Why Do Utilities Have Such High Debt and High Payout Ratios?

Last week I received a couple of great questions, and I felt they were important enough to share with readers. So with permission, I’ve posted the second of two questions. I also invite your discussion as well, since ultimately we are all here to learn!

Why Do Utilities Have Such High Debt and High Payout Ratios?

Question:

I was however left curious about the relatively high DPR’s my utility holdings have.  I own shares of FTS-T, ENB-T, and TRP-T which have DPR’s of 66%, 64%, and 87%. Their corresponding debt/equity ratios are 135%, 190%, and 126%. Are these high ratios something to be concerned about or do their relatively consistent and reliable earnings support the higher DPR’s and debt/equity ratios?

Answer:

Generally utilities do have much higher DPR’s than their blue-chip counterparts. The basic reason being they are matured businesses with less room for growth or expansion. Therefore they tend to pay out more of their earnings or cash-flow as dividends to shareholders. That is the general rule anyway. So as an industry average, there are certainly higher DPR’s among utilities – though I’m not convinced 87% is healthy. Utilities also tend to have higher Debt-to-Equity ratios as well.

Ultimately you can’t compare Wal-Mart to Fortis, or Tim Horton’s to Enbridge. You have to look at the average in a given industry. So if you think TransCanada Corp. (TRP-T) has high debt and a high DPR, then you need to compare it to the average for most utilities, and make your comparison within that sector.

Regardless, I haven’t jumped on board with utility stocks as most of my dividend brother’s and sister’s have. I’ve always been a little wary of the higher DPR’s and higher debt ratios in this sector. In my opinion it just makes these companies more susceptible to economic shifts. There is always a trade-off for a slightly higher yield, isn’t there?

Food for Thought:

As mentioned a DPR and other ratios need to be compared within a sector, rather than the overall broad market, so one isn’t comparing apples to oranges. Throw in the complexity that some smaller companies base their payout ratios on Distributable Cash Flow instead of EPS, and it gets even more convoluted. This is something I cover in my November MoneySaver article.

However, to keep it simple here are some basic criteria to consider: (1) Is the dividend yield reasonable? (2) Does the company carry high debt? (3) Has the company reported positive or negative earnings?, and (4) Is the PE Ratio unusually high, or unusually low?

Readers what’s your take? Do you agree or disagree, or have anything you want to add?

24 Responses to “Why Do Utilities Have Such High Debt and High Payout Ratios?”

  1. MoneyCone

    Oct 25. 2011

    I know utilities are stable businesses with little that can go awry. But that doesn’t mean nothing will go wrong. Reminds me of PG&E and the record claims it had to settle!

  2. spbrunner

    Oct 25. 2011

    Yes, utilities have high debt. You might want to look to see if a company can increase their liquidity with cash flow after dividends have been paid.

    Cash Flow is what is important to me on utilities. I like DPR for cash flow to be less than 40%. I do know that lots of analysts look at AFFO, but this is not easy to get.

    The thing with utilities is they are capital intensive companies and cash flow is all important.

    In a lot of ways, EPS is rather a fake number. It is much easier to muck about with then cash flow is.

    On all stocks, I look at DPR for both earnings and cash flow.

    • The Dividend Ninja

      Oct 25. 2011

      Susan thanx for posting! Yes your focus on analyzing cash flow instead of EPS is a valid one – especially with matured businesses such as utilities. And you are also correct,the earnings is not as transperant as cash flow.

      Trouble is the average investor doesn’t understand or know how to figure this information out. Some posts coming on this topic… I personally go blank whenever I look at a financial report or balance sheet 😉

      Cheers!

  3. Henry

    Oct 25. 2011

    I like utilities, but they’re a capital intensive sector. Two stocks I like are Southern Company (S0) and Oneok (OKE). They have high debt. And any debt limits management flexibility to fund future endeavors.

    • The Dividend Ninja

      Oct 25. 2011

      Henry Yes you are right, debt always limits any business.

  4. DIY Investor

    Oct 25. 2011

    Utilities have high fixed costs which require a lot of debt and because they are regulated they can build their dividend into their rate requests.
    I wonder about their long term record of increasing their dividend compared to say a company like Intel or Bristol Myers.

    • The Dividend Ninja

      Oct 25. 2011

      DYI Robert, I think many of the utilities here in Canada do raise their dividends on a regular basis. But they do so while still maintaining high debt. It all perplexes me actually…

      btw Your comment was my 1000th comment! 🙂

      Cheers

  5. Dividend Mantra

    Oct 25. 2011

    Utilities, in my opinion, should be used to sprinkle a little high yield into an otherwise well-functioning and diversified dividend growth portfolio. I think they should be limited to smaller, ancillary positions due to the high debt and lack of growth catalysts. Utilities are historically defensive positions to keep your portfolio from massive losses in a market downturn. I don’t have any utilities, but I do have holdings with TEF, a Spanish telecom and I consider telecoms quasi-utilities.

    Take care!

  6. The Dividend Ninja

    Oct 25. 2011

    Dividend Mantra I will completely agree with you on this one! I too view Telecomunications as utilities, well actually hybrids of technology and utilties. In fact the telecoms have a lot in common with utilites.. they usually have higher debt, are matured businesses with less room for growth etc.

