Beware Dividend Cuts in Utility ETFs

January 24th at 9:30am by Todd Shriber

Earlier this week, FirstEnergy (NYSE: FE), an Ohio-based utility, slashed its quarterly dividend to 36 cents per share from 55 cents.

It was the first dividend cut for the company and it did not go unnoticed by the financial press. FirstEnegy’s dividend reduction should not go unnoticed by investors considering utilities exchange traded funds.

FirstEnergy is the second big-name U.S. utility to cut its dividend in the past 11 months. Exelon (NYSE: EXC) pared its payout in significant fashion last February. The two stocks combine for 7.6% of the Utilities Select Sector SPDR (NYSEArca; XLU) and 6.3% of the iShares U.S. Utilities ETF (NYSEArca: IDU). Both stocks are also members of the Vanguard Utilities ETF (NYSEArca: VPU). [Low Expectations for Utilities ETFs]

Those may not be the only dividend cuts endured by XLU, VPU, IDU and rival ETFs. “Pepco Holdings Inc., Ameren Corp. and Portland General Electric Co. are among the companies with the weakest ability to sustain their current dividend due to credit quality and growth potential below the industry average,” Mark Chediak reported for Bloomberg, citing Hugh Wynne, an analyst for Sanford C. Bernstein.

Pepco and Ameren combine for 2.8% of XLU while those two stocks and Portland General Electric combine for 2.7% of IDU’s weight.

Slumping revenue growth and intensifying competition from alternative energy sources are among the catalysts crimping some utilities. Last year, XLU was the worst performer among the nine sector SPDR ETFs, but the Guggenheim Solar ETF (NYSEArca: TAN) was the year’s best non-leveraged ETF due in part to the increasing ability of solar companies to drive costs low enough to compel end users to make the switch from traditional fuel sources. [Solar ETF Reigned Supreme in 2013]

The case for utilities stocks and ETFs is not entirely broken. Analysts are more sanguine on regulated utilities and the sector’s large-caps are becoming more reasonable on valuation.

“While the sector still looks expensive relative to its long-term average, valuations have fallen. Given utilities’ underperformance, the sector now trades at a discount to the broader market. Specifically, valuations for the utilities sector have contracted by around 10% since last April, and large-cap utilities companies now trade at a 10% discount to the broader market,” said BlackRock Chief Investment Strategist Russ Koesterich in a note published earlier this week.

iShares U.S. Utilities ETF