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Utilities Look Towards Growth Outside Their Comfort Zones

Stability. It’s why dividend investors buy utility stocks. No matter the economic environment, we still need to keep the lights on and our air conditioners running. And while there are some demand fluctuations with how the economy is doing, electricity demand is pretty stable. As a result, the sector has been able to hand back much of its cash flows to investors as large dividends. The sector proxy Utilities Select Sector SPDR (XLU) is currently yielding more than 4%.

However, recently there have been cracks starting to form in that stability when it comes to the largest utilities. Various efficiency measures, increased regulation and new distributed grid technologies are starting to hinder the potential for growth at many of the largest utilities.

But some utilities have a plan – and it’s not fighting the effects of the Clean Power Plan. Instead, it’s a calculated bet on revitalizing their business models, and moving beyond only electricity generation for their profits, revenues and cash flows. (For more on the Clean Power Plan, check out: How Will Utilities Be Affected If Donald Trump Wins? )

In the end, it could mean big things for investors, and also the sector’s ability to pay and grow their dividends.

Marvelous Midstream

What do Southern (SO ), Duke Energy (DUK ) and Dominion (D ) all have in common? That is, aside from being three of the largest power generators in the country and having the goods to be top-notch dividend stocks. If you guessed “future natural gas rock stars” then pat yourself on the back. All three have recently completed major deals to buy natural gas distributors.

Southern paid $12 billion for AGL Resources; DUK is currently closing on buying Piedmont Natural Gas Company (PNY); and Dominion added Questar to its mix.

At first blush, these deals seem pretty boring. The buys are basically adding gas utility operations into an electric company, but that’s where the ‘boringness’ of the deals ends. Sure, they pick up plenty of residential and industrial customers, but they also pick up something even better – miles and miles of interstate pipelines.

Take SO’s deal for AGL. By adding the firm into its umbrella, Southern gained control of thousands of miles worth of pipelines, salt cavern storage facilities and even a liquefied natural gas (LNG) liquefaction facility. The deal instantly made Southern a huge midstream player in moving natural gas. More importantly, those are all the kind of assets that a firm could put into a master limited partnership (MLP). Southern will be able to realize huge tax savings on its newly acquired midstream portfolio. Meaning more dividends for shareholders.

Monthly oil consumption graph

Duke’s and Dominion’s purchases echo a very similar song as Southern’s. In fact, D’s CEO Thomas Farrell made it known that “it was the MLP-eligible assets that particularly caught Dominion’s [our] attention.” It’ll be able to drop Questar’s 3,500-mile network of transmission pipelines right into Dominion Midstream Partners LP (DM).

The Real Reason for Midstream

Given the reasons discussed, electricity demand is showing some longer-term down trends. In order to offset this weak demand, the big utilities are looking towards rising natural gas demand to provide them with a regulated and growing stream of revenues/profits. Unlike electricity demand, natural gas is growing by leaps and bounds.

Ironically, one of the biggest reasons for that is electricity generation. As various regulations have continued to zap coal demand and the number of coal-fired power plants, utilities are looking to natural gas to fill the void. As a result, moving natural gas from producing areas and into a power plant is big business. The deals give the utilities some major intrastate pipelines and gathering systems that will move the gas from production areas towards end users.

By doing this, the new midstream-based utilities are able to balance their revenues and profits, and find growth in a flat industry. By chucking them into a MLP, they are able to realize just that much more from the cash flows. And let’s not forget the opportunities to boost earnings even further by upgrading aging pipelines and expanding infrastructure to meet demand. (Want more midstream muscle? Please read: Enbridge’s Mega-Merger Will Result in Dividend Gold)

The Utilities Get a New Lease on Life

At the end of the day, investors looking at the so-called ‘boring and stable’ utilities are getting much, much more. They are finally getting a real chance at serious dividend growth and to potentially offset dwindling electricity demand/revenues.

The obvious play here are the three utilities mentioned in this article: SO, DUK and D. All three have made the commitment to add midstream to their portfolios. They’ll be the first to see rising cash flows – and everything that comes with that – which makes them an ideal starting point.

However, they aren’t alone. Mega-utility DTE (DTE ) recently made its plans to acquire gas pipelines known, while Ameren Corp. (AEE ) has been snooping around the various GasCo’s. Even boring sector stalwart Consolidated Edison (ED ) could make a move soon, given its operating area.

The point is that the utilities are quickly moving beyond only providing electricity, and into something more. Investors should catch the change into midstream.