Consolidated Edison (ED): A High Yield Dividend Aristocrat Down 10% Since July

When it comes to high-yield dividend stocks, regulated utilities are a favorite among conservative investors living off dividends in retirement and for good reason.

 

They usually offer generous, secure, and consistently (albeit slowly) growing yields; as well as some of the lowest volatility you can find in the stock market.

 

But nearly a decade of record low interest rates has resulted in yield-starved investors plowing money into the sector, searching for quality bond alternatives.

 

This has resulted in a precarious position for value-focused investors, with unattractive valuations threatening to result in years of poorer performance for the utilities sector going forward.

 

Let’s take a closer look at Consolidated Edison (ED), one of the most popular regulated utilities, to see why if now is a good time for investors to open or add to their positions.

 

Con Ed’s stock has dropped more than 10% since July 2016, and its dividend yield is close to 4%. We hold shares of the company in our Conservative Retirees dividend portfolio.

 

Business Description

Consolidated Edison was founded in 1884 in New York City and serves as a regulated electric and gas utility to the New York metro areas and Westchester County, NY.

 

Its 724 megawatts of electrical generating capacity and 4,348 miles of gas pipes serve 3.4 million and 1.1 million customers, respectively. The company also supplies steam to 1,700 Manhattan customers (for heating purposes).

 

 

Electric operations account for the majority of Con Ed’s total rate base:

 

 

As you can see, Con Ed also has owns a substantial amount of renewable energy assets, dominated by solar power that is sold to other utilities under long-term power purchase agreements.

 

 

However, the Competitive Energy Segment (CES) makes up just a fraction of its overall business (3% of year-to-date adjusted EPS in 2016).

 

 

Management projects that, while renewable energy will represent a larger portion of its revenue and earnings base in the future, its core business will remain dominated by its regulated New York electricity and gas businesses over the next 20 years.

 

 

Business Analysis

Most regulated utilities enjoy monopoly-like status in the markets they operate in because it would be too expensive to have multiple service providers in the same region.

 

There are also relatively few substitutes for electricity and gas, and customers have little choice over the suppliers they receive service from and how much they pay.

 

High barriers to entry help Con Ed and many other utilities generate predictable results every year. Barriers to entry are high because it is extremely costly to maintain transmission infrastructure needed to move electricity and gas from power plants to customers.

 

In fact, Con Ed invests more than $2 billion per year into its systems to remain competitive. New entrants would also need to obtain permission from the state authority, meet a slew of safety and service stands, install transmission facilities, comply with state regulations, and more.

 

After a wave of industry-wide restructuring in the 1990s, all of the electric and gas delivery service in New York State is now provided by four investor-owned utilities or one of two state authorities.

 

It seems very unlikely that another company would be allowed to provide utility delivery services where Con Ed already has a presence after considering the local nature of the utility business and the high amount of regulation.

 

All of these factors, coupled with the industry’s slow pace of change and recession-resistant services, make Con Ed a highly durable business (how many other companies have been in business since the 19^th century, essentially solving the same problem for customers?).

 

While Con Ed’s earnings are among the most stable in the industry, at the same time the company has struggled to record much meaningful earnings growth.

 

This is mainly due to the very mature markets Con Ed operates in, resulting in predictable results at the expense of rather anemic growth in electricity and natural gas demand.

 

As you can see, demand is projected to grow by less than 1% annually over the next two decades for its electric businesses.

 

 

Gas demand is a similar story, although the rate of growth is moderately higher (1.4% CAGR) for Con Ed’s CECONY segment.

 

 

Another hurdle to growth is the high cost of living in New York City, which makes regulators less amenable to raising electricity and gas rates. In fact, the company’s Con Ed New York subsidiary is currently facing frozen electric rates.

 

Combined with the fact that its electric power plants are very old (many run on oil, with the rest powered by gas), this can result in higher fuel costs, hurting profitability.

 

And since New York regulators generally allow lower-than-average returns on equity (political pressure to keep rates low), it can be harder for Con Ed to boost its profitability given that most of its infrastructure is underground and thus costs more to maintain and expand.

 

Utility	Operating Margin	Net Margin	Return On Assets	Return On Equity	Return On Invested Capital
Consolidated Edison	20.7%	10.1%	2.6%	8.9%	6.0%
Industry Average	23.9%	10.9%	2.8%	9.2%	NA

Source: Morningstar

 

Meanwhile, the non-regulated merchant power business (where Con Ed holds its renewable assets), while offering faster sales growth potential, doesn’t do much for profitability. That’s because wholesale power generation is a ferociously competitive, low margin, and unpredictable business.

