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Our Outlook for Utilities Stocks

Financing, demand, and fuel price concerns have besieged the utilities sector.

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Three negative developments have seized the utilities sector, and there are no signs of relief on the immediate horizon. The first is the tightening of credit. While creditworthy utilities are still able to raise money, their cost of borrowing has risen by 300 to 500 basis points. Costlier credit is worrisome given utilities' reliance on debt to finance their capital-intensive operations. In theory, regulated utilities should be able to recover steeper financing costs through commensurately higher rates. But with consumers in a pinch and the number of pending rate cases already at a multidecade high, utilities may have a hard time convincing regulators of their woes. Inadequate rate increases could, in turn, lower utilities' credit standing--thereby raising their cost of financing and exacerbating the original problem.

Declining demand is a second head wind for most utilities. As the recession deepens, hard-hit industrial and commercial customers are dialing back their power consumption at double-digit rates. Households, particularly in weak real estate markets such as Florida, are also trimming their electricity use. Until the economy recovers, lower sales volumes will be a reality across the utilities sector. Because of their largely fixed cost structure, the corresponding decline in revenues will carry a leveraged impact on utilities' earnings.

Plummeting fuel prices are a third challenge. Following a sharp rise in the first half of 2008, oil and natural gas prices have sunk on weak demand. While lower fuel prices will benefit those regulated utilities, such as  PNM Resources (PNM), that had struggled to recover high fuel costs, their damping effect on power prices will lead to margin contraction at unregulated merchants. Unless we experience a cold winter or hot summer (which would boost gas prices), even the best merchants could face trouble.

In response to these head winds, utilities across the sector have revised their capital expenditure plans.  FPL Group (FPL)--a large, A-rated utility--is a case in point. The Florida-based utility slashed its planned 2009 capital spending by a substantial 25%. While lower capital spending should help preserve returns at some utilities, a smaller earnings base will mean lower future profits. Renewable energy projects appear to be the first to have gotten nixed or delayed; declining demand means a less pressing need for new power sources, while limited access to capital has shackled companies' ability to get projects off the ground. The precipitous drop in oil prices, meanwhile, has dented the political urgency to develop alternative energy. And with Washington's finances so thinly stretched, subsidy-dependent technologies appear shakier ventures than before.

Despite these challenges, we see long-term value in the sector. Among the established baseload merchants we cover, we believe  Mirant (MIR),  Exelon (EXC),  PPL (PPL), and  PSEG (PEG) are all underpriced. Our thesis for these firms centers on our long-term bullish outlook for natural gas. As gas prices recover, we expect power prices to rise and margins to expand. Prominent buyout offers for  NRG (NRG) and  Constellation (CEG) suggest other market participants also see value in this subsector. Among regulated utilities, we continue to steer investors toward those utilities with stable rate structures, steady demand, and capital spending plans that regulators have already agreed to include in rates.  NSTAR (NST),  Westar (WR), and  Southern (SO) stand out along these lines.

Valuations by Industry
The median price/fair value estimate for the electric and natural gas utilities sector now stands at about 0.85, which is relatively flat year to date. Although we view utilities as somewhat undervalued, we also consider it the most expensive sector (on a price/fair value basis) in our coverage universe.

 Utilities Valuations

 Price/Fair Value*

Three Months
Electric Utilities 0.86 0.83 3.6
Natural-Gas Utilities 0.84 0.87 -3.4
Water Utilities 0.95 0.85 11.8
Data as of 12-15-08. *Market-Weighted Harmonic Mean

In addition to company-specific regulatory developments, at least four difficult-to-predict macro variables will impact utilities' earnings--and hence valuations--going forward. The first is interest rates. Until the second half of 2008, persistently lower interest rates made utilities' executives reluctant to ask for new rates for fear that regulators would cut allowed returns on equity. But falling equity prices and rising credit spreads now leave executives hoping for every opportunity possible to raise rates and allowed returns. In this environment, those utilities that are able to pursue rate cases will do better than their peers, in our view. A second variable is the availability of credit. If credit remains constrained, so too will utilities' capacity to expand their rate base and thus grow earnings. Third, continued commodity price volatility will impact utilities' margins, depending on their ability to recover input costs through regular rate adjustments. Fourth, general economic conditions will drive demand for power and therefore impact sales volumes and earnings.

Utilities Stocks for Your Radar
We continue to advise investors who are seeking exposure to a possible upswing in power prices to opt for those merchants with low-cost generation assets.  Exelon (EXC),  Public Service Enterprise Group (PEG), and  PPL (PPL) are good examples. Those investors seeking the relative stability of regulated utilities should, as before, focus on companies that operate in supportive regulatory environments. These include  Westar (WR) and  NSTAR (NST).

Although we believe the long-term fundamentals for the utilities industry are solid, we have assigned a 5-star rating to only two of the firms we cover. As credit markets stabilize and the economy recovers, however, we could see more-attractive opportunities emerge among some of our top merchant and regulated utilities. As such, we recommend keeping these stocks on your radar screen.

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

Dividend Yield (%)

PPL (PPL) $45 Narrow Medium 4.6
Exelon (EXC) $76 Wide Medium 3.9
Westar (WR) $27 Narrow Medium 6.2
Southern Company (SO) $41 Narrow Medium 4.7
NSTAR (NST) $36 Narrow Medium 4.3
Data as of 12-16-08.

 PPL Corporation (PPL)
With one of the largest fleets of low-cost coal and nuclear generation in the U.S., PPL dominates the central Pennsylvania power markets. Falling Mid-Atlantic power prices and operating stumbles in late 2008 caused it to fall short of reaching its full profit potential this year. But strong forward hedges and changing Pennsylvania power market regulation still provide good earnings clarity through 2011. If coal prices retreat and natural gas prices rise, PPL should produce strong returns for investors.

 Exelon (EXC)
Because of its low-cost nuclear power plants, Exelon is the only utility we cover that has earned a wide-moat rating. Despite a fall in power prices, we believe Exelon's long-term fundamentals remain intact. Management has demonstrated a long-standing commitment to creating shareholder value through stock repurchases and dividend hikes. As of November, Exelon had hedged substantially all of its power production and fuel costs for 2009 and 2010. This should lend stability to Exelon's earnings in today's turbulent market.

 Westar (WR)
A stable, constructive regulatory environment in Kansas underpins a 10-year, $3 billion capital investment plan Westar began in 2006. Two thirds of that build-out is either complete or fully approved and the company is only now beginning to collect the higher returns on those projects. As rates adjust higher in 2009 and 2010, we expect Westar will post industry-leading earnings growth and returns.

 Southern Company (SO)
Southern has garnered envious regulatory relationships by providing comparatively cheap, reliable power to its customers. As a result, the firm enjoys industry-leading allowed returns on equity. 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.

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 firms available.

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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.