Dividend Stock Wars, Utilities Edition: Consolidated Edison and American Electric Power
We’re at the start of a new month and, like always, that means it’s time to roll out another round of Dividend Stock Wars.
This time, I’m pitting two stocks together from a sector that’s long been recognized as the bread and butter of an income-oriented portfolio. Namely, utilities.
Stalwart, defensive and dividend growth-oriented, they’re classic stocks for good reason.
But, as I’ll reveal below, there’s one other major reason I picked these stocks and not others.
So let’s get cracking…
~Round 1: Simple Business
The rule is easy: The simpler the business, the better the investment.
This holds especially true for income investing. The fewer the moving parts, the fewer the risks – and the more likely you’ll be getting that dividend next quarter (and the next, and the next).
And one of the primary reasons dividend investors find the utility sector so attractive is its simplicity. Individuals, businesses and organizations need water, gas and electric. Utility companies sell it to them.
There are two complicating factors, however.
First, utilities are subject to government regulation…
Regulatory environments often change over time, and these changes don’t necessarily have a utility’s best interest in mind. In other words, earnings might take a hit for reasons beyond a company’s control.
This affects Con Ed and American Electric on a relatively equal basis. The former primarily serves New York, and the latter derives nearly 30% of its revenue from Ohio. Both areas are known in the industry to be among the toughest and more unstable regulatory environments in the country.
Second, utilities often deal in commodities, like oil and natural gas, whose long-term price changes are anything but easy to predict.
Additional regulation surrounds the use of certain sources of energy generation. For instance, coal-burning plants are forever under the thumb of the EPA. Again, what happens in governmental committee today could mean company losses tomorrow.
Case in point: Back in February, American Electric agreed with the EPA to convert three of its power plants from coal to natural gas by 2015. But the cost of compliance proved to be prohibitive, so now the company is opting to shutter those plants instead.
In the end, because American Electric relies on coal plants in a big way, and Con Ed not at all, the latter has the upper hand at avoiding expensive regulatory decisions.
Advantage: Consolidated Edison
~Round 2: Steady Demand
Utilities are widely known for being about as recession proof as you can get. Everyone needs water, gas and electric no matter what’s happening in the economy at large.
But, once again, regulations are liable to muck it up. So even if the implicit demand rises steadily – Morningstar estimates this growth at about 1% annually – it won’t always translate into steadily rising revenue.
American Electric’s plant closings cited above show just why this is. Tack on regulated rate cuts that come and go, and it’s no wonder why revenue is liable to take it on the chin.
So while populations and service areas continue to grow both for Consolidated Edison and American Electric, three-year revenue growth for the former was a tepid 3.48%, and the latter’s dipped into negative territory at -2.21%.
Fortunately, as I’ll show in the next issue, such wonky revenue behavior doesn’t mean that price performance or dividend payments suffer. Hence, utilities remain recession proof in all the ways that matter, despite revenue slippage.
~Round 3: Valuation
Like I said, there’s an overwhelming reason I picked Con Ed and American Electric over other utility stocks.
Recall that, back in May, I pointed out that the utilities sector is suffering from overvaluation. Indeed, the valuation of most utilities is heavily overpriced.
Yes, it can be worth paying a bit more for high dividend growth or solid, defensive performance. But there’s a limit. And the utility sector is far beyond it.
Right now, the average utility trades for more than 35.8 times earnings. That’s over twice the price-to-earnings (P/E) ratio of the S&P 500.
Luckily, American Electric Power and Con Ed are anomalous bargains in the sector, trading at just 18.7 and 17.6 times earnings, respectively.
In other words, while both offer all the defensive and solid income potential of major utilities – and remain reasonably priced – Con Ed has a slight edge.
Advantage: Consolidated Edison
Round for round, with one draw and two wins for Consolidated Edison, American Electric has a little catching up to do.
But with four rounds still left, it has some time to do it. So be sure to keep an eye out for Thursday’s continuation.