The defensive income characteristics of utilities stocks may hold strong investor appeal as the coronavirus fallout deepens.

Companies that provide basic amenities such as electricity, water, sewage services and natural gas are usually described as defensive because they're heavily regulated and deal in long-term contracts that help them ride out volatility.

And like other "defensives" including property trusts and infrastructure stocks—which are sometimes also known as bond proxies because of their fixed income-like characteristics—they usually provide a reliable income stream.

Nor are dividends directly affected by the broader share market performance and are often viewed as a safety net during heightened volatility.

Anton Tagliaferro, founder and investment director at Australian asset manager Investors Mutual Limited notes that when viewed over both 20-year and 40-year timeframes dividends contributed almost half of the returns generated by the Australian share market.

"Over the long term, returns from an equity portfolio come from two sources – the capital appreciation from the shares held in the portfolio, as well as the dividends received from the shares held," Tagliaferro says.

"And while the level of capital returns from an equity portfolio over any defined period generally depends on the movement in the share market, the level of dividends received by an investor from an equity portfolio is dependent on the performance of the underlying companies’ earnings, not the movement in share prices."

Before delving into the dividend yields of some of Australia's largest utility companies, remember you shouldn't view dividends in isolation.

The price paid for the shares should also be weighed alongside the potential dividend yield. Some companies have high payout ratios but have far less stellar fundamentals.

In some cases, abnormally high dividend yields can be a danger sign, as suggested in this article by Morningstar Spain's Fernando Luque.

Overvaluation is one risk of high dividend-paying stocks, as share prices can be bid up by yield-hungry investors.

There's also the risk that companies may lure investors in with the promise of dividends – perhaps funded by high debt – only to cut dividends later if market conditions deteriorate.
Investors must tread carefully. But looking at utility stocks within Morningstar's research coverage, the following companies have the best outlook for dividend yield.

Spark Infrastructure (ASX: SKI)

Expected Dividend yield: 7.2 per cent | Morningstar Rating: 4-star | Economic Moat: None

Spark is an electricity distribution company, owning 49 per cent of three networks: CitiPower and Powercor in Victoria and SA Power Networks in South Australia. It also owns 15 per cent of electricity transmission network TransGrid.

Morningstar senior equity analyst Adrian Atkins tips distributions of 13.5 cents a share in 2020 - down slightly after management's half-yearly earnings update.

"But we remain comfortable with our 2021 forecast of 12 cents per share. The 2021 forecast implies a distribution yield of 5.6 per cent partly franked," he says.

Atkins says the latest financial result was buoyed by rising regulated tariffs and higher services revenue, but this was offset by cost increases linked with the summer bushfires and tree management.

Earnings before interest, tax, depreciation and amortisation was up at each of Spark's largest business units:

  • Victoria Power Networks' EBITDA rose 2 per cent to $849 million;
  • South Australia Power Networks' EBITDA rose 5 per cent to $691 million;
  • TransGrid EBITDA rose 2 per cent to $681 million.

Atkins expects regulatory changes to hit profits over the shorter term, as the tariffs electricity companies are allowed to charge are reviewed every five years by the Australian Energy Regulator.

"SAPN is the first to suffer new, lower regulated returns from mid-2020, followed by VPN in January 2021. TransGrid's returns are locked in for another 3.5 years," he says.

"Regulated revenue is highly secure and predictable between regulatory resets. Unregulated and semi-regulated revenue can be lumpy, particularly as a result of externally initiated projects."

Atkins expects weaker dividend growth for a few years from 2021, but is more upbeat over the longer term as bond yields improve.

This is important because the government tariff adjustments are linked directly to the 10-year bond yield, which hit record lows in mid-2019.

"Distribution growth should be minimal for a few years from fiscal 2021, but our expectations for normalising bond yields should drive improved returns and distributions longer term.

"Additionally, franking should increase from zero currently to about 50 per cent over the next few years as tax payments increase."

AGL Energy (ASX: AGL)

Expected Dividend yield: 5.8 per cent | Morningstar Rating: 4-star | Economic Moat: Narrow

With a projected dividend yield of 5.8 per cent for fiscal 2020, AGL has the second highest dividend outlook among locally-listed utilities.

AGL Energy's disappointing first-half result was largely expected by Atkins. He left his fair value estimate of $20 a share unchanged after the February result, which saw net profit after tax for the half decline 20 per cent to $432 million. 

AGL's solid dividend yield is a key reason for this, along with the company's conservative debt levels, size advantage and low-cost power stations.

Atkins notes that rising costs and the downward pressure on retail electricity prices are hitting AGL's revenue. Operating income from the firm's electricity business fell 10 per cent during the half, hurt by higher prices due to:

  • New LNG supply from North America, Australia and the Middle East
  • Higher gas prices, which increase the cost of operating gas-run power stations
  • Lower production from coal seam gas producers.

But Atkins maintains confidence in AGL's balance sheet. He also expects another share buy-back next year, of a similar size to the $650 million buyback announced in August 2019.

Genesis Energy (ASX: GNE)

Expected Dividend yield: 6.2 per cent | Morningstar Rating: 2-star | Economic Moat: Narrow

New Zealand-based power company Genesis Energy reported a weak first half in February, but Atkins sees the headwinds as only temporary.

Genesis is the largest energy retailer in New Zealand, operating a mix of hydroelectric, coal-fired and wind power stations.

Low rainfall hit the company's hydroelectricity output during the half, as did planned outages at its Kupe oil and gas field.

But Atkins expects "normalisation" of these matters in the second half will drive a better result, and tips the company to deliver on the lower side of management's guidance of between NZ$360 million and NZ$380 million.

He left his fair value estimate for the company unchanged at NZ$2.40 a share following the first-half result.

Atkins notes Genesis's interim dividend payout rose 1 per cent to NZ$8.52 a share as free cash flow increased to 93 per cent from 76 per cent a year earlier. This increase came despite the fall in earnings.

"Genesis' retail division is performing relatively well, and we expect this to continue," he says.

"EBITDA increased 16 per cent to NZ$64 million in the half despite customer numbers falling 2.2 per cent."

Atkins is upbeat about management's response to this fall in customers, viewing it as prioritising profitability over market share: "As the biggest energy retailer in New Zealand, we're not concerned by the loss of low-value customers."

Australian-listed utility stocks covered by Morningstar

Spark Infrastructure (ASX: SKI)
AGL Energy (ASX: AGL)
AusNet Services (ASX: AST)
Genesis Energy (ASX: GNE)
APA Group (ASX: APA)
Meridien Energy (ASX: MEZ)
Mercury NZ (ASX: MCY)