April 14 - The Electric Utility 400

Is there any limit on the public’s appetite for dividend-bearing electric utility stocks? If recent history is any indication, I would have to say the answer is no. Two years ago, when President Bush first proposed altering the tax treatment of dividend income, the Philadelphia Utility Index hovered around 250. The other day it broke 400. That is quite a ride for a stodgy old group like electric utilities. The catalyst for the early part of the move was clearly the tax issue since reforms made it much more attractive to derive income from dividends than treasuries. And with treasuries spitting off historically low yields, utilities offered investors with an attractive investment alternative.

So tax reform can probably be used to explain the first leg up and perhaps even the second and third legs as well, but it strikes me as a ludicrous to suggest that reform alone catapulted this group up to this stratospheric level. In defense of the group, many utilities are much healthier than they were two years ago, having done much repair to their disgusting balance sheets. Debt has been pared, unprofitable assets have been shed and poor management teams have been evicted. These are all positives and as a result, many companies have been able to restore their earnings up to optimal levels. But at what point, is all this priced into the stocks? After all, many companies in the group are now trading at twenty times 2005 estimates, although the lion’s share trade closer to 16 times. Moreover, yields have now fallen to levels that make them no more attractive then treasuries. You can still find some utes that spin off yields greater then four percent, but most are now planted with three handles.

So basically you have well regulated companies with low growth profiles trading at sixteen times earnings and three percent yields. That is pretty damn steep when compared to historical levels even after you consider the new tax treatment of dividend income. So who keeps buying this stuff? That is a good question and my only guess is that retiring baby boomers just cannot get enough of this stuff. This group is desperately searching for income streams and with treasury yields still fairly tame, Utes still look fairly attractive. But how long can this continue? Well, if you believe the Fed will continue to move and long-term rates will continue to rise, you probably would be wise to steer clear of electrics. As those rates rise, investors searching for income will turn their attention to fixed income instruments and there is likely to be some selling pressure on over-bought utes. I am not saying this going to happen tomorrow, but the day doesn’t seem too far off. But heck, I said that four months ago and look what has happened since.