Utility companies are far from exciting businesses, but their dependable cash flow, defensive characteristics, and typically reliable dividend payments can make them compelling stocks for investors living off dividends in retirement.
Consolidated Edison (ED) 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 over 40 consecutive years. In fact, ED is the only utility company in the S&P 500 with 30 or more years of consecutive dividend increases
While no stock is perfect, we hold Consolidated Edison (ED) in our Top 20 Dividend Stocks portfolio and our dividend portfolio for Conservative Retirees.
Business Overview
ED provides electric service to about 3.7 million customers and gas service to approximately 1.2 milliion customers mostly in New York City. ED is mainly a distribution company and has little power generation activities, and the far majority of its income is derived from regulated activities.
ED also plays a meaningful role in the renewable energy market. The company is the 6th largest owner and operator of solar PV in North America (behind Berkshire Hathaway, SunEdison, SolarCity, NRG) 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 which supplier they receive service from and the price 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, ED invests over $2 billion per year into 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 ED 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 profitability. 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 that a utility company operates in. 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 ED’s credit rating by two notches after the company experienced a series of unfavorable rate cases.
Most recently, ED 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, we think 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.
We believe ED is better protected from this risk compared to other utilities because of its substantial investment in solar (6th largest operator in North America) and presence in New York City (wind farm activity is severely limited). We hope 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+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. ED’s long-term dividend and fundamental data charts can all be seen by clicking here.
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 very good, and 25 or lower is considered weak.
ED earned a very 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, ED’s earnings payout ratio is 70%. While this would be risky for cyclical companies, it is reasonable for a stable utility company like ED.
Looking below, we can see that ED’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 ED 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 we previously mentioned, ED’s profitability is determined by state authorities, which determine rate increases and an acceptable return on capital for utility companies. For this reason, we can see that ED’s return on equity has remained very stable at 9-10% over the last decade:
Source: Simply Safe Dividends
Looking at the balance sheet, ED 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 ED 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, ED 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 ED was heavily dependent on capital markets to finance its ongoing operations. Investor confidence in utility companies plunged.
We don’t view this as a risk today (ED is not involved in electricity power generation, only distribution), but it’s worth mentioning. Altogether, we believe ED’s dividend payment is very 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 very good, and 25 or lower is considered weak.
ED’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, ED 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 ED’s EPS payout ratio (70%) is at the upper end of management’s target (60% to 70%), we expect future dividend growth to track earnings growth and remain in the low-single digit range.
Valuation
ED 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 2-4% 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, we believe ED appears to be reasonably priced.
For investors wondering if today’s low interest rate environment has caused a bubble in utility stocks such as ED, we would encourage you to read our article, “Are Utility Stocks in a Bubble?”
Conclusion
ED 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, ED has proven to be very durable and committed to its dividend.
The utility sector is being forced to evolve as renewable energy markets enjoy rapid growth, but ED appears to be reasonably positioned for this trend (recall that ED is the 6th 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, ED’s status as one of our favorite blue chip dividend stocks looks very secure.
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