After all of the gyrations of the market in 2011, it turns out that utilities were the best-performing sector of the S&P 500 last year, posting 15% returns. So far this year, however, utilities have missed out on the broad market rally. These stocks are down roughly 2%  while the S&P has risen 11%.

But investors shouldn’t forget about these dependable income stocks. In fact, I’ve found some utilities that yield as high as 6%, which is nothing to sneeze at. Consider the fact that stocks in the S&P 500 currently yield an average of less than 2%, while 10-year Treasuries yield slightly above 2%.

#-ad_banner-#The reason utilities are off to a slow start is the unusually mild winter, which caused U.S. households to use 9% less electricity than the previous year. Lower sales squeezed utility profit margins. But the longer-term outlook of the utility sector is good. Energy demand is expected to rise, which will likely push utility stocks up. As a result, analysts expect utility sector earnings to rise an average of 4% to 6% a year, with similar growth in dividend payments.

And right now, investors can take advantage of this situation by purchasing utility stocks at discount prices while locking in exceptionally high yields and watch their dividends grow.

With this in mind, I went looking for utility stocks with strong cash flow, capacity upgrades and expansion plans in place, and generous yields. Here are three I find especially attractive…

1. Pepco Holdings (NYSE: POM)
Yield: 6%
Pepco Holdings Inc. is one of the largest energy utilities in the Mid-Atlantic region, serving about 2 million customers in Delaware, the District of Columbia, Maryland and New Jersey. Pepco supplies electricity, natural gas and energy management services to its customers.

Despite lower energy demand, Pepco was able to deliver 2% earnings growth in 2011 to $283 million, compared with $277 million in 2010. This growth was primarily the result of rate increases, higher margins on electricity sales and reduced interest expense.

Pepco also invested $900 million in infrastructure upgrades and plans to invest about $5.6 billion during the next five years in energy distribution and transmission systems improvements.

The company has filed for rate increase approvals in three states. If approved, Pepco’s annual earnings should see a 10% boost. These rate increases are expected to go into effect in mid-2012.

Pepco pays a $1.08 annual dividend and yields just under 6%. Cash flow provides three-fold coverage of the dividend. In the past five years, dividend growth has been just 1%, but analysts say future earnings gains, projected at 4%-5% a year, can support rising dividends.

2. PP&L Corp. (NYSE: PPL)
Yield: 5%
PP&L controls 19,000 megawatts of power-generating capacity and delivers electricity and natural gas to about 10 million customers in the United States and the United Kingdom.

The company has aggressive plans to improve capacity generation. Last year, it acquired two Kentucky utilities and bought a Pennsylvania power plant just last month.
In 2011, the company registered a strong performance by its U.K. subsidiary and was benefited by a favorable Supreme Court ruling that allowed PP&L to be refunded the rent money it used to pay the state of Montana for its hydroelectric operations in the Missouri River. These two events alone resulted in nearly 60% earnings growth compared with the year before, bringing in a total of $1.5 billion, and a 25% growth in earnings per share (EPS) to $2.70. Consensus analyst estimates predict 5% earnings growth   in each of the next five years. 

PP&L’s dividend payout is less than one-third of cash flow, and the company recently hiked the dividend 3% to a $1.44 annual rate. This was the eighth dividend increase in nine years. PP&L shares yield roughly 5% based on the new dividend rate.

3. The Southern Co. (NYSE: SO)
Yield: 4%
Southern Co. owns more than 42,000 megawatts of power-generating capacity and is the largest generator of electricity in the Southeastern United States. The company provides electricity to 4.4 million retail customers in Alabama, Florida, Georgia, Mississippi and the Carolinas.

Southern has a more diverse revenue stream than most utilities: it also owns wholesale power marketing, along with fiber optics and wireless communications businesses.

Southern’s earnings rose 12% to $2.2 billion in 2011 from $1.97 billion in 2010, while earnings improved 8% to $2.57 per share in the same period. Earnings were higher because of a utility rate increase in Georgia and the signing of new long-term contracts that increased margins on natural gas sales. 

The Southeast markets Southern serves are growing faster than other regions of the country. The company also benefits from automakers such as Kia and Mercedes-Benz, which are building new manufacturing plants in the region.

In the next three years, Southern plans to invest $14 billion in transmission systems and expansion of power-generating capacity. Management targets 5% to 7% earnings growth in each of the next five years. Analysts say the company can easily deliver 6% annual earnings gains. 

Southern delivers much faster dividend growth than most utilities. Dividends have grown more than 40% in 10 years. The last dividend hike was a 4% increase last April to a $1.89 annual rate, with another increase likely to take place this year. Payout is modest at less than 30% of cash flow, which leaves plenty of cushion for more dividend growth.

Risks to consider: Pepco may not be granted its request to hike rates this year. In addition, the company is raising funds through an equity offering that is dilutive to shareholders. Southern plans to build nuclear plants in Georgia, but is encountering roadblocks from environmental groups that want to block its construction.

Action to take –> Though the three utilities I mentioned here are great investments, my top pick overall is Southern Co. because it offers the best prospects for high dividend growth. Southern is also more diversified, has a foothold in faster-growing Southeastern markets and a stellar dividend record. Pepco and PP&L are good picks for investors who want safety, high income and improving growth.