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Feature Article

Yield with a Growth Kicker

By Roger S. Conrad on Mar. 10, 2016

With US economic growth under pressure and the risk of a bear-market correction still elevated, utility stocks could be poised for a strong year relative to their counterparts in cyclical sectors. Utilities’ reputation for safety and generous yields make the group an ideal place for investors to ride out periods of volatility and uncertainty.

But best-in-class utility stocks offer more than just a reliable dividend. Our favorites have the potential to grow their earnings at annual rates that are in the upper single digits, an acceleration from the usual low to mid-single digits.

And faster earnings growth usually fuels robust dividend growth, thanks to the highly visible nature of utilities’ underlying cash flow. Supportive regulators and growing demand for renewable energy and inexpensive, cleaner-burning natural gas create a need for significant capital spending, all of which is recovered through increases in the rate base.

In other words, the sector’s current opportunity set differs dramatically from the late 1990s, when almost two dozen electric utilities either declared bankruptcy or found themselves teetering on the brink after ill-fated pushes into energy trading and other risky businesses. The massive debts assumed to finance these strategic blunders only worsened matters.

Utilities continue to enjoy relatively low costs of debt and equity capital and have tapped both markets to fund the latest round of capital spending. Thanks to regulatory support, however, these companies earn a return on investment shortly after putting this money to work. And because these projects provide an essential service, the cash flow generated from these assets offer a degree of protection against economic cycles.

The market also assigns a higher valuation to a company that can grow its payout by 8 percent to 10 percent annually than one increasing its dividend by 3 percent to 5 percent.

For utility stocks, a bit of additional growth goes a long way.

We highlighted utilities leveraging their low cost of capital to grow their midstream gas businesses and renewable-energy capacity in the February 2016 issue of Conrad’s Utility Investor. (See In the Land of Infrastructure, Capital is King.)

Here, we delve into an important, but underappreciated, growth area: energy storage, a major focus at the recent ARPA-E Energy Innovation Summit, one of several industry conferences I attend each year as part of my research process.

Merger and acquisition activity has also picked up dramatically in the utility sector, with international companies looking to add exposure to the aforementioned growth stories and major players looking to increase scale and unlock synergies by moving into adjacent business lines.

We recently highlighted our top takeover picks in a special report; this time, we examine the list of pending transactions for key themes and opportunities. Finally, we take a look at opportunities on the fixed-income side of the market.

Focus on Innovation: Energy Storage

Growing adoption of intermittent sources of renewable energy—the wind doesn’t always blow at the same strength and the sun doesn’t always shine—creates a need for the ability to store excess energy generated during off-peak hours for use during periods of higher demand.

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