2012 wasn’t the best year for utility shares, but Mario Gabelli, who manages Gabelli Utility Fund, has a positive long-term outlook for the sector. In fact, with the dividend tax overhang now behind the industry, the famed manager expects 2013 to be a better year. Three of the stocks he recently highlighted have interesting prospects.
Gabelli Utility Fund
Gabelli focuses on “quality in selecting utility investments.” Key factors the manager considers on an individual stock basis include a company’s earnings expectations and history, financial strength, management ability, valuation relative to peers, and the industry conditions in the company’s local markets. Looking at the broader industry, the fund manager monitors such factors as interest rates, government regulations, fuel prices, and environmental protection and energy conservation regulations. In addition, Gabelli tends to view the world through a value lens.
With the dividend tax issue settled, the manager doesn’t see anything that would materially alter his 8% to 10% long-term total return expectation for utilities. He believes that big picture items such as interest rates, natural gas prices, and economic growth will be the dominant themes. On a stock-by-stock basis, he expects that regulatory decisions, demand growth, power supply and demand, and consolidation will have the biggest impacts. Essentially, nothing new for the industry.
Consolidation is an important theme for the fund, as Gabelli believes there are too many utilities in the United States. Moreover, the increasingly regulated industry will likely see economies of scale as an important tool for both driving earnings growth and supporting the increasing demands for more environmentally friendly power options. “Larger players with greater financial resources and portfolios of assets can turn these challenges into opportunities.”
The Need for Power
One factor he recently highlighted was the way in which people take power for granted: “Utility service has grown so safe and reliable that it is nearly viewed as an entitlement, and it takes a natural disaster (i.e., Sandy, the Great East Japan earthquake and tsunami, the Joplin Missouri tornado) to force customers to realize its value and the value of investing in utility infrastructure. We emphasize that utility stocks offer much more than the bond-like features highlighted in a ‘Risk-Off’ strategy, but the defensive characteristics are of significant value during periods of political and economic uncertainty.”
He believes that current valuations for utilities are reasonable. And, perhaps more importantly for some investors, that the recent yields offered by utility shares are worthwhile. He notes that, overall, the industry’s dividends are backed by financially secure companies with room to grow distributions and protect them if earnings should slump.
With this as a backdrop, Gabelli recently highlighted these three stocks:
The AES Corporation (NYSE:AES)
AES is a global provider of electricity. It has operations in almost 30 countries, with a notable presence in Latin America. Although the company had a near-death experience when the merchant power business collapsed around Enron, it has managed to come back and significantly improve its business.
Gabelli highlights the fact that the new CEO “has focused the company’s strategy on improving existing operations and divesting non core assets.” In functional terms, this means a company focus on Latin America, North America, and current markets in which it has a notable presence.
The company’s asset sales could reach as high as $2 billion. That money can be used to help solidify its position in core markets, buy back stock, or support the recently initiated dividend. The dividend, while relatively small today, likely has notable growth potential once the company completes its restructuring. Moreover, it is a statement to the company’s strengths that management was willing to put a dividend in place after suffering through a very difficult stretch several years ago.
One of the biggest attractions of the stock, however, is its international exposure. The focus on faster growing nations materially alters the company’s long-term outlook. Although it increases risks to some degree, U.S. investors can very easily get a diversified portfolio of foreign utility assets via investment in The AES Corporation (NYSE:AES), a U.S. listed company.
American Electric Power Company, Inc. (NYSE:AEP)
American Electric Power, more often called AEP, is a large domestic power company. It has operations in 11 states and serves millions of customers. One of the big things going on for the company in its utility division is the expected closure of less efficient coal plants, a process that Gabelli expects to take until 2020 to complete. However, that will be combined with spending of “$5 billion – $6 billion” on environmental upgrades and new natural gas-powered plants. All of these expenses should benefit the company’s efforts to get rate increases.
While these moves are nice to see, the more interesting facet of the story is the company’s American Electric Power Company, Inc. (NYSE:AEP) Transco division. Gabelli expects this group, which develops transmission systems (power lines), to spend $2.5 billion on new projects. Because of the country’s aging infrastructure, regulatory bodies tend to view these expenses favorably, resulting in better regulated returns. Gabelli believes that this division will contribute $0.31 a share in earnings by 2015, up from $0.06 in 2011.