In the constant search for high-yielding stocks, the utility space frequently comes up in the conversation. Sure, the sector is pretty boring and slow-growing overall, but it can be counted on for stable returns and above-average dividend yields. This consistency and the search for yield in a low-rate environment are big reasons the industry’s stock returns have been strong lately, but many leading players have seen their share prices take a breather in the current market run-up.

The domestic utilities sector consists of four different industries. The first three include gas, electric and water utilities, while the fourth is a mix of the first three, known as diversified utilities. The most individual stock opportunities exist in the electric space, followed by the diversified group.

I recently spent some time checking out many of the players in each industry and have concluded that, for most investors, the diversified utility group is the best bet. There are a couple of key reasons for this. For starters, as the name implies, they are diversified across a number of different businesses. Additionally, they tend to be the largest players out there and can be counted on for stable sales and income to support generous dividend payments. Finally, state regulation ensures a modest return off the sales they make. As such, they are basically monopolies with guaranteed business where they operate.

The best utility in this space has a fair number of investment positives. It is one of the largest players in its region, has one of the highest dividend yields and returns on equity in the sector, and is also a large player in the environmentally friendly part of the market given its nuclear power generation capabilities.

#-ad_banner-#The company in question is Exelon Corp. (NYSE: EXC). Exelon operates in Illinois and Pennsylvania under the Commonwealth Edison and PECO Energy names. The company serves an estimated 5.5 million electric and gas customers, consisting of residents as well as large, medium and small businesses. The large and diversified client bases are positives, and though the geographic mix is a bit limited, there is potential for acquiring market share down the road.

M&A activity in the industry has heated up a bit lately, as firms interested in growth have been acquiring rivals that generate tons of cash. One of the biggest mergers recently was between Northeast Utilities (NYSE: NU) and Nstar (NYSE: NST) in a $17.5 billion deal that was announced in October 2010 and combines two of the largest utilities in New England.

Exelon’s current dividend yield is 5%, and offers a yield that is among the highest in the utility sector and well above the S&P 500’s average yield of less than 2%. Return on equity (ROE) during the past 12 months has also been impressive at just under 20%. Again, this is right up there as the highest ROE in the industry and bests the overall stock market’s ROE of just over 17%. Net income margins hover in the mid-teens, which is also impressive and demonstrates the appeal of being allowed to operate as a virtual monopoly.

Running a regulated utility requires billions of dollars to be spent in annual upkeep to maintain power production capabilities, but Exelon still manages to throw off nearly $3 billion in free cash flow each year. About half of this goes to paying the dividend and leaves room for management to start buying back stock again after a hiatus in 2009, which was likely due to the turbulent financial markets. Share repurchases have helped boost earnings, as they lower the number of shares outstanding and allow Exelon to grow per-share profits faster than sales.  

Action to Take —> Analysts expect Exelon to earn more than $4 a share for all of fiscal 2010, as well as 2011. Based on a recent share price of about $42, this represents a very reasonable forward price-to-earnings (P/E) multiple of about 10.6.

As I mentioned, sales growth is generally modest in the industry, and Exelon has been no exception, as it has grown in the low single digits (less than 4%) annually during the past five years. The company has managed to boost earnings about an 8% annual clip during this time frame. This suggests profitability and dividends can grow modestly over time, but the main reason to own Exelon is for its above-average dividend yield and downside protection, given its captive customer bases in Illinois and Pennsylvania.