This Utility Stock is STILL a Great Buy

Last year, the Dow Jones Utility Average (DJU) was on a tear. At least for a boring utility index, it was. The index returned 15% before dividends, its best annual performance in four years.

Throw dividends in, and we’re probably flirting with close to a 20% return.

Some of the bigger utilities performed even better then the index. Atlanta-based Southern Co. (NYSE: SO), for instance, returned about 17% before dividends, while North Carolina power giant Duke Energy (NYSE: DUK) turned in 23% before dividends. That’s was quite impressive, considering the S&P 500 was dead flat for the entire year, returning only about 2%.

But things have changed. Well, sort of…

The pundits and spinners would have you believe that utilities fell out of bed in the first quarter of 2012. But while these stocks are visibly lagging the broader market, with the DJU having returned -1.7% so far this year compared to a roughly 10% gain for the S&P 500 in the same period, a lot of the more widely-held utility stocks are what I consider fully valued, trading at price-to-earnings (P/E/) ratios of 14 or higher.

As a money manager and an investor, I like to see forward P/E ratios below 15 for larger utilities, with dividend yield of 5% or higher. I’ve recently recommended, for instance, Exelon Corp. (NYSE: EXC), which is a very attractive holding. It’s still a timely idea that fits my P/E and dividend criteria.

Another utility stock I’ve also followed closely is TECO Energy (NYSE: TE). Here’s why this stock has attracted my interest lately…
A diverse, progressive and undervalued business
Starting out as Florida’s old Tampa Electric Co, TECO has evolved into a holding company with diverse energy operations. The different divisions encompass electric power generation and distribution, natural gas distribution, a coal mining operation and a Guatemalan electric utility subsidiary. The new Tampa Electric Co. now operates as TECO’s main subsidiary.

The bulk of TECO’s business, about 60.5%, comes from the electric utility operations in Florida, which provides the company with a steady cash flow. And although the state’s economy and housing market are still trying to get off of the mat, the company is forecasting a slight customer growth in that business line for 2012. Positive customer growth for an electric utility is an impressive accomplishment, considering Florida has one of the worst housing markets in the nation.

It’s got gas…

The coal business and the pipeline development business are what have really piqued my interest in this stock. In 2008, TECO formed SeaCoast Gas Transmission LLC, a subsidiary that plans to develop and own an intrastate natural gas pipeline in Florida.

Not only would this help grow the distribution side of TECO’s natural gas utility — People’s Gas System — it would also position the company as a potential wholesale transporter of the fuel in the region. As the nation increasingly switches toward natural gas as a viable energy source, this is a great advantage to have.

TECO’s electric utility fuel breakdown is currently 62% coal and 38% natural gas. So if the company transitions toward more natural gas, then a cheap and efficient delivery system will already be in place. I like this kind of forward thinking.

Recently, TECO shares have been under pressure for two main reasons: Investors are shifting away from richly valued utility stocks, and the coal business is seeing lower margins due to higher production costs.

This year, TECO is expected to sell roughly 7 million tons of coal. Production costs are projected to increase to between $83 and $87 per ton, which is up from $80 per ton last year. The positive offset is that the 2012 average selling price is expected to come in at $96 per ton compared with last year’s $88 per ton.

To see how this stock still has a good chance to grow, let’s do a simple math. Last year’s margin was right at about 10%. Let’s get in the middle of TECO’s expected production cost for coal this year, and call it $85 per ton. Based on a selling price of $96, that’s about a 13% margin, and this could actually increase if the company is able to tighten production costs.

Risks to consider: Although aggressively marketed as “clean,” coal is truly the environmental whipping boy. More than two thirds of TECO’s power generation is coal-fired, so having a coal-mining business that generates about 24% of the company’s revenue causes some obvious concerns. That said, it appears the company is correctly and intelligently poised to take advantage of the natural gas boom. Also, while the broader investor coolness toward utility names is without merit, it takes a while for the herd to come back around (which is why you should buy and sell before they do).

Action to Take — >
With a forward P/E of roughly 13 and a dividend yield of about 5.0%, TECO could earn $1.35 in earnings per share (EPS) this year, a 6% increase compared with 2011. Be prepared to wait for some upward movement in share price. The generous dividend is good compensation for that wait.

All in all, this is not bad for a company that’s priced like a traditional utility. I’m comfortable with the company’s 67% dividend payout ratio and its ability to generate cash. With this in mind, a modest P/E expansion of 15% would create a 12-month price target of $20 per share. Adding the dividend would bring the total return to 20%. This is definitely not Apple (Nasdaq: AAPL) or Google (NYSE: GOOG)-like return territory, but if you’re looking for stability, income and some growth, then this fits the bill.