Regulated utilities are some of the best high dividend stocks that low risk income investors look to in order to meet their high-yield needs.

That’s understandable since the business model for these government sanctioned monopolies is highly stable, allowing for consistent cash flow with which to pay generous and highly secure dividends.

However, investing is never done in a vacuum. After all, there are differences in quality between the dozens of utilities investors have to choose from, so you need to be selective with where you deploy your capital.

Let’s take a look at PPL Corp (PPL), a regulated utility yielding 4% that recently doubled its expected annual dividend growth rate, to see if the company might be attractive for investors living off dividends in retirement.

Business Overview
Founded in 1920 in Allentown, Pennsylvania, PPL Corp is a regulated gas and electricity utility serving about 10 million customers in the U.S. and the U.K. via its three business segments:

Kentucky Regulated: 324,000 natural gas and 407,000 electricity customers in and around Louisville, Kentucky. This business also serves 521,000 other Kentucky customers, as well as 28,000 in five counties in southwestern Virginia via its Louisville Gas & Electric and Kentucky Utilities subsidiaries.

Pennsylvania Regulated: serves 1.4 million electric customers in 29 Pennsylvania counties.

U.K. Regulated: serves 7.8 million electrical customers via 15 power distribution networks.

PPL’s largest customer base, as well as most of its sales, earnings, and cash flow, are derived from the U.K. (providing international diversification), where regulators are nice enough to allow for returns on equity that put most U.S. utilities to shame.

Source: PPL Investor Presentation

Business Analysis
At first glance PPL Corp doesn’t appear to have very stable revenue, earnings or cash flow at all.

Source: Simply Safe Dividends

However, it’s important to realize that this apparent sales and earnings volatility is a result of the utility’s history of acquisitions and divestitures.

For example, the huge sales boost in 2011 was a result of PPL acquiring a large chunk of E.On’s UK distribution grids, which vastly increased its highest profit segment.

And as for the drop in 2015, PPL decided to spin off its merchant power generation business (which has highly variable profitability) into Talen Energy, of which it owned 65% of the shares.

Later it sold off those shares to further reduced its earnings volatility.

As for the most recent weak results, that’s due to two factors.

First, in mid-2016 PPL sold off PPL Solutions, which provided IT solutions for utility operators, to Hansen Technologies.

This divestiture is part of a long-term plan to refocus the company on its core regulated businesses, which offer far steadier, higher, and improving margins and returns on shareholder capital.

In fact, thanks to this long-term strategy PPL Corp is now one of the most profitable utilities in the industry.

Thanks to PPL’s large size and track record of smart capital allocation decisions, the utility also benefits from a very low cost of capital near 5%, which makes it easier for management to grow the company profitably and at an accelerating rate.

In fact, PPL is confident that, thanks to its aggressive investment plan, as well as highly favorable relationships with regulators (80% of its planned capex spending has no regulatory lag, meaning that the company can pass on the cost of new investments quickly to customers), it will be able to grow its rate base and earnings at a high and steady rate in the coming years.

That in turn should translate to impressive (for a regulated utility) dividend growth of 4% a year, which marks a nice acceleration from the 1-2% growth PPL has recorded in recent years.

This nice growth is thanks to PPL’s plan to invest $5.4 billion over the next four years into its Pennsylvania and Kentucky electrical transmission businesses at a healthy weighted average return on equity of 10.7%.

And that’s just the start of PPL’s long-term growth runway, which involves $16 billion in growth investment over the next five years.

A large part of that is the company’s aggressive push into renewable energy in the U.K., where the utility is already connecting consumers to 20 GW of green energy, a figure that is likely to soar in the coming years and decades.

In fact, PPL’s growth plans set up all of its businesses for healthy mid-single-digit base revenue growth through 2021, which bodes well for dividend lovers.

Overall, PPL appears to be a durable business that generates predictable earnings, participates in geographies with generally supportive regulatory bodies, and is poised for somewhat faster growth in the years ahead.

Key Risks
While PPL’s growth plans make it appealing for risk averse income growth investors, nonetheless there are several risks to keep in mind.

First, as with all regulated utilities, there is political risk. That’s because a utility’s profitability, especially its return on equity, come directly out of the pocket of customers.

During economic downturns, populist political attacks against “greedy utility monopolies” could sour regulatory relationships between PPL and its regulators, especially in the U.K. where PPL’s allowed return on equity is among the highest in the industry.

Next, we have to remember that, while PPL’s growth plans are impressive and provide a long growth runway, there is no guarantee that management can bring those projects in on time and on budget.

In addition, because of the highly capital intensive nature of the utility industry, PPL is dependent on external debt and equity markets for capital.

For example, over the next four years management says it plans to issue $1.4 billion in new equity, meaning selling new shares and diluting investors by 5.3%, in order to help finance its growth plans.

That brings us to another risk, which is that PPL, like many fast-growing utilities, could find its growth ambitions watered down if interest rates rise too high and fast and/or investor demand for its shares dips.

For example, over the last 36 years, the correlation between the yield in 10-year Treasuries and the S&P 500 has been pretty strong.

Source: S&P 500, Motley Fool

In other words, PPL has benefited over the past eight years from the lowest interest rates in history, resulting in low debt costs as well as high demand for its shares to keep its cost of equity low. That’s because low bond yields have caused many income investors into a desperate hunt for “bond alternatives.”

Low volatility regulated utilities have been some of the biggest beneficiaries of this trend, but their favorable environment could reverse itself as the Federal Reserve continues on its interest rate increasing program.

That’s especially true if the U.S. Treasury makes good on its proposal to issue 50 and 100-year Treasury Bonds, which would offer yields that are likely at least 0.5% to 1.0% higher than 30-year Treasury yields that currently yield about 3%.

