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Our Outlook for the Utilities Sector

Regulated utilities are bearing the brunt of today's high-cost environment.

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Although we remain buoyant about merchant utilities' prospects, recent trends in the regulated space worry us. A growing number of firms in this group are finding themselves pinned between rising commodity costs on one side and unaccommodating regulators on the other. We would not be surprised to see margins contract over the next several quarters as these twin pressures come to bear.

Today's high commodity prices carry a double punch for some regulated utilities--cutting into profits at those firms that lack a timely fuel pass-through mechanism, while indirectly raising the cost to build new infrastructure just when it is needed most. In the first camp are utilities such as  PNM Resources (PNM), whose inability to pass fuel costs along to consumers has dragged returns on equity into the low single digits. Construction cost inflation is a broader challenge. In the next few years, most utilities will have to invest significant capital to upgrade aging assets, meet rising demand, comply with environmental standards, or all of the above. Normally this would spell opportunity for utilities, whose very profit growth hinges on capital spending. But the sheer cost of new projects (by some estimates, 50% higher than just five years ago) heightens the risk that regulators will balk at commensurate rate increases--potentially leaving shareholders to foot the bill. Recent figures for nuclear plant construction underscore our concern. In early June, South Carolina utility  SCANA (SCG) disclosed projected costs for its two proposed nuclear units. The total, which came to a hefty $5,100 per kilowatt, supports our view that new nuclear plants are high-risk projects that utilities can justify only under the most advantageous regulatory structures.

A generally deteriorating state regulatory environment is a second source of concern. Average allowed returns have been trending down for years, but as consumer inflation rears its head, regulators may be tempted to hasten the decline in an attempt to shelter voters' pocketbooks. Public commissions in New York and New Mexico, for example, have already slashed allowed returns to their lowest levels in decades.

In light of these trends, we recommend two strategies for utilities-oriented investors. The first is to focus on merchant operators with low-cost generation assets. We expect power prices to rise as uncertainty surrounding carbon legislation delays new plant construction, and as the industry shuns coal in favor of more-expensive (but more environmentally palatable) natural gas. Existing generators that hold a structural cost advantage, such as nuclear-heavy  Exelon (EXC) and  Entergy (ETR), will be prime beneficiaries of higher electricity prices, in our view.

The second approach is to sift out those rare regulated utilities that 1) possess a fuel pass-through clause, 2) have locked in rates for several years (and can thus avoid petitioning for rate changes in the near future), and 3) do not face a pressing need for a major infrastructure build-out. A fourth plus is the ability to invest in transmission assets. As a FERC-regulated activity, transmission offers returns in the 12% range, versus 9%-10% for state-regulated generation and distribution. While there are some compelling exceptions, in general we believe these attributes will serve utilities well in the years ahead. At least one firm, Boston-based  NSTAR (NST), passes the test with flying colors.

Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.98, which is 5% higher year-to-date. At current prices, we view the sector as fairly valued on the whole. Although the table below suggests that we currently favor water utilities, our sample set for this segment is relatively small and therefore less meaningful.

 Utilities Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Electric Utilities 0.96 0.92 4.3
Natural-Gas Utilities 1.00 0.96 4.2
Water Utilities 0.92 0.85 8.2
Data as of 06-13-08.

As global demand for electric power marches upward, we foresee significant capital spending needs in the U.S. and abroad. Moreover, 29 states have mandated renewable portfolio standards. These will necessitate unprecedented levels of investment in alternative energy sources. In light of today's high costs for raw materials and labor, the challenge facing utilities will be to earn an adequate return on these investments. Their ability to do so is uncertain, as it will depend largely on regulatory support for higher customer rates.

Utility Stocks for Your Radar
We would advise investors seeking exposure to elevated power prices to opt for entrenched merchant players with low-cost generation assets. Among these, we favor nuclear over coal, given the former's carbonless footprint.  Public Service Enterprise Group (PEG) is a good example. We suggest that those investors seeking the relative stability of regulated utilities limit themselves to companies in areas with historically favorable regulatory environments, such as  Southern Company (SO), NSTAR, and  Wisconsin Energy (WEC)

Although our outlook is positive for several utilities in our coverage universe, none currently receives our 5-star rating. But a drop in natural-gas prices, or rise in interest rates, could create buying opportunities among merchant and regulated utilities, respectively. As such, we recommend keeping these stocks on your radar screen.

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

Yield (%)

Sempra Energy $68 Narrow Medium 2.3
Southern Company $41 Narrow Low 4.7
NSTAR $36 Narrow Low 4.0
PSEG $54 None Medium 2.7
Wisconsin Energy $48 Narrow Low 2.2
Data as of 06-20-08.

 Sempra Energy (SRE)
Sempra's deployment of capital into energy trading and leading natural-gas infrastructure leave the company with few true peers. The firm's timely investments have translated into high returns on invested capital, a rarity in the utility space. We believe that today's share price is allowing investors to grab a piece of an attractive enterprise with several years of double-digit earnings growth.

 Southern Company (SO)
Southern has garnered envious regulatory relationships, which in turn result in industry-leading allowed returns on equity, by providing comparatively cheap, reliable power to its customers. Southern's strong earnings growth prospects, rock-solid financial condition, and appealing dividend yield justify its place as a core holding in most income investors' portfolios.

 NSTAR (NST)
We think Boston-based NSTAR, a fully regulated transmission and distribution utility, will continue to outshine its peers. NSTAR's strength is its predictable, rising cash flow. Strong cash flows, in turn, have translated into an impressive record of dividend increases. We expect the firm will continue its dividend growth at a healthy 5%-6% pace for at least the next five years. For risk-averse, income-seeking investors, we think NSTAR is among the most attractive options available.

 Public Service Enterprise Group (PEG)
Public Service Enterprise Group, which is the largest utility in New Jersey, benefits from rising power prices in the Mid-Atlantic. The company's merchant generation segment derives rising profits from its low-cost nuclear and coal plants primarily located in New Jersey. As demand for power generation in the state rises and no new power plants are built in the region, PSEG is best-positioned to capture higher returns. We expect near-term earnings growth to exceed 10% annually.

 Wisconsin Energy Corporation (WEC)
We think Wisconsin Energy presents investors the opportunity to capture above-average growth with low uncertainty. Past underinvestment in infrastructure has generated regulatory support for a plan to invest $2 billion in new projects between 2008 and 2009. These investments will expand the company's asset base, and hence its earnings, at a clip that far exceeds demand growth.

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