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Thursday, December 12, 2013 - 08:30
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Thursday, December 12, 2013 - 08:30

This Stock Combines Safety, A 5% Yield And 30% Upside

Thursday, December 12, 2013 - 8:30am

Look over a typical dividend investor portfolio, and you'll probably find the usual utility stock suspects: Southern Co. (NYSE: SO), American Electric Power (NYSE: AEP), Consolidated Edison (NYSE: ED).

These are the biggest of the big domestic power generators. You can set your watch by their cash flow, which means you know what kind of dividends to expect.

But they don't grow much. Because of the highly regulated nature of the business, there's little opportunity to expand their footprint or unlock special value for shareholders.

When this happens, stock prices don't move much. Just look at the price action of the Dow Jones Utility Average over the past half-decade:

A five-year average annual return of better than 13% is nothing to sneeze at. Investors have always gravitated toward utilities for their stable income and safety during turbulent markets. However, when equity markets are in full-tilt boogie, utility stocks typically underperform.

What about the best of both worlds? Is there an investment that provides dependably high income with growth superior to that of the Dow Jones Utilities?

I've found a utility stock that provides a great, safe income stream and has outperformed the Dow Jones Utilities by over 70% over the past five years. With a market capitalization of over $47 billion, this company's business has an international focus in both gas and electrical distribution. And while it owns assets in the U.S., it's based in the United Kingdom.

Based in Great Britain and formerly known as National Grid Transco, National Grid (NYSE: NGG) owns and operates regulated electric and gas networks in the U.K. and U.S. In the U.K., the company serves over 30 million customers -- nearly half the nation's population of 67 million. With a near-monopoly like that, it's probably a safe bet the dividend stream is fairly dependable.

Locked In
National Grid's U.K. business provides the income side of this income and growth story. Since National Grid is in the business of being a public utility, the rates it charges are regulated by a government entity.

From an income investor's point of view, this is a dream come true. Rates are set and locked in for extended periods of time. The regulated utility knows how much revenue it has coming in over the next few years. That way, the company can budget for capital expenditures, manage debt effectively, and determine how much it will pay out to shareholders in the form of dividends. Put simply: National Grid's business model is extremely low risk.

Electricity rates in the United Kingdom have been set through March 2021. This will allow National Grid to invest nearly $11.5 billion in its electrical transmission system. This will boost capacity on its home turf, expanding its regulated asset base and generating predictable, low-risk returns.

But although the company's U.K. business is locked in, it only represents 41% of total sales. National Grid's growth story lies across the pond.

Switched On For Growth
More than half of National Grid's annual revenues, 55%, come from regulated U.S. electric and gas utilities. And while the company's stateside assets also fall into the regulated utility category, the growth opportunities are far more abundant than in the U.K.

Lately, the company has been keeping its M&A bankers busy. In 2007, National Grid acquired KeySpan, the largest distributor of natural gas in the Northeast and the fifth-largest in the U.S. In 2008, the company sold KeySpan's Ravenswood power plant to New York City for $2.9 billion. Last year, the company sold its New Hampshire gas and electric business for $285 million.

The ability to buy and sell assets helps the company unlock value for shareholders by selling at a profit (hopefully) and at the same time shedding weaker assets to raise cash to fund future acquisitions. The success of this strategy is reflected in the stock price.

Since the market lows of 2009, investors in NGG have enjoyed average annual returns of 21% -- higher than that of the Dow Jones Utility Index. Even better, the stock has room to move higher.

Strength In Numbers
National Grid's earnings per share (EPS) this year are right at $4.92 per American depositary share (ADS), an 8.6% increase over last year's EPS of $4.53. The company has also done an excellent job with the money it makes: NGG's average return on revenue sits at 16%. That's better than regulated behemoths Consolidated Edison and PG&E Resources (NYSE: PCG), which average about a 5.3% return on revenue.

The company's dividend payout ratio is also lower than those of its peers. National Grid's payout ratio has held steady at around 65% for the past few years while the likes of American Electric Power and Southern Co. come in slightly higher above 70%. The difference of a few percentage points could mean more money to fuel growth.

NGG trades just above $60 with a dividend yield of 5.1% and a price-to-earnings (P/E) ratio of about 12. Consistent 8% earnings growth for a large, regulated utility is also a compelling reason to own the stock. Successful execution should propel shares higher while the safety of the dividend adds support.

Risks to Consider: Utilities typically rely on debt to finance expansion and some operations, so National Grid's borrowing costs could rise along with interest rates. However, the company has planned for this, and management has done an excellent job of reducing the long-term debt-to-capitalization ratio from 85% in 2010 to a current 65%. The North American component of National Grid's business also faces regulatory risk due to the lack of a comprehensive U.S. energy policy.

Action to Take --> Based on National Grid's profile as a steady dividend income payer with the ability to grow thanks to the opportunities the company has in the U.S., NGG is a great way to add safe, high-quality international exposure to your portfolio. The company's steady performance should help NGG reach my 12-month target price of $77. Combined with the dividend, total returns would approach 30%.

P.S. 43% Safer Returns + 7.2% Average Yields + 127% Gains = $47,921.70. Are you using this moneymaking equation? Click here to learn how.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.