Utility companies are far from exciting businesses, but their dependable cash flows, defensive characteristics and typically reliable dividend payments can make them compelling stocks for investors living off dividends in retirement.
Consolidated Edison (ED, Financial) possesses many characteristics that make it appealing to conservative dividend investors. The company has served the New York marketplace for more than 180 years and has grown its dividend for more than 40 consecutive years. In fact, Consolidated Edison is the only utility company in the Standard & Poor's 500 with 30 or more years of consecutive dividend increases.
While no stock is perfect, we hold Consolidated Edison in our Top 20 Dividend Stocks portfolio.
Business overview
Consolidated Edison provides electric service to about 3.7 million customers and gas service to approximately 1.2 milliion customers mostly in New York City. Consolidated Edison is mainly a distribution company and has few power generation activities. The majority of its income is derived from regulated activities.
Consolidated Edison also plays a meaningful role in the renewable energy market. The company is the sixth-largest owner and operator of solar PV in North America behind Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), SunEdison (SUNE, Financial), SolarCity (SCTY, Financial) and NRG Energy (NRG, Financial) and had 446 megawatts of solar and wind projects in operation at the end of 2014.
Business analysis
Many utility companies operate like monopolies in local or regional markets where it would be too costly to have multiple competitors offering electricity services. There are also few substitutes for electricity, and customers have historically had little to no choice over the suppliers from whom they receive service and the prices they pay.
Barriers to entry are generally high for several reasons. Maintaining transmission infrastructure to move electricity and gas from power plants to customers is extremely capital intensive and demands chronic maintenance and repair. For example, Consolidated Edison invests more than $2 billion per year in its systems to remain competitive. In addition to cost, new entrants would need to obtain consent from the state authority, meet various safety and service standards, install transmission facilities to provide the service, comply with ongoing state regulations and more.
Furthermore, following a wave of utility industry restructuring in the 1990s, all of the electric and gas delivery service in New York state is now provided by just four investor-owned utility companies or one of two state authorities. Given the local / regional nature of the business and the high amount of government regulation, it seems unlikely that another company would be authorized to provide utility delivery services where Consolidated Edison already has a presence.
Finally, the pace of change in the utility sector has historically been very slow. Much of the core technology developed for transmission lines has remained stable for decades. More recently, attention has increasingly focused on efficiency upgrades (e.g., the smart grid) and preparing for wider adoption of renewable energy sources (e.g., solar).
Key risks
Despite the competitive advantages enjoyed by utility companies, they face several important limitations that serve to restrict their growth and profitability.
Traditional monopoly companies typically demonstrate strong pricing power. However, as most income investors know, maximum retail prices charged by regulated utilities are set by state governments. This limits the profitability a utility can enjoy and can significantly impact it. However, it does provide them a guaranteed rate of return (in most cases).
Given the capital intensity of transmission infrastructure and the government's interest in keeping electricity prices reasonable for consumers, utilities typically earn a relatively low but stable return on equity.
Income investors should be aware of government regulations in the key states in which a utility company operates. Some areas are much friendlier than others, and rate policies can change over time.
If utilities receive unfavorable rate increases, they might be unable to offset cost increases they incur. Given their high debt loads, this can be a big deal. For example, during 2009, Moody's downgraded Consolidated Edison's credit rating by two notches after the company experienced a series of unfavorable rate cases.
Most recently, Consolidated Edison received news that its electricity rates will be flat in 2016 for the third year in a row. The high cost of living in New York probably doesn't help the case to push rates higher each year. While it's disappointing to not get a rate increase and puts more pressure on 2017, the company remains in good shape.
Overall, New York's regulatory system has generally been consistent and reasonable over the years. Importantly, it includes revenue decoupling for electric and gas services. This means that the utility company's profits are disassociated from its sales of the energy commodity itself. In other words, rates are adjusted up or down to help the utility meet a targeted rate of return regardless of how much product is sold.
Looking longer term, renewable energy sources will continue to impact the utility sector. For example, New York targets 50% renewable energy by 2030, twice the amount installed in the state today.
