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Are Utilities' Dividends Worth the Worry?

We sort through the multitude of issues surrounding these stocks.

Haywood Kelly, 01/05/2010

Dividend yields for utilities look as attractive as ever. But trying to figure out what might happen to the sector if inflation returns, interest rates rise, commodity prices spike, or environmental legislation passes can leave investors pleading to higher powers. To help break these issues into digestible pieces, we talked with Travis Miller, the senior analyst in charge of Morningstar's Equity Research utilities team.

Haywood Kelly: You're bullish on power prices. Could you walk us through your reasoning?

Travis Miller: Like all commodities, power prices depend on two factors, the marginal cost to produce power and the market's supply-demand balance. On the cost side, marginal costs of power are closely tied to natural gas. During the past decade, utilities built many natural gas-fired power plants to meet rising electricity demand. Now, in most markets, the cost to buy natural gas is the primary compo­nent of marginal cost and is the key determi­nant of power prices. We do not see that changing. We also think natural-gas prices could rise some 50% by 2012 as rising demand in an improving economy helps work off the current oversupply of natural gas in North America, boosting power prices commensu­rately. Caps on carbon emissions could lift prices further by raising marginal costs for natural gas- and coal-fired power plants.

On the power-demand side, weather and the economy are the key factors. Back-to-back years of cool summer weather in 2008 and 2009 as well as the economic downturn have damped electricity use. As the economy rebounds, weather conditions normalize, and consumers adopt new products such as electric cars, demand should rise, once again stressing a mostly fixed supply base of power plants. Blackouts in California and the Northeast during the last decade and annual power price spikes in Texas demonstrate the perils of stretching the supply/demand balance too thin.

HK: Which companies would stand to gain the most from this pricing scenario?

TM: We think two types of companies benefit from higher power prices. The clear winners are utilities with nuclear plants or renewable power generation in deregulated markets. The biggest U.S. nuclear owners include Exelon EXC, Entergy ETR, and Constellation CEG. Nuclear power has the lowest operating costs of any fuel-based power generation source. Moreover, nuclear costs are relatively fixed and are not tied to natural-gas prices. So as natural gas prices and higher electricity demand drive power prices higher, nuclear companies' operating leverage drives profits much higher. Large renewable power generation owners such as FPL Group FPL realize similar benefits. The second group of winners includes utilities that own highly efficient power plants in high-demand areas such as New York City; Washington, D.C.; Eastern Texas; and areas of the Northeast. Although these utilities do not have as much operating leverage because their costs often are tied to fossil fuel prices, they should nonetheless benefit from tight supply conditions in their regions. Utilities we think fall into this category are Public Service Enterprise Group PEG, Mirant MIR, and NRG Energy NRG.PAGEBREAK

HK: We've gone through a horrendous period of industrial demand for electricity. How important are near-term demand forecasts to your fair value estimates?

TM: As we discussed, demand forecasts are critical to our outlook for power prices. Demand forecasts also are critical for distribution utilities in regulated markets because demand drives investment needs and, ultimately, earnings growth. Through August, total U.S. power demand was down more than 4% year over year. If this holds for the full year, it would be just the fourth time in 60 years that annual usage has fallen, and it would eclipse the current record 2.8% decline in 1982. Among industrial customers, electricity use has fallen and then plateaued since the late 1990s. We think it will end 2009 down another 12%, for a 16% total decline since the economy entered the recession in 2007. That should correct a bit as the economy recovers, but we do not expect it to return even to 2007 levels. The largest rebound we expect to see is in weather-sensitive residential demand. Here, a reversal of cool summers in 2008 and 2009 could lead to a 3% jump in residential demand as well as a return to 1% to 2% annual demand growth. If consumers continue adopting electricity-hungry products, including electric cars, demand could rise even faster.

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