Utilities Companies Face Challenges with Debt Maturities, High Dividends, and Limited Growth
High dividend payers have always managed to attract investors. The thought of getting a “safe” yield on your investment with the potential appreciation of the principal investment is indeed appealing. However, historically speaking, high dividend payers are not always the best investments.
A notable example is AT&T (T), which has been paying out generous dividends despite its debt load. Even as far back as 1995, the company was unprofitable with a net income of $3 billion, but it paid $1.8 billion in dividends. That is why it has had loyal dividend collectors. Currently, it has a dividend yield of around 6%.
However, eventually, high debt knocked on the door. The company continued issuing debt, not only to refinance upcoming debt maturities but also to sustain its dividend and share buybacks. This approach was unsustainable. Interest expense as a percentage of revenue became higher and higher. This became a problem particularly in 2017, when this ratio reached 3.9%, significantly higher compared to the 2.4% in 2010.
While investors were concerned, they were also pleased with the direct value to shareholders through dividends. However, this strategy proved unprofitable. Since January 2017, as AT&T prioritized strengthening its balance sheet and paying down debt, its growth disappointed investors. The resulting stock price decline far outweighed the dividend payouts.
If you had bought one AT&T share in January 2017 at $31, you would have collected $12.41 in dividends by January 2024. Your initial investment of $31 would have declined by $12.5. At the same time, the S&P 500 surged 144%. This would have been a terrible investment decision.
This brings us to the utilities sector, an industry that typically pays high dividends and carries a significant debt load. Utilities companies are often considered safe, stable investments due to their consistent cash flows and essential services. However, their valuation metrics reveal a different story, particularly in how these companies are priced and their growth prospects.
This article explores why utilities are mostly valued with a consistent price-to-book (P/B) ratio, their reliance on debt for growth, and why this might not be the best time to invest in these companies. We also discuss the implications of their high dividend yields and offer some insights into alternative investment strategies.
The Market Understands Most Utility Businesses
Utilities businesses provide essential services such as electricity, natural gas, water, and sewage treatment to consumers and businesses. These services are critical for daily life and economic activity, making utilities generally stable and predictable investments.
Usually, these companies own the assets with which the infrastructure runs. These companies are active from the extraction of resources to the generation of power and to the distribution of that power to residential and commercial areas.
Utilities companies typically earn a stable return on their assets. Their businesses are heavily regulated by government agencies to ensure that they provide reliable services at reasonable rates. These regulations can dictate the rates utilities can charge, the level of service they must provide, and the investments they need to make in infrastructure.
Therefore, usually, how much they can earn is a function of their asset base. The larger the footprint, the larger the earnings. The market understands that.
That is why the stocks of utilities companies are typically valued with a consistent price-to-book ratio. This metric indicates that the market understands these companies have limited opportunities to increase their return on assets (ROA) in the long term. Unlike tech companies that can rapidly increase their ROA through innovation, utilities operate in a heavily regulated environment with high capital expenditure requirements and limited pricing power.
The Need For Growth Made Utilities Companies Turn To Debt
Historically, utilities have funded their growth primarily through debt. This approach has been effective during periods of low interest rates, allowing these companies to expand their infrastructure and services without significantly diluting shareholder value. However, this heavy reliance on debt has led to poor credit structures for many utilities companies.
A great example is Enbridge (ENB). It is an infrastructure company in the US owning infrastructure that transports and distributes oil and natural gas. The company’s high asset growth coincides with times of low interest rates, and stagnant growth coincides with times of high interest rates.
As the P/B multiple is stable, the market rewards the company for high growth and punishes it for low growth. That can clearly be seen in the stock price, which surged together with growth until 2015.
Now, when rates are high, is not the best time for these companies. They are already overloaded with debt, and will have to pay those down as maturities approach.
Facing limited and costly financing options, they will have to either raise more debt at high interest rates or issue new equity, both of which can negatively impact shareholders. Raising new debt increases the financial burden, while issuing new stock dilutes existing shareholders' equity and can lead to a decline in stock prices.
Despite Hardships, Dividends Remain
As mentioned, utilities companies often offer high dividend yields to attract investors. Enbridge, for example, currently offers a 7.6% dividend yield. We already discussed how a high yield can be appealing but may not make for a good investment. There are many instances where utilities companies issue debt or stock to pay dividends. This practice can strain their financial health and lead to a decline in stock prices. This is especially not sustainable right now, when rates remain higher for longer.
A perspective some investors employ is thinking of high-yield utilities stocks as similar to bonds that make regular payments. However, unlike bonds, which return the principal at a specific maturity date, utilities stocks do not guarantee the principal amount back, and the stock price can decline. Investors might be better off buying the bonds of these companies if they believe the credit structure is relatively safe.
Alternative Investment Strategies
Given the current challenges facing utilities companies, investors might want to consider alternative strategies. Here are a few suggestions:
1. Investing in Bonds
Investing in bonds issued by utilities companies with relatively safe credit structures can offer a more secure income stream compared to equity investments. Bonds provide regular interest payments and return the principal at maturity, offering more predictability in returns.
2. Choose Stocks Wisely
Although business models are similar, the utilities sector includes many companies with exposure to different end markets. Currently, the most intriguing ones seem to be companies producing power and suppliers of those. As the need for power increases thanks to new technologies, these companies may achieve higher return on assets in the short-term.
3. Seeking Out Utilities with Strong Balance Sheets
Not all utilities companies are equally burdened by debt. Some have managed their finances prudently and maintain strong balance sheets. Identifying and investing in these companies can provide exposure to the utilities sector without the associated risks of high leverage.
There Are Always Options For Smart Investors
Utilities companies have long been seen as stable, income-generating investments. However, their heavy reliance on debt, combined with the current high interest rate environment, presents significant challenges. While high dividend yields can be attractive, they often come at the expense of long-term financial health. Investors should carefully evaluate the credit structures and growth prospects of utilities companies before investing.
By considering alternative investment strategies, such as investing in bonds, diversifying into other sectors, or focusing on utilities companies with strong fundamentals, investors can mitigate risks and seek more secure and potentially higher returns. Understanding the underlying financial health and market dynamics of utilities companies is crucial for making informed investment decisions.
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