Wall Street loves or hates utility companies based on the rise and fall of their dividends. But a corporation with a high dividend could be headed for destruction, while a low-yielding company might be making strategic acquisitions that'll reap long-term returns for investors. Read below for three simple steps to ensure that your dividend play isn't going to purge your profits.
Step 1: Dividends
Utility companies are (generally speaking) slow-moving companies operating in saturated markets. The first place to look and see if your shares are worth their weight is dividends. Let's take a look at the following five companies:
Atlantic Power (NYS: AT)
PPL (NYS: PPL)
Entergy (NYS: ETR)
Southern Company (NYS: SO)
NextEra Energy (NYS: NEE)
Source: Yahoo! Finance and YCharts.com. NM = not meaningful due to negative earnings.
Atlantic Power boasts a shocking 8.2% dividend, but its lack of earnings poses a threat to sustaining such a high dividend in the future. PPL comes in second and, with a mid-range payout ratio, looks to be a good option.
By this measure, Southern seems to be headed south. It hasn't raised its dividend as much as some of its competitors and, with a 77% payout ratio, doesn't look to be in a position to improve its yield any time soon.
Step 2: Capital expenditures
If utilities aren't raining gold on their shareholders in the form of dividends, it might be because they're digging for it. Capital expenditures, in short, represent money that a company decides is best spent on itself to enable future profits. For example, NextEra Energy is looking to make the U.S.' largest fleet of wind power generation even bigger, increasing its output by 14% this year. It's also part of a partnership to acquire a 550 megawatt solar farm in California. Let's see how NextEra and its competitors stack up:
Capital Expenditures (millions)
Cap Ex/Sales (%)
Sources: etrade.com and Yahoo! Finance. Figures for 2011.
Atlantic Power takes the cake, with 40% of its sales pushed back into the company through capital expenditures. It's little surprise that Atlantic Power is focusing on its investments, since it also has the smallest sales of all the utilities listed above. NextEra might be expanding its wind facilities and solar farms, but it's either doing it on the cheap or not as fast as investors might think. The company is spending only 23% of sales on capital expenditures.
Step 3: Margins
If a utility company isn't doling out dividends or focusing on its own growth, it might be spending more than it should. Margins provide investors with easy tools to see exactly how much of a company's total sales are eaten up by costs like energy production and operating expenses. Regardless of whether a utility company is an energy producer or provider, the prices it can charge are ultimately affected by the regulated cost of electricity charged to consumers. Let's see what companies are most efficient with their moola:
Source: S&P Capital IQ.
What a spread! Right off the bat, Atlantic ends up eating a 21% loss. But even though Southern's 40% gross margin is a bit lower, it enjoys high operating and profit margins.
NextEra's renewable energy seems to pay off in efficiencies, costing the company relatively little to produce, operate, and ship out to customers. At the end of the day, NextEra pockets 14% of its sales, the highest percentage of any company here.
Foolish bottom line
When you're making a dividend play, do yourself a favor and look at more than just the dividends. Following these three steps will provide you with a well-rounded assessment of a company's sustainable returns, growth opportunities, and efficiencies.
For income investors, it's hard to argue with PPL's 9.9 P/E ratio (the industry average is 15.6), solid dividend, and stable margins. For growth opportunities, look to NextEra's renewables or Entergy's heavy reinvestment for the next big break. With respective P/Es of 13.2 and 12.9, both remain affordable even as they line up for expansion in the years to come. It's tempting to bet big on Atlantic Power, but the company's unsustainable dividend seems backwards to what would otherwise be a growth grab.
Understanding your dividend plays will not only allow you greater peace of mind, but also seal up any cracks in your investing thesis. Try this analysis out on your own stocks and shoot me an email me with any interesting finds. If used correctly, dividend stocks can steadily boost your portfolio's returns, generating sustainable income for years to come.
If you're looking for solid dividends that aren't going to disappear anytime soon, the Dow is loaded with sustainable companies built for the long haul. To get the inside scoop, Motley Fool analyst Dan Caplinger has prepared a special free report, "The 3 Dow Stocks Dividend Investors Need Now." It's as free as this article and available for a limited time only, so grab yours today.
The article Are Your Utility Dividends Doomed to Die? originally appeared on Fool.com.
Fool contributor Justin Loiseau uses electricity. You can follow him on Twitter, @TMFJLo, and on Motley Fool CAPS under the screen name TMFJLo.Motley Fool newsletter serviceshave recommended buying shares of Southern. The Motley Fool has adisclosure policy.
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