Finally, it's worth mentioning that most utility companies will continue to deal with falling per capita energy consumption in the U.S. (energy efficiency) and a desire by customers to find cheaper, cleaner energy, including renewables. If customers are able to increasingly generate their own electricity (e.g., solar panels), it could take away sales from utilities and lead to higher costs for other customers.
Consolidated Edison is better protected from this risk compared to other utilities because of its substantial investment in solar (sixth-largest operator in North America) and presence in New York City (wind farm activity is severely limited). Hopefully the renewables market will develop to allow utilities to own the renewable energy sources on behalf of customers rather than handing over more control to third parties, but we will continue to watch for new developments.
Dividend analysis
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Consolidated Edison earned a strong dividend Safety Score of 78, suggesting its dividend payment is very secure. The company's payout ratio is reasonable, it generates consistent cash flow, and its business is protected by government regulations.
Over the last four quarters, Consolidated Edison's earnings payout ratio is 70%. While this would be risky for cyclical companies, it is reasonable for a stable utility company like Consolidated Edison.
Looking below, we can see that Consolidated Edison's earnings payout ratio has remained between 60% and 70% most years, in line with management's target.
Source: Simply Safe Dividends
Not surprisingly, we can see that Consolidated Edison performed well during the financial crisis. Sales fell by 4% in 2009, and operating margins actually improved. While demand for electricity drops a little during economic slowdowns, it is still an essential need for consumers and businesses.
Source: Simply Safe Dividends
As previously mentioned, Consolidated Edison's profitability is determined by state authorities, who determine rate increases and an acceptable return on capital for utility companies. For this reason, Consolidated Edison's return on equity has remained very stable at 9% to 10% over the last decade:
Source: Simply Safe Dividends
Looking at the balance sheet, Consolidated Edison maintains a lot of debt relative to its cash on hand. With that said, utilities have been able to maintain more debt than an average business because their cash flow generation is so consistent. The company has reasonable credit ratings with S&P and Fitch.
Source: Simply Safe Dividends
Finally, it's worth mentioning that Consolidated Edison suspended its dividend in 1974, which was the first time since 1885 that the company omitted its quarterly dividend.
Why did this happen? At the time, Consolidated Edison was much more involved in power generation and relied heavily on various fuels for its generating facilities. The price of residual oil unexpectedly quadrupled, crimping profitability. Management also made a few executional missteps, and Consolidated Edison was heavily dependent on capital markets to finance its ongoing operations. Investor confidence in utility companies plunged.
This isn't a risk today (Consolidated Edison is not involved in electricity power generation, only distribution), but it's worth mentioning. Altogether, Consolidated Edison's dividend payment is safe.
Dividend Growth Score
Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Consolidated Edison's dividend Growth Score was 9, suggesting its growth potential is very low. As a mature utility company with a 70% payout ratio and limited earnings growth opportunities, this shouldn't come as a surprise.
As seen below, the company's dividend has grown between 1% and 2% per year over the last decade. Despite the low growth rate, Consolidated Edison is on the dividend aristocrats list and has raised its dividend for 41 consecutive years (the third-longest streak in the electric utility industry).
Source: Simply Safe Dividends
Since Consolidated Edison's EPS payout ratio (70%) is at the upper end of management's target (60% to 70%), future dividend growth is expected to track earnings growth and remain in the low-single digit range.
Valuation
Consolidated Edison trades at 16x forward earnings and offers a dividend yield of 4%, which is a little below its five-year average dividend yield (4.26%).
With future earnings growth likely in the 2% to 4% range, the stock's total return potential would appear to be 6% to 8% per year. For retirees and conservative income investors concerned with capital preservation, Consolidated Edison appears to be reasonably priced.
Conclusion
Consolidated Edison is one of the most reliable utility companies that conservative income investors can find. With an operating history going back more than 180 years and over 40 straight years of dividend increases, Consolidated Edison has proven to be durable and committed to its dividend.
The utility sector is being forced to evolve as renewable energy markets enjoy rapid growth, but Consolidated Edison appears to be reasonably positioned for this trend (recall that Consolidated Edison is the sixth-largest owner and operator of solar PV in North America). We think the bigger risk is future electricity rates allowed by New York's public utility commission. For now, Consolidated Edison's status as one of our favorite blue chip dividend stocks looks very secure.
