While many of the small-cap stocks in Bottom of the Barrel are growth plays, some readers have asked if it's possible to build a small-cap income portfolio.
Indeed it is, and with this week's profile,
Empire District Electric
, the Bottom of the Barrel Income Portfolio debuts. We'll profile a new small-cap income play each month.
Empire fits the bill perfectly. It is a regional electric utility delivering juice to a 10,000-mile area where Arkansas, Kansas, Missouri and Oklahoma converge. For investors, Empire delivers a 6%-plus yield and a strong commitment to continue the payout.
Basic Power, Basic Story
The Empire story isn't complex. The company has been doing the same thing, generating and delivering electricity, since 1909 and serves 450,000 residents. While electricity is Empire's primary business -- more than 99% of revenue comes from power -- it also provides water, residential security and local fiber-optic services, and has a specialty lighting business.
For investors looking for stability, Empire may be your grandfather's utility. The company wasn't lured into the promising growth of deregulated energy or into a telephony trap to boost earnings. Instead, it remains content as a regulated utility, growing its power base as industry develops around its core cities like Joplin, Mo.
Empire's growth profile isn't meteoric, but it is impressive by utility standards. In the 1990s, Empire's customer base grew by 30% and electricity consumption increased more than 45%. Growth will continue as annual population growth is estimated at 1.6% in the future.
Empire generation mix is also conservative. Its generation portfolio of more than 1,000 megawatts is fueled 55% by coal and 42% by natural gas. A small hydro project and 162 megawatts of contracted power purchases complete the portfolio. To meet future needs, Empire will increase peak generation capacity by 100 megawatts by 2003.
Powering the Balance Sheet
Empire has faced challenges in the past two years. In 1999, responding to rapid changes in the power business, the company agreed to merge with based
. However, as regulatory approvals for the merger proved difficult, UtiliCorp walked away in 2001.
Not only was the merger a distraction, it also wasn't cheap. "We entered into the merger as a strong company," wrote Empire CEO Myron McKinney in the company's 2000 annual report. "We left it only somewhat weakened." Merger-related costs reached more than $5 million during the course of the dance with UtiliCorp.
At the same time, the capital-intensive nature of the business pushed Empire's debt-to-capital ratio above 60%, a level considered high for a stable, regulated electric utility.
Empire's new year should be revved up by a number of positive developments in the second half of 2001. With the merger-related distractions behind it, the company improved its balance sheet through an equity offering. In December, Empire sold 2 million shares at $20.37, using proceeds to reduce debt. The offering reduced Empire's debt-to-capital ratio to 59%, and the company's long-term goal is to reduce its debt-to-capital ratio to approximately 50%.
While Empire District is the quintessential staid electric utility, there are risks.
With Empire's 2001 earnings estimated at 80 cents, the $1.28 dividend looks rich. Recovery from merger-related charges in the next two years should provide earnings power and cash flow to cover the dividend, but mild weather and increased natural gas costs also affect earnings. If those factors pressure earnings further, Empire could be forced to revisit the payout.
Speaking of gas, Empire's natural gas purchase contracts with now bankrupt
could be in jeopardy. If Enron is unable to deliver and Empire is forced to purchase on the open market, rising gas prices could affect earnings. Empire recently secured a rate increase that will allow it to recover its fuel and purchased-power costs, as long as the cost remains below $30.60 per megawatt hour.
Finally, Empire stock isn't cheap. Assuming 2002 earnings of $1.50, it trades at about 14 times estimates, slightly above the average utility. Yet, the dividend of more than 6%, combined with the possibility that Empire would again be a merger target if consolidation is re-energized, could cause the small-cap's multiple to expand.
For conservative investors looking for small-cap income, we think Empire makes sense, especially below $20.50. The dividend appears safe, and, while fairly valued, earnings growth will support the stock. We give Empire 2.5 barrels.
The Dividend Portfolio
In addition to Empire District, we'll kick off the Bottom of the Barrel Income Portfolio by adding a previous Barrel stock to the portfolio:
with a 4.9% yield.
Speaking of Integra, the company preannounced 2001earnings of 40 cents to 45 cents a share vs. estimates of $1.40. The numbers include a loss of up to 79 cents in the fourth quarter -- compared with estimates of a 33-cent profit -- resulting from a loan portfolio restructuring.
Integra first appeared in this column, I listed three key points: While safe, the loan portfolio would be affected by lower interest rates; given the continued decline in interest rates, I'd wait to purchase the stock until fourth quarter results became clearer; and, I'd wait until the stock fell below $20.
Two of those conditions have been met. Yet, the
Fed appears likely to cut rates one more time later this month. While the stock is attractive and a partial position seems prudent, we would wait to commit further until the Fed acts and the company provides 2002 guidance at the end of the month. Barring the unexpected, the dividend appears secure.
The other previous pick of note is
Hibbett Sporting Goods
. Last week, Hibbett announced record holiday sales and a 3-for-2 stock split. As I noted during the dark days of December, it would pay to stay in the game. Since the pre-Christmas lows, the stock is up a tidy 45%, and 15% from our original recommendation. That said, retailers have had a nice run and the easy money is made.
Finally, two Barrel companies reported earnings Tuesday.
reported 70 cents, and
reported 8 cents, both for the fourth quarter and in line with estimates.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to