 

Management is hoping that the large amount of capital spending it’s done recently will result in higher rates in 2017 (when the rate freeze ends).

 

However, even if regulators oblige it higher rates to recoup the utility’s investments, earnings per share seem likely to only grow around 3% annually over the long term; just barely ahead of inflation.

 

 

Essentially, Consolidated Edison is the definition of a bond-like stock: safe, predictable dividends, but very low growth.

 

Key Risks

The biggest risk to Consolidated Edison is its ability to grow in one of the more challenging regulatory markets in the country.

 

New York City has the highest cost of living in North America and the 3rd highest in the world. Compared to the U.S. average, New York City is 68% more expensive to live in, mostly due to its legendarily expensive housing costs, which are 136% above the U.S. average.

 

In fact, an average 480 square foot studio goes for between $2,000 and $2,900 a month, while the average 900 square foot one bedroom apartment fetches $3,000 to $3,700 in monthly costs.

 

This high cost of living makes regulators skeptical about raising utility rates, which are already 33% higher than the U.S. average. This explains why Con Ed’s rates have been frozen for three straight years now.

 

Overall, however, New York’s regulatory system has been consistent and reasonable over time. As seen below, New York’s targeted return on equity has remained between 9% and 11% over the last decade.

 

 

However, the regulatory environment includes a challenge of $400 million in potential annual non-performance fees the company might have to pay if it can’t maintain certain reliability benchmarks.

 

Of course with inflation in New York higher than the U.S. average and rates being frozen, this would only further pressure margins.

 

Con Ed also faces ongoing tax risks, specifically the high property taxes in New York City, which the company has no protections against, and for which the annual cost will continue to rise along with New York real estate values.

 

Finally, it’s worth mentioning that Con Ed’s credit profile could potentially be hurt once an investigation related to a gas explosion in 2014 concludes.

 

The National Transportation Safety Board found that Con Ed was partly at fault in the accident, but management believes insurance proceeds should cover its exposure.

 

Given the capital-intensive nature of utilities, it is very important that they maintain easy and affordable access to debt and equity markets to finance their businesses.

 

Dividend Safety Analysis: Consolidated Edison

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Consolidated Edison has a Dividend Safety Score of 97, making it extremely safe and dependable, which is evident from the company’s very consistent dividend growth history.

 

In fact, Con Ed is not just a dividend aristocrat, with 43 years of consecutive dividend growth, but only seven years away from achieving dividend king status.

 

This is possible thanks to the fact that, though its sales and earnings grow at a snail’s pace, management has taken a very conservative approach to dividend growth.

 

Specifically, while many regulated utilities have payout ratios of 75% to 85%, Con Ed chooses to keep its ratio far lower, ensuring enough cushion to keep its impressive growth streak alive, even when earnings occasionally take a dip.

 

Management formally targets a payout ratio between 60% and 70%, which is obvious from the chart below. Such stability is usually a good indicator of a predictable business, which is better for dividend safety.

 

 

While regulated utility companies usually deal with a relatively slow pace of earnings growth, the rates they get help guarantee a minimum rate of return for their investments.

 

You can see that Con Ed’s return on equity has hovered between 9% and 10% for the last decade, resulting in predictable earnings from which it can reliably pay dividends.

 

 

Con Ed’s dividend is further secured by the recession-resistant nature of the business. Consumers and businesses still need electricity during economic downturns, which helped Con Ed improve operating margins during the financial crisis while limiting its sales decline to just 4%.

 

 

Another important factor to the utility’s dividend security is its strong balance sheet, as represented by a conservative approach to debt.

 

Now that doesn’t mean that Con Ed doesn’t have a large absolute debt burden, because it does.

 

 

However, keep in mind that this is a highly capital-intensive industry. When we compare the company’s leverage ratio, interest coverage ratio, and current ratio to that of its peers, we can see that the company should have no challenges servicing its debts or liabilities with its steady earnings and cash flow.

 

Utility	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
Consolidated Edison	3.91	5.47	47%	0.88	A-
Industry Average	3.34	NA	48%	0.87	NA

Source: Morningstar, Fastgraphs

 

Con Ed’s debt maturities are also nicely staggered the next several years, reducing some of the risk of rising interest rates and tighter credit conditions over the medium term.

