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.
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).
Source: Con Ed Investor Presentation
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.
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 19th 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.
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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.
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,