Three top picks in the utility sector

by Richard Moroney, editor Dow Theory Forecasts

In their flight to safety, investors may overlook some of the utility sector’s drawbacks; half of the 32 utilities in the S&P 500 Index missed March-quarter profit estimates, and the 2012 outlook is eroding.

Nevertheless, we have reviewed some key industries within the utility sector and have found three intriguing stocks for income-oriented investors: PNM Resources (PNM), NextEra Energy (NEE) and American States Water (AWR).

The median diversified utility stock in our research universe has generated an 18% total return over the past year, tops among the five utility industries. But that surge leaves many stocks
looking richly valued.

Still, this industry has a strong track record for growing dividends, with median annualized growth of 6% in the past five years.

PNM Resources is being added to the Top 15 Utilities Portfolio. Besides operating regulated utilities in Texas and New Mexico, PNM also sells energy to wholesale customers.

Recent asset sales skew revenue-growth numbers, though operating profit margins are on the rise. Both the three-analyst consensus and the midpoint of PNM’s guidance call for per-share profits to rise 17% this year to $1.26.

The stock’s yield of 3.1% lags the industry median, but PNM raised its distribution 16% this year — the first hike since 2007. The company currently pays out about 48% of earnings in dividends, and management targets a long-term payout ratio of 50% to 60%.

Moreover, PNM lowered its share count 12% over the last six months, unusual for a utility. In addition, PNM looks cheap, trading at less than 16 times trailing earnings, a 36% discount to its five-year average.

Electric utilities have managed a median total return of 13% in the past year, even as per-share earnings declined 4%. Despite that rally, some stocks in the group still look inexpensive.

NextEra Energy has generated a 24% total return over the past year but appear to have more room to run. At 15 times trailing earnings, shares trade 10% below the median electric utility in the S&P 1500 Index.

One of the largest electricity distributors in the U.S., NextEra Energy operates a Florida utility and an unregulated wholesale business across 22 states and three Canadian provinces.

Current projects include construction of solar-thermal facilities in Spain and California slated to
come online in the next two years.

Compared to its peer group, NextEra Energy has delivered superior growth in both sales and per-share profi ts over the past 12 months while expanding operating profit margins.  

Among the utility industries, water has generated the best 12-month growth for sales and earnings per share, and it is the only group with recent growth near its five-year track
record.

Water also boasts an attractive earnings outlook for the current fiscal year, with the median stock’s estimates holding up in the past 90 days. With a median trailing P/E of 21, water utilities trade in line with their historical norms but seem pricey relative to other utility groups.

American States Water supplies water and electricity, primarily in California. It also administers water and wastewater contracts at nine military bases throughout the U.S.

The company is bidding on several more military contracts, as more bases move toward privatizing utility services.

In 2011, American States delivered all-time highs for sales, net income, and cash provided by operations. Growth has continued into 2012, with all three metrics showing double- digit growth in the March quarter.

Its dividend has increased in each of the last 57 years, and the company targets long-term growth of at least 5%. With a payout ratio of 47%, that target appears reasonable.

Learn  more about this financial newsletter at Richard Moroney's Dow Theory Forecasts.

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