 

 

Finally, it’s worth mentioning that Con Ed suspended its dividend in 1974, which was the first time since 1885 that the company omitted its quarterly dividend.

 

Back then, Con Ed was more involved in power generation activities and depended heavily on various fuels to run its generating facilities. With little warning, the price of residual oil quadrupled, crimping the firm’s profits.

 

The company’s management team also made several executional missteps, and Con Ed was overly dependent on capital markets to fund its ongoing operations. Investors’ confidence in utility businesses plunged, cutting off affordable financing.

 

This shouldn’t be a concern today because Con Ed is not involved in electricity power generation (only distribution). However, it goes to show that even the “safest” companies can encounter unexpected challenges from time to time.

 

Overall, Con Ed’s dividend payment is extremely safe.

 

Dividend Growth Analysis

Our Dividend 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.

 

Consolidated Edison is the only utility company in the S&P 500 with 30 or more straight years of dividend increases.

 

However, Consolidated Edison has a Dividend Growth Score of 20, indicating weak dividend growth prospects. That’s no surprise given the tough regulatory environment, very slow pace of demand growth, high payout ratio, and EPS growth that barely stays ahead of inflation.

 

As seen below, Con Ed has increased its dividend by just 2.2% annually over the last five years. Dividend growth has been better lately, and management last raised Con Ed’s dividend by 3% last week, extending the company’s dividend growth streak to 43 years.

 

 

Management has a plan to drive consistent (albeit slow) EPS growth to continue the company’s dividend growth streak far into the future.

 

Part of this plan includes ongoing investments into Con Ed’s natural gas business, especially by building the Stage Coach and Mountain Valley gas pipelines and distribution projects.

 

 

This will bring cheap shale gas from Pennsylvania and Ohio to New York City (which has very expensive natural gas prices) and hopefully boost profits in both its gas and electricity businesses (through lower input prices).

 

That being said, even with its long-term growth plans, which involve a major push into smart grid technology, electric efficiency initiatives, and renewable energy and storage, Con Ed is likely to achieve long-term EPS growth of about 3% per year.

 

Since Con Ed’s EPS payout ratio (66%) is in line with management’s target, future dividend growth will likely track earnings growth and remain in the low-single digit range.

 

Valuation

Given its low earnings and dividend growth rates, investing in Con Ed requires very careful timing, specifically only acquiring shares when they trade at a discount.

 

Unfortunately, while Con Ed is down more than 10% from its July 2016 highs, the low interest rate environment following the financial crisis has resulted in a very strong rally for utilities (Con Ed included).

 

While Con Ed’s trailing P/E of 18.1 is nowhere close to the 26.2 of the broader S&P 500’s, given its slow growth outlook, the current P/E suggests the stock isn’t cheap today.

 

Con Ed’s 3.8% dividend yield also sits below the stock’s 13-year median dividend yield of 4.5%, according to data from Gurufocus.

 

Con Ed’s annual total return potential today is around 7-8% (3.8% dividend yield plus 3-4% annual earnings growth rate).

 

Considering Consolidated Edison’s reliable but relatively slow earnings growth rate, conservative income investors looking to establish a position are probably best suited waiting on the sidelines for a better price.

 

A dividend yield closer to 4.5%, in line with Con Ed’s historical trading range and representative of a $61 stock price (16% below today’s price), would seem like a more attractive entry point for long-term dividend growth investors to add new money.

 

Closing Thoughts on Consolidated Edison

Consolidated Edison is a time-tested and dependable high-yield utility blue chip. Owning it over the long-term isn’t likely to result in a loss of capital, and the income it generates is steady, secure, and likely fast-growing enough to offset inflation.

 

However, given the slow growth prospects of the company, as well as the historically high valuation that plagues the entire utility industry right now, investors looking to put new money to work might want to look elsewhere at this time.

 

Con Ed is mainly of use only to those investors who prize dependable income, dividend growth that will probably keep up with inflation, and some of the lowest volatility of any stock in the U.S. (beta of -0.02).

 

Two quality utility companies with higher yields than Con Ed are Duke Energy (DUK) and Southern Company (SO). I am watching both companies and like the markets they operate in, which are characterized by relatively friendly regulatory markets and nice population growth trends to support long-term earnings growth.