treasury note.
Of course, there is no certainty in the coronavirus environment. The economic shock from the pandemic may pressure profits in the short term. Should the economy go from bad to worse, swelling ranks of unemployed customers might stop paying their monthly electric bills, commercial and industrial demand could drop significantly, supply chains could be disrupted and delays to important construction projects could occur.
But there is no doubt that given the unique nature of their operations and revenue stream, as well as increasing residential demand from stay-at-home lockdown restrictions, the utility sector offers the best choice for investors who are weary from the quest to find dividends that likely won’t be on the chopping block.
The principal business of American Electric is operating regulated utilities. American Electric, like many other utilities, has exited from highly volatile business operations, such as merchant power— producing electricity to sell to other utilities—which is subject to the vagaries of spot market prices. These changes have made American Electric and other regulated utilities more durable business enterprises.
The company’s payout ratio last year was 64%, which is fairly standard for the utility industry.
A payout ratio in that range would allow American Electric to maintain its dividend should earnings fall slightly. This prognosis assumes, however, that there will be no industry-wide drop. American Electric currently is yielding 3.2% and is trading at $83.50. Its 52-week high was $104.97; its 52-week low was $65.14.
The company stated in a recent Securities and Exchange Commission disclosure filing that the coronavirus pandemic’s “ultimate impact also depends on factors beyond our knowledge or control, including the duration and severity of this outbreak.”
FirstEnergy, like American Electric, divested its laggard merchant power business so that it could focus on regulated operations. The company looks well-positioned to weather any covid-19 economic fallout. FirstEnergy’s businesses include regulated electric distribution divisions in its home state of Ohio, as well as Pennsylvania, New Jersey, Maryland and West Virginia. Another financial advantage the company enjoys is that over 66% of its customers are residential.
FirstEnergy’s broad residential base of customers provides financial stability. Utilities make more money from residential that commercial sales. The current lockdown means increased electricity demand, as many employees are now working from home. FirstEnergy also stated in a recent filing that its operations were well-equipped to respond to an economic downturn.
Morgan Stanley anticipates that overall electricity demand will decline approximately 5% this year, commercial volume will drop by 10% and industrial will fall by 6%, yet residential will rise by 2%. FirstEnergy currently yields 3.4% and is trading at $44.48.
Given the current turmoil, defensive investors who are looking for dividend preservation in uncertain times should look to the regulated utility industry since it is worthy of consideration.
Disclosure: I have no position in any of the securities referenced in this article.
Read more here:
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- Seth Klarman: Embrace Your Contrarian Convictions
- Howard Marks: Anatomy of a Selloff
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