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Lean, Mean Dividend Machines

In an increasingly uncertain world, income investors want to know which utility stocks are safest, especially given the ill portent of the market’s recent tumult.

While it’s easy to assert that part of the answer involves selecting firms that have deployed debt judiciously and are prudent in their overall financial management, historically low interest rates have distorted the picture.

Indeed, in an environment of cheap debt and rich valuations, the very definitions of “judicious” and “prudent” are still being hotly debated among investors, regulators and utility executives.

Like most U.S. firms, electric utilities have gorged themselves on debt in recent years. In fact, some utilities sport debt-to-equity ratios at previously unheard of levels, as high as 200%.

And these are not just any firms–some companies with debt-to-equity levels well in excess of 100% boast mid- and upper-tier investment-grade credit ratings.

Though these debt-heavy utilities make a good case that such expenditures will more than pay for themselves by adding to rate base, I’m still skeptical, particularly when it comes to the dozen or so firms whose debt-to-equity ratios are hovering near 200%.

A banker I once knew in the early 2000s said that, based on what he’d seen historically, the utilities industry should maintain a 50% debt-to-equity ratio.

But with rates for borrowing less than half of what they were 10 to 15 years ago, a utility might reasonably claim it’s still taking a conservative approach if its debt-to-equity ratio is between 50% and 100%, or even somewhat higher in certain cases.

In fact, fewer than 11 electric utilities have debt-to-equity ratios below 100%, and the industry average is around 134%.

Although low rates and regulated returns allow some headroom for leverage, I’ve lived through previous utility busts, when credit-rating agencies quickly changed their view of what’s permissible. And that had a material impact on firms’ cost of capital and their ability to deliver shareholder value.

After all, access to credit can quickly freeze up during a downturn.

Nevertheless, utilities’ regulated earnings streams and steady dividends have often made them one of the best investments during downturns.

But that doesn’t mean investors shouldn’t be highly selective. In the latest issue of Utility Forecaster, we examined which utilities are giving investors the most bang for their buck in terms of capital spending.

That’s one way to be selective. Another is to pay close attention to debt.

Why Cheap Debt Means More Equity Risk

Most investors intuitively understand that more debt means more risk–and that conservative investors should avoid the most indebted utilities.

Furthermore, it’s also worth noting that some companies aren’t generating high enough returns to compensate for increased levels of borrowing. And right now, at least, income investors aren’t differentiating between utilities that are spending wisely and those that are spending simply for the sake of spending. That’s one reason why we undertook the aforementioned analysis in our latest issue.

As the consultancy the Brattle Group observed in a recent report, entitled “The Effect of Debt on the Cost of Equity in a Regulatory Setting,” there is no magic in financial leverage: Higher risk from leverage means a higher required rate of return.

“The reason that the risk of equity increases as debt is added to the capital structure is because debt magnifies the variability of the equity return,” the consultancy found.

Even when a company uses modest amounts of debt, the overall risk to the company’s assets falls on a fraction of its capital: the equity. And as debt rises, the required return per dollar of equity goes up as well. This means that the benefit of low rates is soon offset by rising debt levels.

The Safest of the Safe

Utility Forecaster has long focused on the utility sector’s credit quality as part of our effort to evaluate the safety and sustainability of dividends. This approach is encapsulated by our proprietary Safety Rating System, which scores each stock in our coverage universe according to eight fundamental criteria.

And over the past few weeks, we’ve gone beyond our standard analysis as part of our research into establishing a new framework for analyzing and selecting utility bonds.

In looking at the safest utilities, one obvious starting point is to look at those utilities that scored the highest Safety Rating–a perfect 8.

Our enhanced credit screen goes even further than our Safety Rating System, by reviewing metrics such as debt to equity, short-term liquidity measures, and free cash flow, among myriad data points.

Once we finish developing this credit screen, we’ll be using it in the months ahead to perform stress tests on various holdings through scenario analyses.

For subscribers, we share our initial results by identifying one of the safest of our lean, mean dividend machines.

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