The stock market collapse rekindled investors' love affair with dividends, and President Bush's proposal to eliminate taxes on the quarterly payouts has only enflamed their passion for cold, hard cash.
Unfortunately, their yearning comes at a difficult time for utility stocks, traditionally the most logical of dividend plays. Before deregulation, utility stocks were slow and steady performers, prized more for the checks they sent to shareholders every three months than for the increase in their share prices.
Deregulation, which enabled power companies to pursue customers outside of their traditional markets as well as new businesses, changed all of that. Many utilities went on a building binge, constructing new power plants that would serve growing demand for electricity. Others invested in unrelated businesses, including venture capital.
The excitement turned utility stocks upside down. Instead of dividends, investors purchased them for capital appreciation and for a few years they got what they were looking for. Between 1997 and 2000, the Dow Jones Utilities index jumped 20 percent annually, with dividends accounting for 30 percent of the total return.
But the boom ended with the recession and the corruption and abuses typified by the collapse of Enron. Too many power plants were built, throwing supply out of whack with demand. The Dow utilities index lost about 25 percent annually over the last two years and the ability of many power companies to pay dividends has been debilitated by falling electricity prices and writeoffs for investments that didn't pan out. Utilities are slashing or eliminating dividends right and left.
Last week, American Electric Power of Columbus, Ohio [ticker: AEP] reduced its dividend 42 percent and Dearborn, Mich.-based CMS Energy [CMS], which cut its dividend in half in August, eliminated it. They joined a long list of cash-poor utilities that includes Allegheny Energy [AYE], which has suspended its dividend, and DQE [DQE], which slashed its quarterly payout 40 percent last year.
What's a dividend disciple to do?
There are still plenty of opportunities in utilities; you just have to be more careful says Judith Saryan, manager of the Eaton Vance Utilities Fund [EVTMX].
"We've definitely taken a more conservative stance in the last year and a half and I think we'll continue to do that because we think quality does matter," Saryan says. "We're looking for quality companies that have good balance sheets, companies that are generating free cash flow or are moving toward a free cash flow situation."
Companies that don't generate excess cash will have trouble supporting a dividend, much less increasing it, she says.
Utilities that rely on selling power are most likely to be dividend challenged according to Saryan. Their prospects are closely linked with demand for electricity and prices, both of which have been constrained by problems with the economy and the glut of generating capacity. The sooner and stronger the economy rebounds, the quicker those restraints will dissipate. Given the stalled recovery, Saryan believes investors looking for yield may be better off elsewhere.
"This is not going to be fertile ground for consistent cash flow and dividends," she says.
Saryan says utilities that supplement their generating business with power transmission and distribution units offer the potential for some earnings and dividend growth. But if you're looking strictly for dividends, the most conservative play is utilities that rely on just power transmission and distribution. Earnings for these utilities provide consistent dividends and a little bit of growth, and "that's not a bad thing in this kind of market," Saryan says.
She's run the $351 million fund since March 1999, outperforming the Dow utilities index in every year except 2000. (The last two years have been losing ones for the fund, but the Dow utilities lost more.) Over the last 10 years, the fund's returned an average of 9.5 percent annually. Morningstar gives the fund's A shares (5.75 percent front load) a four-star rating.
About 60 percent of the fund's assets are in electric utilities with 25 percent in telecommunications stocks. One of Saryan's 10 largest holdings is Verizon Communications [VZ, 4 percent yield]. She likes the regional Bell's management and strong position in the wireless business. While Verizon's balance sheet isn't as strong as some of its competitors, it's good enough.
"We think they have room to raise their dividend at above average rates," she says.
Dominion Resources [D], 4.8 percent yield], which acquired Pittsburgh-based Consolidated Natural Gas three years ago, dropped out of her top 10 recently. Saryan believes the Richmond, Va. utility's diversified businesses make it an attractive play at the right price.
"It's a little bit more expensive than others, but they do have the potential to grow the dividend," she says.
Saryan doesn't own Allegheny Energy, which has been battered by accounting scandals and the demise of energy trading. The Hagerstown, Md. company is in crucial negotiations with creditors and has warned it could seek Chapter 11 bankruptcy protection.
Her holdings do include DQE (7.2 percent yield), which like many utilities is trying to dig out from ill-conceived investments. The utility trimmed its dividend to 25 cents in October, a level Saryan thinks is supportable.
"It's still a little high relative to their earnings ability, but I think it's OK," she says.
First Published: February 3, 2003, 5:00 a.m.