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Our Outlook for the Utilities Sector

Merchant generation is back in vogue.

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Although we still appreciate the relative safety of regulated utilities compared with their unregulated peers, our outlook for the latter group has improved significantly over the past year given recent industry dynamics. High commodity prices combined with generation capacity growth that has failed to keep pace with persistently increasing power demand have brought the good times back to the merchant generation business. The excess supply glut of five years ago, brought on by too many natural-gas-powered initiatives to increase capacity, appears to have all but evaporated, which has endowed the industry's survivors with plentiful cash flows of late. Additionally, several factors have aligned that have led us to believe that the next few years could be even better for this once-battered subsector of the electric industry.

Utility executives are no longer pondering if carbon legislation will happen; instead, they are focusing on when and how much it will impact power prices. The consensus is that power prices will indeed be higher and that the relative burden will be carried by coal generation, which currently accounts for half of the nation's power generation. While natural gas also emits carbon dioxide, its relative contribution is significantly lower and will thus recognize a relative benefit to coal generation. This has prompted several traditional coal-focused utilities, including  Southern (SO),  Exel Energy (XEL), and  Energy East (EE), to abandon environmental retrofit plans on some of their existing coal fleet, instead opting to build new efficient combined cycle gas plants.

Prolonged debate over greenhouse gas legislation is also leading to delays in power plant construction decisions, further shifting the supply and demand balance in favor of merchant power producers. Power demand continues to lumber forward while companies have shelved their construction plans until they have additional insight into future market constructs. Unless considerable construction planning is initiated expeditiously, already-thin capacity margins could fall even further in the Northeast and Texas. This would likely lead to higher power prices--and fat profit margins for producers--for at least five more years. Further complicating proposals to build new plants are rising engineering, procurement, and construction costs: We estimate that the overnight costs to construct a new coal facility are already 40% higher today than just four years ago.

The biggest beneficiaries of the carbon debate, in our opinion, are existing nuclear power plants, given their carbonless footprint and extremely low fuel costs in the face of rising power prices. Based on the appealing economics of the business, we recently upgraded  Exelon's (EXC) moat rating to wide, making it the only utility we cover with such a distinction. Other utilities that we cover with appealing exposure to nuclear power include  Entergy (ETR),  Constellation Energy (CEG), and  Dominion (D).

Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.98, which is only modestly undervalued as a whole and little changed from the third quarter. Although the table below illustrates that we currently favor natural-gas distribution companies, selective opportunities remain in the electric sector as well.

 Utilities Industry Valuations
Segment

Median
Price/Fair Value

Three Months
Prior
Change 
(%)
Electric Utilities 0.98 0.97 1%
Natural-Gas Utilities 0.92 0.93 -1%
Water Utilities 0.93 0.93 0%
Data as of 11-16-07.

We see ample opportunities for both regulated and merchant utilities to grow over the next several years. In the fourth quarter of 2007, the first wave of new nuclear plant applications hit the offices of the Nuclear Regulatory Commission, and it now expects to see as many as 21 applications through 2009. We also expect further investments in renewable energy sources, mandated largely by individual states' renewable portfolio standards, to address our needs for additional electric capacity while maintaining a minimal carbon footprint. Although we'll readily concede that rising credit spreads and the threat of inflation increase the risk of these multibillion-dollar projects, regulators who wish to ensure grid reliability have no appealing alternative to granting adequate allowed returns that compensate utilities fairly.

Utilities Stocks for Your Radar
Even though we believe that the merchant generation sector's prospects have improved recently, we still have not assigned any of these stocks our 5-star rating. Should this winter be mild, like those of the past two years, today's already-high natural-gas storage levels could cause weakness in natural-gas prices, which would also result in lower power prices. We would deem such an event a buying opportunity, and thus we recommend keeping the following stocks on your radar screen. The fundamental generation supply issues facing the nation would outweigh any short-term blips in commodity prices, in our opinion. We also see some appealing prospects within the regulated space that would be appealing to both income- and total-return focused investors alike.  

 Stocks to Watch--Utilities
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Yield

Edison International $69 Narrow Average 2.0%
Enersis $23 Narrow Above Avg 3.3%
Atmos Energy $31 Narrow Below Avg 4.8%
PG&E $54 Narrow Below Avg 3.0%
Data as of 12-11-07.

 Edison International (EIX)
Edison International, which owns Southern California's largest electric utility, benefits from utility-friendly California regulation. Like its neighbor to the north, PG&E, we think Edison can create billions of dollars in value for shareholders during the next decade by earning favorable regulated returns on the capital it plans to invest in California's power infrastructure. Edison investors also should continue to benefit from the company's low-cost merchant generating plants in the Midwest, which we think can continue producing 50%-70% gross margins as power prices continue to rise.

 Enersis (ENI)
A balanced mix of generation and distribution assets positions Chile's Enersis to profit handsomely from South America's fast-growing demand for power. We think Enersis' dirt-cheap hydroelectric assets give it an edge over competitors that rely more heavily on higher-cost thermal plants. On the distribution side, regulated rates ensure steady cash flow. Above-average business risk cools our enthusiasm somewhat. Enersis is vulnerable to a depreciation of major South American currencies, and while the Chilean economy is comparatively sound, the firm derives nearly two thirds of operating income from less-stable regional markets.

 Atmos Energy (ATO)
Atmos Energy is the nation's largest utility focused solely on natural-gas distribution, with a growing Texas pipeline division to boot. By diversifying its earnings across 12 states, shareholders are insulated from adverse regulatory rulings in any single state. With weather-normalized rates in most of the company's jurisdictions, we believe the company's operating cash flows are safer than those of most utilities we cover. Throw in continued strong performance from the company's competitive businesses, and Atmos continues to find growth avenues that do not require immense capital expenditures.

 PG&E (PCG)
California's growing electricity demand and the strictest renewable energy requirements in the country support our high-growth, high-return forecast for Pacific Gas & Electric during the next five years. Regulators already have approved a five-year, $14 billion of capital investment program through 2010 with customer rates that support 9% total returns. As long as PG&E keeps its operating and capital costs in line, investors should enjoy a long stretch of value creation.  

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Paul Justice does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.