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Utilities

The World’s Cheapest Utility Stock

By Roger S. Conrad, on Nov. 25, 2014

Cheap utility stocks are hard to come by these days, especially with the Dow Jones Utilities Average trading at 20 times earnings and yielding 3.3 percent—a full valuation relative to the index’s long-term average.

(Click table to enlarge.)
DJUA Yield PE PB Table

Valuation multiples in the utility sector have expanded for a number of reasons.

First and foremost, these providers of essential services find themselves in much better financial health than in 2002, when about two dozen names had declared bankruptcy or were one false step away from Chapter 11.

Utilities have also reduced debt and operating risk systematically over the ensuing decade, increasing the reliability of future cash flow and creating a platform for sustainable dividend growth.

And with the exception of a handful of states, relations between utilities and regulators remain sanguine. As we explained in the November issue of Conrad’s Utility Investor, recent gubernatorial elections didn’t affect the supportive regulatory environment.

The sector has also benefited from the lowest corporate borrowing rates in generations, which have enabled utilities to shore up their balance sheets by refinance existing debt, reducing interest expense and lengthening maturities.

Meanwhile, the sector’s above-average dividend yields have found favor at a time when fixed-income securities offer paltry current returns unless investors assume significant credit risk.

When you throw in investors’ desire for safety in a bull market that’s approaching its seventh year, it’s no surprise that utility stocks have outperformed.

Although higher valuation multiples have generated handsome profits for investors who follow our three Model Portfolios in Conrad’s Utility Investor, utilities face a higher bar of expectations.

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Investors must remain patient in this environment, adhere to our buy targets to avoid overpaying and remember the wild momentum shifts of recent years can send winners spiraling lower without any deterioration in the underlying business.

Bottom Line: Bargains are hard to come by in the Dow Jones Utilities Average, an index that comprises 15 names that operate a wide variety of business models. (See Dow Jones Utilities Average: Buy Individual Stocks, Not the Index.)

Consolidated Edison (NYSE: ED), for example, generates almost all its profits from regulated electric and gas utilities in New York. When natural-gas prices are soft, customers enjoy lower bills and regulators are more likely to grant a solid rate of return for system investment.

In contrast, Exelon Corp (NYSE: EXC) derives about half its earnings from wholesale electricity, an unregulated business that suffers when natural-gas prices are low.

The varying business models represented in the Dow Jones Utilities Average push and pull the index in different directions. And the same is true of other utility stock indexes and the exchange-traded funds notes set up to mirror their performance.

Don’t get me wrong: Sometimes the time is ripe to bet on the Dow Jones Utilities Average. Conrad’s Utility Investor readers who followed our lead booked a 16 percent gain in ProShares Ultra Utilities (NYSE: UPW), a four-week bet on the index’s seasonal strength. (See Closing Our Seasonal Trade and a New Portfolio Addition.)

Overall, however, understanding the upside drivers for individual companies and investing based on that knowledge—the approach that has served me and my subscribers well for almost three decades—remains the best way to outperform and build lasting wealth.

And the best time to buy is when a stock’s price doesn’t reflect the underlying company’s prospects.

If you’re a conservative investor like me, you probably focus on stocks issued by strong companies that have fallen out of favor temporarily.

Sometimes, however, a company that faces major business challenges can be worth buying because the stock has already priced in everything that can go wrong—and then some.

Meet Companhia Energetica de Minas Gerais (Sao Paulo: CMIG4, NYSE: CIG), Brazil’s largest power transmission, generation and distribution utility. Trading at 5.6 times earnings and 0.9 times sales, Companhia Energetica de Minas Gerais (CEMIG, for short), is arguably the world’s cheapest utility stock.

Including the Brazilian utility’s recently declared special cash dividend—an annual phenomenon over the past decade—the American depositary receipt (ADR) yields almost 27 percent.

Two developments have landed CEMIG in the bargain bin.

President Dilma Rousseff’s government has sought to leverage expiring hydropower licenses to force utility’s to slash wholesale electricity prices and the rates charged by transmission providers. The rationale behind this move: Lower electricity prices will stimulate Brazil’s economy.

Rousseff’s reelection this fall dashed investors’ hopes that a new administration might take a different tack and seek to repair regulatory relations.

Now, CEMIG faces the prospect of either losing some of its hydropower concessions or accepting the lower rates associated with the new licensing terms.

At the same time, the worst drought in decades has dramatically reduced output from the hydropower facilities that generate more than 95 percent of CEMIG’s electricity, forcing the company to purchase output from rivals that operate thermal-powered plants.

All told, the utility’s cash flow plummeted 60 percent from year-ago levels, while the firm’s cash flow margin compressed to 13.39 percent from 36.34 percent a year ago. Net income adjusted for regulatory items tumbled by more than 96 percent, and the company barely broke even.

Terrible third-quarter results, coupled with widespread selling of Brazilian equities and currency weakness, fueled a major selloff in CEMIG’s shares; the utility’s New York-traded ADR earlier this month tumbled to US$4.81, its lowest price since the height of the financial crisis.

To be sure, CEMIG likely won’t be able to support a 27 percent dividend yield over the next 12 months. Leaving aside the company’s disputes with the government, the drought has shriveled up its cash flow at a time when the firm’s capital and refinancing needs are elevated.

(Click graph to enlarge.)

DEMIG DDIS

And Rousseff’s political party has taken charge in CEMIG’s home state of Minas Gerais, promising that the new board appointees will pursue policies that are friendlier to consumers, which presumably will translate into lower returns for the utility.

Despite these serious headwinds, CEMIG should benefit from enormous opportunities to expand its output in coming years. The utility has 1,313 megawatts of generation capacity in development and ample expansion opportunities in transmission and distribution to meet critical needs in advance of Brazil hosting the 2016 Summer Olympics.

And the new management will also be more likely to negotiate with the government to retain the three operating concessions in dispute.

The drought is a major wild card. And until water levels normalize at CEMIG’s hydropower plants, the company will be forced to wrestle with higher costs.

But at these levels, it’s hard to argue that the stock hasn’t priced in all this bad news and then some.

Although the stock is dirt cheap and downside risk appears limited, CEMIG has a lot of work to do and a long way to go before the ADR returns to its midsummer high of about US$9.00. This peak occurred when the prospect of a Rousseff defeat appeared greatest.

For aggressive investors, buying when expectations for a stock are at their nadir can be a lucrative strategy—provided there are identifiable upside catalysts on the horizon.

CEMIG fits the bill, though this stock is suitable only for patient investors who understand the risks.

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