(Published Feb. 27 by Bob Ciura)
It is no secret that utility stocks are great for income. They arguably enjoy the most defensive, recession-resistant business model one can find.
This makes them ideal for investors interested in high dividend yields and safe dividend payouts.
Southern Co. (SO, Financial) and Consolidated Edison Inc. (ED, Financial) are two of the largest utilities in the U.S.
Southern has raised its dividend for 15 years in a row. It is a Dividend Achiever, a group of 272 stocks with at least 10 years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
Consolidated Edison has reached an even more exclusive level. It is a Dividend Aristocrat since it has raised its dividend for 43 years in a row.
You can see the entire list of all 50 Dividend Aristocrats here.
We will compare and contrast these two utility stocks to determine which one is the better pick for income investors.
Fundamentals winner: Consolidated Edison
Southern and Consolidated Edison are in the same industry—electricity generation and distribution. They differ in size and regional market served.
Southern serves 9 million electric and gas customers located primarily in the southeastern U.S.
Consolidated Edison provides electric services to more than 3 million customers in New York.
Source: 4Q Earnings Presentation, page 4
Consolidated Edison performed slightly better than Southern in 2016. Its earnings per share rose 2% to $4.15 last year. Adjusted EPS increased 13% in the fourth quarter thanks to favorable weather trends.
For its part, Southern’s EPS declined 1.2% in 2016Â to $2.57. One reason for the decline is Southern continues to be dragged down by cost overruns at its major Kemper project.
The Kemper facility is a massive electric power plant that utilizes a new technology for burning coal. It uses lignite, which can be converted to gas at a lower temperature than existing techniques.
According to Southern, this is expected to result in lower costs with less harmful environmental impacts.
The problem is that costs are coming in much higher than originally anticipated.
Last year, Southern absorbed $428 million in excess losses at the Kemper Integrated gasification combined cycle. This was an increase from $365 million of such losses incurred in 2015.
This issue has weighed on Southern for a few years now, but the project is finally nearing completion. Once Southern can rid itself of these losses, its earnings growth is likely to improve.
Growth prospects winner: Southern
The trade-off for the certainty of their business models is that utilities exhibit fairly low rates of earnings growth.
Rather than companies in other industries that can innovate and develop new products, electricity is an extremely stable business.
Southern and Consolidated Edison have regulated operations. This provides them with a modest amount of growth since utilities regularly receive approval for periodic rate increases.
In a normal climate, they can be expected to grow EPS a few percentage points above GDP growth.
Consolidated Edison’s future growth will benefit from its recently approved three-year rate plans for its electric and gas delivery businesses.
Overall, Consolidated Edison expects 2017 adjusted EPS of $3.95 to $4.15. At the midpoint, its EPS, on an adjusted basis, are set to increase 1.5% this year.
Source: 4Q Earnings Presentation, page 21
Meanwhile, Southern appears to have better growth prospects. It has taken a more aggressive approach to merger and acquisition activity, such as its $8 billion merger with AGL Resources last year.
The deal expands on Southern’s customer growth initiative.
Source: Fourth Quarter Presentation, page 7
Southern expects EPS growth of 2.4% in 2017 due to customer additions and new energy infrastructure improvements booked under long-term contracts.
Long term, the company sees the potential for 5% annual EPS growth. Growth is expected to accelerate due largely to customer growth and the projected completion of the Kemper project in early 2017.
Source: Fourth Quarter Presentation, page 12
For a utility, a 5% annual EPS growth rate is an impressive figure. This could lead to stronger dividend growth as well moving forward.
Dividends: Southern
Investors have long relied upon utility stocks for dependable dividends. They were once known as “widow and orphan” stocks because they could be passed on to heirs and continued paying reliable dividends.
Since everyone needs to keep the lights on, utility stocks could even be owned by the most risk-averse among us.
As a result, well-run utilities can provide consistent (if unspectacular) earnings growth and dividend hikes every year.
Consolidated Edison’s longer history of annual dividend increases, not to mention its membership in the Dividend Aristocrats, would normally make it the clear winner over a Dividend Achiever.
Source: November 2016 Investor Update Presentation, page 20
However, this is an unusual time for utility stocks.
The mad rush for yield over the past few years has resulted in declining dividend yields across the utility sector. In a low-interest environment, investors are scrambling for the high yields that utilities typically provide.
As share prices rose across the utility sector, dividend yields declined. Consolidated Edison enjoyed a much stronger rally than Southern in recent years. Over the past three years, Consolidated Edison stock increased 38%, compared with a milder 18% rise for Southern.
Of course, this is not surprising given Southern’s problems at its Kemper facility.
Nevertheless, right now, Southern and Consolidated Edison have respective dividend yields of 4.5% and 3.6%. This is a big difference—Southern yields nearly a full percentage point higher than Consolidated Edison.
Put differently, a $10,000 investment in Consolidated Edison would generate $360 in annual dividend income. The same investment in Southern would provide $450 in annual income—25% more income than with the former.
Southern appears willing to pay out more of its earnings in dividends, relative to Consolidated Edison. Consolidated Edison seeks to maintain a payout ratio of 60% to 70% of adjusted EPS. Southern currently maintains a payout ratio closer to 80%.
There is nothing alarming about Southern’s payout ratio. Even though it is higher, the company still easily covers its dividend with earnings. The benefit is that investors are treated to a significantly higher yield.
Final thoughts
Consolidated Edison stock rose much more than Southern over the past few years, which was great for its shareholders.
But, those interested in buying the stock now have to settle for a relatively low dividend yield for a utility stock.
By contrast, Southern has a much higher dividend yield and could exhibit stronger earnings and dividend growth moving forward due to its M&A activity and recovery at the Kemper facility.
As a result, while both stocks are strong picks for income, Southern could be the more rewarding income investment. The 8 Rules of Dividend Investing agree with this qualitative assessment as Southern Co. outranks Consolidated Edison.
Disclosure: I am not long any of the stocks mentioned in this article.
Start a free 7-day trial of Premium Membership to GuruFocus.