    TEF-N is pretty scary with its high yield. You may prefer to buy Telus Communications (TU-N) which is Canada’s third largest telecom. It has the lowest debt level and lowest dividend payout ratio of the Canadian telecoms:

    http://www.dividendstocksonline.com/2011/09/the-canadian-telecoms/

    Cheers
    The Dividend Ninja

  7. Michel

    Oct 26. 2011

    Good article and great comments. Utilities and telecoms make up a good portion of my own portfolio. I love those high dividends that compound over time. Some comments refer to the risk of “higher dividends”. A group of us “dividend lovers” here in my city have taken a like for a utilities ETF in order to minimize the risk. It’s called ZUT and offered by BMO. It holds the major utilities that we all like. It’s up 8.88% since inception (Jan. 19,2009). The fee is 0.550%.

    • The Dividend Ninja

      Oct 26. 2011

      Michel

      ZUT-T sounds interesting, and a nice way to play the utilities. The yield on this ETF is juicy @ 5.2% as well! I’ll have to check that out 🙂 Nice!

      Cheers

  8. Think Dividends

    Oct 26. 2011

    Most homeowners have a high debt/asset ratio… Like a house, pipelines are expensive assets to build and since they spinoff fairly predictable cash flow (like rental income from an apartment building) it is very natural for them to be financed with lots of debt (just like a mortgage on a house)…

    • The Dividend Ninja

      Oct 26. 2011

      Think Dividends

      I love the way you take something which seems so complex, and make it so easy to understand! Nice analogy 😉

      Cheers

  9. spbrunner

    Oct 26. 2011

    Some utilities have done very well as far as dividends are concerned. Take Fortis (TSX-FTS) that I have had since 1987. Then it had a dividend of $.32 a share. Now dividends are $1.16 a share. This is a 257% increase.

    I disagree with Telecoms being utilities. They used to be. When I first bought Bell in 1982, it was considered a “Widows and Orphan” stock. I do not think this has been the case for some time. I currently think that Telcom Stocks are rather risky.

    • The Dividend Ninja

      Oct 26. 2011

      Susan

      I don’t think Telecoms are any more risky than utilities. Seems to me Utilities and Telecoms have a lot in common, including: (1) They have huge infastructures that require large capital outlay. (2)They finance and maintain that infastrucutre through debt. (3) They tend to have higher dividend yields and higher payout ratios. (4) They usually have higher debt, and (5) They are matured businesses with less room for expansion and growth.

      Cheers

  10. My Own Advisor

    Oct 27. 2011

    Sorry I’m late to the comments party Ninja, it’s been a busy week for me!

    Cash flow is very important to me as an investor. Even though utilities’ debt/equity ratio is much higher than the DPR, utilities have so much infrastructure to maintain than many other companies or some sectors. Telcos are the same.

    I’m not worried Ninja, those companies you mentioned are some of the best in the world. If they all go under, we’re sunk in this country! 🙂

    Nice post and great of you to share some of your reader questions!

    Will tweet and of course, you’ll be in my roundup for weekend reading.

    Cheers!

  11. Rock the Casbah

    Oct 27. 2011

    Thanx D Ninja for this article on this important topic. As an investor in utilities, I appreciated it. I think your 5 point comment above nicely summarizes some important aspects of utilities as investments. In general I think the right utilities can offer an investor a reasonably high stable yield w/ dividend growth (albeit usually modest). And, of course, the commodity they sell is necessary w/ relatively inelastic demand. As such, I think they should be an important part of a dividend investor’s portfolio.

    My fav in this sector is EXC. It sports a reasonably high yield w/ a DPR (about 50%) that bodes well for it’s sustainability. It’s nuke fleet can generate electricity cost-effectively and w/ lo emissions. Although there are some concerns (underfunded pensions, slight risk of nuke accident), still a good divvy play in my opinion. Div growth has been flat last 3 yrs (also a concern) but growth for the 6-7 yrs before that was good (therefore, 5 and esp. 10 yrs Div growth is good).

    I looked at North of the border at Fortis and Emera (and liked both) but decided I was already a bit overweight in this sector.

    Off the subject, I just bought RY earlier this week. Any thoughts? Also appreciated your input on TEF-N from previous post. Not necessarily what I wanted to hear but food for thought. As u say we’re all here to learn.

    As usual, thanx.

  12. 101 Centavos

    Dec 18. 2011

    Good post, Ninja. I considered Duke and AEP as additions to my div portfolio, and they’re still on watch list. I may add some of our Canadian brothers to that list.

    • The Dividend Ninja

      Dec 18. 2011

      101 Centavos Thanx for dropping by! 🙂 The Canadian utilities have had an excellent run-up the last few years, and the prices may seems expensive, but these are great companies.

      Cheers

  13. Brady

    Jan 03. 2012

    This is my first visit to the site and I like what I’ve read so far. I’m going to read back even further into the archives.

    Another thing that hasn’t been mentioned is that utilities have regulated rates of return. This means the regulator provides a rate of return on both debt and equity that has historically kept the utilities in Canada healthy. Nobody wants their natural provider to go bankrupt in the middle of winter. As such, when debt costs increase, the regulator generally provides increases in rates of return.

    Of course, there is still risk that things can go wrong: stranded (unused) assets that are no longer compensated, liability for accidents, construction cost escalation…but Canadian regulators generally provide sufficient return on capital to keep the utilities in good financial shape.

    • The Dividend Ninja

      Jan 03. 2012

      Brady Thanx for stopping by and I appreciate the feedback. Interesting info as well.

      Cheers

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