Small-Cap Utility Stocks: No Flash… All Cash

By WallStreetDaily.com

In recent weeks, we’ve talked about trips to Mars, cancer cures, world-saving membranes and neural dust, among other dazzling subject matter focused on innovation and “exponential technologies.”

Today we’re going to take it a little “old school.” We’re going to focus on small-cap stocks that help provide protection for your wealth over the long term, generate consistent income, and are desired by some of the best investors the world has ever known.

I’m talking about essential services — electric, gas and water utilities — that form the bailiwick for that traditional group of safety-conscious, risk-averse investors, “widows and orphans.”

In a world where artificially low interest rates continue to punish savers and retirees, yields of 2.5%, 3%, and higher offered by utilities are pretty compelling.

Consider: Nearly 500 million people are living in countries with negative interest rates. In the United States, we’re coping with 0.05% rates on traditional savings accounts, 1.05% on “high yield savings” rates, and 1.55% yields on U.S. 10-year notes.

That’s to say nothing of the dividend growth that will carry share prices even higher going forward.

And there’s a long-term consolidation trend, particularly in the power space, which should continue to juice valuations.

These are attractive assets for sophisticated global investors seeking steady returns from critical businesses with staying power:

• Spain’s Iberdrola SA used its USA unit to acquire diversified utility UIL Holdings Corp. in December 2015 for approximately $3 billion. Iberdrola paid a 25% premium for UIL’s consistent, reliable revenue and earnings, as well as to provide a hedge against unpredictable energy policies and sluggish economic growth in Spain.

• In April 2016, Cleco Corp. was acquired by a consortium of investors led by Macquarie Infrastructure and Real Assets (MIRA) and British Columbia Investment Management Corp. (bcIMC) for approximately $4.7 billion. The MIRA/bcIMC group paid a 15% premium for Cleco, which the consortium described as a “well-run utility” and “an attractive infrastructure business operating in a stable, regulated environment.”

Those themes have defined large-scale electric utility acquisitions since 1999, when Berkshire Hathaway Inc. announced the acquisition of Iowa-based utility MidAmerican Energy Holdings Co. for $2 billion and $7 billion in assumed debt.

Warren Buffett explained the move this way: “We buy good companies with outstanding management and good growth potential at a fair price, and we’re willing to wait longer than some investors for that potential to be realized.”

Berkshire and Buffett have used MidAmerican Energy as a vehicle for additional utility expansion, including a $5.1 billion deal to buy PacifiCorp from Scottish Power in mid-2005; a $5.6 billion deal for NV Energy Inc. in 2013; and a $2.9 billion deal for Alberta, Canada, transmission grid operator AltaLink.

As Buffett said at the time of the announcement of the PacifiCorp acquisition, energy will be “an important industry 10, 20, 50 years from now, and Berkshire Hathaway hopes to expand its investments” in the sector.

“We will look at energy assets around the world,” he said. “The energy field is one that I basically like. It’s not a business you can dream about, however. It’s a capital-intensive business that provides decent returns. It’s stable and it’s predictable.”

The key concern right now when it comes to essential-service stocks — including electric, gas, and water utilities — is “fair price.”

Yield-hungry investors, starved amid this era of “ZIRP,” “NIRP,” and other forms of extraordinary monetary policy the world over, have chased utilities’ share prices ever higher in search of “stable and predictable” income.

But let’s remember that famed “value investor” Buffett agreed to pay a 28.6% premium to MidAmerican’s share price on October 22, 1999, the last trading day before the deal’s announcement. And he paid a 23% premium for NV Energy in 2013.

More recent mergers in the utility sector, including WEC Energy Group Inc.’s 2015 acquisition of Integrys Energy Group Inc., have come at more modest valuations.

WEC paid a 17% premium for Integrys, while this year, Great Plains Energy Inc. agreed to pay 13% above Westar Energy Inc.’s May 30 closing price in a deal announced May 31.

WEC was once rumored to be a target of Buffett’s MidAmerican Energy, valued for its strong management, regulated and diversified operations, consistent and reliable revenue and earnings growth, and the solid health of its local economic base.

So which among the group of small-cap power utilities fit those criteria?

• Idacorp Inc. (IDA): The holding company for electric utility Idaho Power, derives more than 90% its revenue from regulated activities. Earnings have improved year to year from 2008–2015 consecutively. Its service territory is enjoying solid economic growth, too. According to the Bureau of Labor Statistics, Idaho has been the No. 1 state for job growth since March 2015. The regulatory environment is also favorable. And management continues to maintain a healthy balance sheet. All of which will support continuing customer and revenue growth as well as solid annual dividend growth. Idacorp’s share price has surged 23% over the last year, and the stock is trading at nearly 21 times trailing-12-months earnings. The dividend yield is still relatively attractive at 2.6%, and in the current low-rate environment multiple, there’s additional multiple expansion ahead based on the company’s strong fundamentals.

• Avista Corp. (AVA): The company serves electric and natural gas customers in eastern Washington, northern Idaho, parts of Oregon, and Alaska. Its revenue is 96% regulated. It also enjoys solid underlying economic fundamentals in its service territory. Like Idacorp, yield-chasers have bid up Avista’s share price, but it’s poised for growth in customer base, revenue, earnings, and dividends. Avista yields 3.3% at current levels.

• Portland General Electric Co. (POR) benefits from the same positive economic trends buoying Idacorp and Avista in the Pacific Northwest. All of its revenue is generated from regulated activity. After a 6.7% dividend increase announced along with first-quarter 2016 results, Portland General yields 3%.

The consolidation game for U.S. water utilities differs quite a bit from that in the power sector.

Most of the water systems in the United States don’t have the resources to meet safe drinking water standards, particularly with pollutants intensifying from every direction.

Rising pressure to upgrade infrastructure also argues for greater scale and the increased access to capital it brings.

Most of the sector’s takeover action will continue to be in the 85% of U.S. water systems owned by companies with fewer than 3,300 customers.

That augurs well for continued growth-by-acquisition among heavyweights such as American Water Works Inc. (AWK) and Aqua America Inc. (WTR).

But smaller operators such as Connecticut Water Service Inc. (CTWS), which yields 2.3%, and York Water Co. (YORW), which yields 2.1%, will also be able to grow customer bases via tuck-in acquisitions of smaller, neighboring systems.

Regulated operations support more than 90% of Connecticut Water’s revenue and 100% of York Water’s.

York Water, which serves a small, concentrated territory in south-central Pennsylvania, is the one investor-owned water utility that could generate a bid from a larger peer.

With the Federal Reserve continuing to hem and haw over its next rate hike, stocks that generate stable, predictable, and growing dividend income are going to continue to demand valuation premiums.

A good place to start is with those power and water utilities that provide that kind of juice — and more.

NBNBC

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Smart Investing,

David Dittman
Editorial Director, Wall Street Daily

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