In other words, yield-hungry, risk averse income investors may be able to enjoy 5% or even 6% risk-free yields in the coming years, which could decrease demand for PPL’s generous but ultimately slow-growing dividend.

That could cause PPL’s shares to stagnate or fall, which would bring the utility’s dividend yield up to a level that makes it more competitive with risk-free U.S. Treasuries.

In addition, we can’t forget that PPL’s ace in the hole, its U.K. energy transmission business, is also a double-edged sword. That’s because it potentially exposes the utility to long-term currency risk after 2019, which PPL’s current hedges do not cover.

While PPL does a great job of hedging its short-term currency risk against the British Pound, the uncertainty about Brexit’s effects on the U.K. economy means that when those hedges roll off a much weaker British Pound could result in a decline in PPL’s overall earnings growth potential.

The same could occur if sweeping tax reform, which Congress is currently working on, results in the elimination of the interest deduction. Bloomberg has calculated that PPL is one of the most exposed utility in the event that such a deduction be eliminated.

Some utilities could face an earnings hit of as much as 8.5% if this provision of tax reform ends up becoming law, according to an analysis by Bloomberg and Morgan Stanley.

Fortunately, these risks seem unlikely to jeopardize the safety of PPL’s dividend.

PPL Corp’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

PPL Corp’s Dividend Safety Score of 86 indicates that its dividend is among the safest on Wall Street. That’s no surprise given the utilities strong track record of steadily rising payouts over the years.

Note that PPL’s dividend cut in 1998 was a result of the merchant power business experiencing exceptionally strong weakness due to increased competition. PPL was also hurt by unfavorable regulatory rulings for rates on its new power plants in Pennsylvania and its high payout ratio near 90%.

Fortunately management ultimately decided to spin off PPL’s merchant power to focus on the company’s purely regulated and more profitable core businesses. The company is also more financially conservative and diversified today.

And thanks to a disciplined dividend growth approach, in which management keeps the EPS payout ratio at around 70% or so (based on the planned 4% annual dividend growth rate through 2020), investors can rest easy knowing that the company’s future payouts will likely remain highly secure and dependable.

In addition, the second important factor to consider when determining dividend safety is the strength of a company’s balance sheet.

At first glance investors might think that PPL’s debt levels are too high to allow for a safe and growing payout. After all, with a net debt position of $19.6 billion and combined interest and dividend costs equal to 2016’s net income, it doesn’t necessarily look like PPL’s balance sheet can allow both its aggressive growth plans and sustainable 4% dividend growth.

However, because of the highly capital intensive nature of the regulated utility industry and the fact that utilities generally pay out 70% to 85% of EPS as dividends, a high debt load is to be expected.

While it is true that PPL’s overall debt levels are slightly higher than its industry peers, we can’t forget that its business is also highly stable, recession resistant (sales dipped just 5% during the financial crisis), and generates industry-leading profitability. As a result, PPL enjoys a very strong credit rating (A- from S&P) and should have plenty of access to cheap debt capital.

In other words, barring another financial crisis that disrupts credit markets for years on end, PPL Corp should be able to both invest in its future growth, as well as maintain a safe and steadily growing dividend.

PPL Corp’s Dividend Growth Prospects
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

PPL Corp’s Dividend Growth Score is 8, which indicates weak growth ahead. However, don’t let that fool you because that low score is mostly based on the company’s relatively unimpressive long-term dividend growth record.

After all, over the past two decades PPL’s dividend growth rate has barely kept up with inflation, which averaged 2.15% annually between 1996 and 2016. Meanwhile over the last five years the company’s dividend growth rate has slowed to a crawl, with PPL’s 1.7% annualized payout growth beating inflation (1.3%) by an even smaller amount.

[ad#Google Adsense 336×280-IA]However, keep in mind that the slow rate of payout growth has been mainly because management was focusing on putting its cash flow to work on growing the business.

Now, with guidance of 4% annual dividend growth over the next four years, it appears that PPL is getting ready to accelerate its payout growth.

Better yet?

While the 4% growth guidance is only through 2020, its strong growth in base rate and growth capex extends through 2021, which means that investors are likely to enjoy more than just four years of 4% payout growth going forward.

Valuation
Over the past year PPL shares have underperformed the market by more than 10%. While some investors may see this as a bad thing, longer-term shareholders, especially those attracted to the safe and steadily growing dividend should evaluate this underperformance as a potential buying opportunity.

PPL’s forward P/E ratio now sits at 18.4, a slight premium to the utility sector’s 17.7 forward multiple and the S&P 500’s 17.3 multiple.

Meanwhile, while PPL’s 4.0% yield may be lower than the utility’s 13-year median yield of 4.7%, it’s still higher than 63% of its industry peers, whose median yield is a much less impressive 3.3%.

With expected earnings growth around 5% to 6% per year, PPL’s stock has annual total return potential of 9% to 10% (4% dividend yield plus 5-6% earnings growth).

The stock doesn’t necessarily appear to be a bargain today, but it doesn’t look unattractive for long-term shareholders either, especially with the firm’s dividend growth rate set to more than double in the next few years.

A pullback to $35 per share (from $40 today) would result in a 4.5% dividend yield and a forward P/E ratio closer to 16, putting the stock’s valuation metrics more in line with their long-term averages and making PPL a more attractive investment option to consider.

Concluding Thoughts on PPL Corp
Regulated utilities aren’t a sexy industry, and if you are looking for substantial long-term capital appreciation, it may not be the best sector for you.

On the other hand, if your main goals are generous, secure, and moderately growing (i.e. about double the rate of inflation) income, than PPL appears to represent a reasonable choice for income investors looking to build a diversified dividend portfolio.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends