In case you haven’t heard, the long overdue interest rate cuts are finally coming. The “when” still remains up in the air, but the bond market and interest rate futures contracts have been signaling lower Fed Funds rates in the September to December period. These lower interest rates being paid by the Treasury as a risk-free rate of return should make established dividends more attractive because companies try to avoid cutting their dividends at every reasonable cost. Utilities stocks depend heavily on borrowing, so lower interest rates are almost an assured catalyst for the sector. The question is which utilities will thrive the most.
Oggonomics is looking for the large-cap utilities stocks within the S&P 500 with dividends that should be more attractive than their peers in a rate-cutting environment. Again, almost all utilities will benefit if interest rates fall — but these two should have “catalyst-driven dividend situations” on top of the mere rate cuts — and these stocks have lagged their peers’ stocks handily.
Let’s move past taking the cynical view that Jerome Powell and the Federal Reserve have become used to higher rates to the point that there is no way they will cut rates right before the election. The financial markets with trillions in exposure are forecasting that the next directional move in interest rates will be lower. Jerome Powell even fessed up in Jackson Hole on August 23, 2024 about where rates need to go:
“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks.”
Investors should keep relative investor performance in mind here. Despite interest rates not having been cut yet, long-term rates have already come down handily in anticipation of lower rates and weaker economic data. The Utilities Select Sector SPDR ETF (NYSEArca: XLU) tracks the utilities within the S&P 500 Index and its shares are up about 19% over the last year and year-to-date. So, which two utilities dividends does Oggonomics see as having more upside than their peers in the S&P 500 with added catalysts on top of interest rates heading lower very soon? Let’s see…
UTILITY CLEAN-UP (OR TURNAROUND?)
Centerpoint Energy Inc. (NYSE: CNP) is the worst performing REIT in the S&P 500 in 2024 (down over 6% YTD and down 5% from a year ago). It deserves to be the worst performer because its prep-plan ahead of Hurricane Beryl and the extended power outages that followed for the greater Houston area were almost unforgivable. They do own the distribution and generation assets including the power lines. Even with local and state investigations ongoing, the value of the assets alone (worth $40 billion according to the company, versus a $17.5 billion market cap) may be too large ignore even if Wells Fargo, KeyBanc, JPMorgan, BMO Capital Markets and Morgan Stanley have all downgraded CNP shares.
The Houston-based power generator and distributor of electricity and natural gas is just begging for an activist investor to swoop in here. What may be overlooked here is that its 7 million “metered customers” are not just in Texas — Indiana, Louisiana, Minnesota, Mississippi and Ohio assets are also counted.
With shares still under $27, this was a $31 stock before hurricane season. There are definitely going to be some unpleasant factors and charges when this stock reports third-quarter earnings despite prior attempts to maintain many of its forecast operating metrics in the post-hurricane guidance for the remainder of 2024. The stock is still higher than the post-Beryl depths and is higher even after a $250 million stock offering. Centerpoint is also expected to conduct another bond offering according to Bloomberg, so its long-term debt-to-equity ratio of 1.8 may be heading a tad higher. Centerpoint did maintain its $0.20 dividend in August and its dividend yield is about 3% today.
Being in the S&P 500 Utilities sector as Centerpoint is means the company automatically implies a strong dependence on being able to issue long-term debt. That means lower rates are simply a gift to operators who have stable markets with absolute pricing power. The Utilities Select Sector SPDR Fund (XLU) is the key “utilities ETF” and the SSGA site shows it has $17.2 billion in assets — nearly half the value of the median market cap of the 32 stocks in the S&P 500 Utilities Index.
WATER & GAS… WATER “OR” GAS
Essential Utilities, Inc. (NYSE: WTRG) is classified as a regulated water a utility, but the reality is that it is more diversified between offering natural gas (Peoples) and water (Aqua) utility services. It also now serves about 5 million people in 9 states. Essential Utilities’ shares have been difficult for many investors to value as a split of water and nat-gas because water gets a premium and natural gas often gets a discount. Another issue in the Peoples acquisition in 2020 was that it was all-cash at a $4.275 billion enterprise value versus a $10.7 billion market cap at the present time. That deal is now about 4 years behind it and the market should be more open to this stock. That is particularly true if interest rates are coming lower.
Essential Utilities’ is at $39 at the present time but it was a $50 stock in 2019 before its merger. The company has raised its dividend by 32% since merging and now yields 3.3% for investors who own the stock at current prices. It is also down about 6% from its 52-week high, but is only up 5% YTD and up 6% over the last year. Shares traded above $52.00 in late-2021 and the consensus analyst price target was closer to $47 on last look.
A debt-to-equity ratio of close to 1.2 is manageable for a utility, but warmer weather in the Northeast has been an issue for two consecutive years. Essential is seeking a weather normalization clause to bring less volatility in its revenue. As of June 30, 2024, Essential’s weighted average cost of fixed-rate long-term debt was 3.97% and it had almost $900 million available on its credit lines. Essential is also targeting higher base rates for customers in several of its water and gas markets in separate cases while its capex will be high for 2024 to 2028 in gas and in water.
In short, lower interest rates can save the company money that can then go straight to Essential Utilities’ bottom line — and should allow it to continue building on its 34th dividend hikes in 33 years.
