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Utilities for Safe Income
and Low-Risk Growth

By David Sandell
Leeb's Income Performance Letter

       In 2009's liquidity-driven stock market rally of historic proportions, the Standard & Poor's 500 was up 66 percent from its March lows and 26 percent for 2009 near year-end. The industry groups hurt the worst by the financial and economic crisis rebounded the most, while the most stable sectors significantly lagged the market.
        In 2010, we anticipate additional stock-market gains. But the advance will be less robust and more selective. And bonds won't have it so easy either: Yields are generally low, and rising interest rates at some point will push down prices.
        In this investment environment, a good way to get the income you need is to invest in stable companies whose shares pay good income and haven't yet outrun the fundamentals.

Undervalued sector for 2010

        We think the time is right for utility stocks. Dividend yields average close to 5 percent while benchmark 10-year U.S. Treasury securities pay just 3.4 percent. And the utilities in the S&P 500 have risen only 5 percent this year after holding up much better than the broad market in 2008. All told, utilities have outperformed since the market's October 2007 high.
        Earnings of regulated utilities were held back in 2009 by reduced power consumption and other factors. But the stocks also trade at a significant discount to the broad market, typically at 12-13 times projected 2010 profits.
        Traditional, regulated, essential-service companies serve as portfolio stabilizers in a sluggish economic environment. Many utilities enjoy quasi-monopoly positions because of the prohibitive costs of building new power plants.
        Many utilities now are seeking significant rate increases, and prospects for approval are considered positive overall, particularly because some of the additional revenue will be used to upgrade aging systems.

Four-Stock Foundation

        Our recommended utility holdings remain good, safe investments, with generous yields in a low-income environment.
        Southern Company (SO) is the second largest U.S. utility by market capitalization ($27 billion) after Exelon (a member of our Growth & Income Portfolio). Southern is the premier energy company in the Southeast, serving 4.4 million customers with its 42,000 megawatts of generating capacity. More than two-thirds of its generating power comes from coal, with the remainder mostly oil/gas and nuclear.
        Southern operates in a relatively business-friendly regulatory environment. This is important because regulators set traditional utilities' rates and allowed return The company also should benefit as the region returns to its long-term pattern of above-average population and economic growth.
        We expect long-term earnings growth averaging 5 percent annually, with dividend growth of 4 percent or so. Add this to the 5.2 percent current yield and it should make the stock a cornerstone of an income-oriented utility portfolio.
        Entergy (ETR), another strong utility, boasts 30,000 megawatts of electric generating capacity. It's also the second largest nuclear generator in the county with 5,000 megawatts of nuclear capacity.
        The nuclear business sets the company apart. Thanks to 25 percent-plus annualized growth, this non-regulated operation now accounts for 20 percent of the company's $13 billion revenues.
        Nuclear and renewable energy sources will continue to come into favor as traditional fuel prices rise over time, with ongoing environmental restrictions and public opposition to new power plants. Entergy's nuclear power plants have strong operating-cost advantages particularly in areas, such as the Northeast, where rates are set based on higher cost natural gas-fired power plants.
        Entergy's regulated businesses constitute half of consolidated operating profit. Like Southern, Entergy is a dominant utility in the business friendly South, with service territories in Texas, Arkansas, Mississippi and Louisiana. With the exception of Texas, Entergy's service territories have not seen a significant push toward deregulation, thereby helping to preserve the company's long-term competitive position.
        The company should be able to grow earnings by at least 6 percent, helping to support future dividend increases averaging 4-5 percent a year, starting from a 3.6 percent yield. At 12, the stock's price/earnings multiple based on projected 2010 profits is at a level last seen in 2004. We see this as a buying opportunity.
        TECO Energy (TE), capitalized at $3.4 billion, is the most speculative of our utility holdings, and the best performer of late too. The stock has almost doubled from its March lows, while further rewarding investors with its 4.9 percent payout.
        The company is comprised of four businesses: Tampa Electric, Peoples Gas System, TECO Coal and TECO Guatemala. Tampa Electric and People Gas are Florida-based regulated utilities. The two segments account for 80 percent of the company's $3.4 billion in annual revenues, but the two unregulated businesses account for a third of the profits.
        TECO Energy has been in turnaround mode for 10 years after a disastrous foray into unregulated energy markets. But it has made considerable progress despite the weakened Florida economy, restructuring to create a leaner organization.
        With divestments, debt reduction and new investments, TECO is repositioning itself for solid earnings and dividend growth as the economy improves.
        Middlesex Water (MSEX), our lone water holding, has seen its shares rally by almost 50 percent since their March lows. The company serves over 137,000 customers in New Jersey and Delaware as a provider of regulated and non-regulated water and wastewater services.
       Like our aging energy infrastructure, water systems will require tremendous amounts of investment in coming years. In this relatively small niche, reputable companies will be the likely winners.
        Middlesex has been a leader in improving wastewater systems. The company is small, with a market capitalization of only $225 million. But a strong management team continues to keep the company on course in these tough times, while identifying attractive expansion opportunities.
        Even with the recent economic distress, 2009 marked the 36th consecutive year the company raised its dividend. We continue to recommend Middlesex for its current income. Current yield: 4.2 percent.
       Editor's Note: David Sandell is a portfolio editor for Leeb's Income Performance Letter, P.O. Box 97, Williamsport, PA 17703. Monthly, 1 year, $72. www.leebincomeletter.com.