QE3: Time to Buy Utilities?

Ben Bernanke and the Federal Reserve announced a third round of accommodative monetary policy earlier this week, which will be an open-ended form of purchasing additional mortgage-backed securities at a pace of $40 billion per month.

One key aspect of Ben Bernanke’s QE3 is the open market committee’s decision to keep the target range for the fed funds rate at 0-0.25% through at least mid-2015.

Ben Bernanke

Yields near the zero-bound make it difficult for investors to earn income, but also make inflation a concern. As inflation slowly creeps onto the economic horizon, many funds are flowing into commodities, but we believe that as economic concerns resurface and treasuries remain low, with the 10-year being around 2% and the 30-year at 3%, utilities will also be a key part of investors’ portfolios.

First on our list is American Electric Power Company, Inc. (NYSE:AEP), an electric utility company operating in various U.S. states. American Electric Power reported 2Q earnings of $362 million or $0.75 per share, compared to $352 million or $0.73 per share in 2Q 2011. The company recently suspended its 2012 earnings guidance because of ongoing Ohio regulatory proceedings, but analysts’ estimates of 3Q EPS ($1.04) would be down 11% from the same quarter last year. The company trades at a trailing P/E of 11 and a forward P/E of 14 and has a solid funds from operations to debt ratio of 0.17. The company pays a dividend of 4.3% and we believe it is still one of the best utilities around.

Consolidated Edison, Inc. (NYSE:ED), the utility company that operates primarily in New York, posted 2Q EPS of $0.61 versus the consensus estimate of $0.50, and the company reaffirmed  full-year guidance of $3.65-$3.85, with consensus at $3.75. Consolidated Edison recently purchased a 70MW solar development project that should contribute to earnings as early as 2013, helping fuel the company’s modest 2013 expected EPS growth of 3%. The company trades a bit richer than American Energy at a 16 trailing P/E and 15 forward P/E, but has an in-line dividend yield at 4.1% and a FFO/debt ratio of 0.18.

Dominion Resources, Inc. (NYSE:D) has 2Q EPS that came in at $0.01 below estimates – $0.59 versus $0.60 estimates – but guidance was strong. Management reaffirmed the expected 5-6% growth rate in EPS for 2013. The company trades the highest on a trailing P/E basis, at 22, but positive growth prospects puts the company’s forward P/E at 16. The company has the lowest FFO/debt ratio of these five utility stocks at 0.14.

Duke Energy Corp (NYSE:DUK) boasts the highest dividend yield of our five utility picks at 4.8%. Duke is also the largest company of the five by market cap at over $40 billion. The company trades at a P/B of 1.5 versus the peer average of 1.9 and its FFO/debt ratio is in line with the industry at 0.18. The company trades at a trailing P/E of 19 and a forward P/E of 14. Next quarter earnings are expected to come in 5% below the same quarter last year, but the PGN merger should help the company meet expectations of a 3.5% earnings increase for 2013.

The Southern Company (NYSE:SO) is expected to grow operating EPS in 2012 by nearly 4% from 2011’s $2.57. In the first half of 2012, operating EPS was $0.08 below the year-earlier period. The first-half revenues for 2011 were down 8.8%. FFO to debt comes in at 0.18 for the most recent fiscal year and the trailing P/E is 18, with the forward P/E at 16. The company’s dividend represents a 4.3% yield.

Two big name fund managers in a majority of our five utility stocks are Michael Messner of Seminole Capital and Jim Simons of Renaissance Technologies. Messner upped various holdings, including: his Duke Energy position by 255% in 2Q, Consolidated Edison by 67%, Southern Co by 106%, and he took a new position in American Electric. Jim Simons was also increasing various positions: Duke Energy by 510%, Dominion Resources by 57%, Consolidated Edison by 60%, and American Electric by 799%. Other managers in at least three of the utility stocks are Israel Englander of Millennium Management and Cliff Asness of AQR Capital Management.

We believe that these utilities will continue to pay stable dividends and will be a haven for investors looking for income with less risk than other equities. Even with an average beta of the five utility stocks at 0.34 and the generally low beta of utility stocks, the Dow Jones Utility Index was up 12%, while the Dow Jones Industrial Average was up only 8% in 2011.