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Steer Clear: Utility Dividends on the Chopping Block

We sift out the safe from the unsafe.

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The utility sector is fast losing its luster as a reliable income-producer. Although utilities as a group raised dividends in 2008, recent announcements indicate an abrupt reversal of this trend. Three major firms-- Great Plains Energy (GXP),  Ameren (AEE), and  Constellation (CEG)--have announced dividend cuts as the twin forces of tight credit and deteriorating demand drain capital from their coffers. While we don't believe these cuts will devolve into a sectorwide event, we are concerned there are more reductions to come.

In this piece we'll discuss whose payouts may be in peril and why. We'll also cite a few standout utilities that, despite current economic head winds, could actually raise their dividends in the quarters ahead.

Dividends Caught Out in the Cold
In theory, regulated utilities should be able to recover today's steeper financing costs through commensurately higher rates. But with consumers in a pinch and the number of pending rate cases already at a multidecade high, regulators may be less accommodating. Inadequate rate increases could, in turn, lower utilities' credit standing, thereby raising their costs of financing and exacerbating the problem. If outside credit remains scarce, utilities may be forced to lean more heavily on their own earnings.

Declining customer demand is a second threat to dividends. As the recession deepens, hard-hit industrial and commercial customers are dialing back their power consumption at double-digit rates. Households, particularly in weak real estate markets such as Florida, are also trimming their electricity use. Until the economy recovers, lower sales volumes will be a reality across the sector. Because of utilities' largely fixed cost structure, the corresponding decline in revenue will carry an outsized impact on earnings and, therefore, on the sustainability of payouts.

Tight financing and slack demand are coming at an especially inopportune time for the sector. Earlier this decade, when credit was flowing smoothly and growth was marching steadily upward, the industry embarked on an expansion that is yet unfinished. Once underway, large projects can be difficult to abandon; a partially completed power plant, after all, is useless.

Great Plains Energy typifies the overstretched utility. The firm committed to constructing a major coal facility under the assumption that capital markets and demand fundamentals would remain favorable in 2009 and beyond. Faced with today's economic turn of events, Great Plains has said it will cut its dividend by 50% in order to forge ahead with its build-out.

Who Might Be Next?
Below we highlight four candidates whose dividends could wind up on the chopping block. As an aside, all carry a high yield relative to their peers. While alluring at first glance, high dividend yields can sometimes mean trouble. Fully regulated electric utilities are yielding 5% on average; as a rule of thumb, we think investors should question yields that are more than a percentage point or two above this level.

 Pinnacle West (PNW)
Earnings at this Arizona utility are hurting from reduced power usage and losses at its real estate arm. While the firm has lightened its capital spending commitments, it still plans to invest some $800 million per year over the next three years. With total dividends that already exceed 2008 earnings, we think management may have to take an axe to payouts.

 Hawaiian Electric (HE)
Plummeting tourism, a feeble real estate market, rising operating costs, and significant capital investment needs combine to make this Hawaiian utility an uncertain dividend payer, in our opinion. The firm's prospects are further shadowed by the struggles of its second-tier bank subsidiary. With internal cash flow under strain, we don't expect any dividend increases for the foreseeable future and would not be surprised to see a cut in payouts.

 PNM Resources (PNM)
Despite its status as a regulated utility, PNM has experienced severe margin pressure over the past year as a result of poor fuel cost recovery and a misconceived wholesale energy strategy. Although the company cut its dividend by almost half in mid-2008, we're not certain that income-oriented investors are in the clear just yet. Until we see a material strengthening in earnings power, we'd keep a close eye on this firm's payouts.

 NiSource (NI)
We think recent aggressive capital spending at NiSource is ill-timed, adding as it does to the above-average debt load the firm already carries as a result of its merger with Columbia Energy. Given management's ongoing focus on growth, we think it will opt to issue still more debt. The company's deteriorating financial health, in our view, heightens the risk of an eventual dividend cut.

A Few Bright Spots
There's good news for the discerning income-seeker: a handful of utilities are well-positioned to buck the trend and raise payouts. The likeliest candidates are those with resilient service territories, strong balance sheets, and preapproved capital investments. We think the following firms fit the bill.

We think Boston-based NSTAR, a fully regulated transmission and distribution utility, will continue to outshine its peers. NSTAR's strength is its predictable, rising cash flow predicated on preapproved rate increases and disciplined cost control. Strong cash flows, in turn, have translated into an impressive record of dividend increases. We expect the firm will continue its dividend growth at a healthy 5%-6% pace for at least the next five years.

 Southern (SO)
This Southeastern giant enjoys some of the best regulatory relationships in the country. Southern combines a strong investment profile with mechanisms for rapid cost recovery in rates, eliminating much of the uncertainty of cash flows that regulatory lag can create. With much of its spending program already spoken for in rates, Southern's dividend is one of the best bets in the business.

 Westar Energy (WR)
With regulatory approval for a major rate increase in 2009, this Kansas utility should generate enough cash to raise its dividend for a fifth consecutive year while still supporting its growth projects. Its location in the U.S. wind corridor creates opportunities to invest in high-return transmission lines that connect new wind power projects to the national grid.

 Northeast Utilities (NU)
High-return investment opportunities in transmission and "green" energy in Connecticut and Massachusetts justified a 12% dividend increase in February. Current projects should lift earnings for another 3-4 years, likely leading to similar dividend hikes down the road.

Mark Barnett and Travis Miller contributed to this article.

Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.