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Stock Strategist

Five Utility Stocks to Keep on Your Radar Screen

At the right price, these firms would be solid investments.

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Utility stocks have been on an impressive run over the past three years--the sector is up 23%, second only to energy. At Morningstar, we're sticklers for valuation; we think that the price investors pay for a stock is one of the most critical factors in making a sound long-term investment. This is especially relevant in utilities, where investors often bid up prices in their desire for high-yielding assets.

Because we're looking for stocks priced at a comfortable discount to our fair value estimate, utility stocks' outstanding performance has left us with few compelling investment ideas today. As of Aug. 4, the average price/fair value ratio for the 70-plus utility stocks that we cover sat at a discouraging 1.12. Highlighting this overvaluation, none of these stocks currently holds a 5-star Morningstar Rating for stocks. And just two are currently rated 4 stars: Huaneng Power International (HNP) and  United Utilities (UU).

That said, here are five stocks that we think are worth keeping an eye on. While none are currently available at what we would consider to be bargain prices, we would eagerly invest if prices fell to attractive levels.

If there's a central theme to our favorite utilities, it's location. A company's service territory has a major impact on its profitability. Utilities in areas with above-average population growth and a high concentration of residential customers have great potential for steady earnings expansion. (Residential customers are less price-sensitive than industrial customers and cannot easily seek out alternatives such as self-generation.) We also look for utilities that have friendly relationships with their regulators--a company cannot be profitable without a regulator that allows for a decent return on investment and an adequate pass-through of commodity costs.

The following five companies each have at least one of these desirable traits, and they all represent solid underlying utility fundamentals, which is exactly what we are looking for.

New Jersey Resources  (NJR)
Analyst: John Kearney, CFA
Fair Value Estimate: $42
Consider Buy Price: $35.80
From the  Analyst Report: New Jersey Resources exemplifies the stability and consistency that risk-averse, income-oriented investors look for. NJR's business is centered in its regulated natural-gas distribution subsidiary, New Jersey Natural Gas. This distribution business accounts for roughly 80% of NJR's operations and represents the heart of its stability. It is one of the fastest-growing local distribution companies in the United States, with customer growth averaging 3% over the past 10 years--well above the national average for natural-gas distributors. New customers have been the foundation of the company's growth, adding $6.5 million to margins every year. Perhaps even more impressive than its above-average growth has been New Jersey Natural Gas' ability to manage the business without relying on regulators for rate-base increases. While the company's regulators allow it to capture an 11.5% return on equity and to pass through natural-gas costs to its customers, the company has not received a rate increase in 10 years. Despite this, New Jersey Natural Gas continues to consistently increase its profitability.

Piedmont Natural Gas (PNY)
Analyst: Paul Justice
Fair Value Estimate: $25
Consider Buy Price $21.30
From the  Analyst Report: Piedmont's persistently simple operating model, strong regulatory relationships, and enviable service territory allow the company to generate highly consistent operating cash flows, making its low return potential respectable on a risk-adjusted basis. The company is a plain-vanilla distributor of natural gas to customers in the Carolinas and Tennessee that has avoided the nonregulated business traps that have plagued several of its competitors over the last decade. The firm enjoys a diversified customer base, with just under half of its operating revenues and earnings coming from residential customers. Add in the above-average population and economic growth, and it is no wonder why the area's consumption of natural gas is stable and growing. Piedmont has generated an 11.4% average return on equity over the past five years, which is better than the median natural-gas utility in our stock universe. Dependable earnings and a strong balance sheet lead to a steady and growing dividend. Piedmont has paid a dividend every year since 1956, and it has consistently increased its payout since 1978. The growth in natural-gas consumption in the Southeast suggests that dividend growth will continue to be above 5% for the foreseeable future.

FPL Group  (FPL)
Analyst: Mark Sadeghian
Fair Value Estimate: $39
Consider Buy Price: $33.20
From the  Analyst Report: Despite last year's brutal hurricane season, FPL remains an attractive utility thanks to its excellent growth prospects, sunny relationships with regulators, and diversified generation base. FPL's long-term competitive position is something to write home about. The company occupies one of the few high-growth service territories in the United States--greater coastal Florida, including Miami. This region should continue to enjoy above-average growth as the U.S. population migrates south. FPL's competitive position is reinforced by Florida's reluctance to deregulate its energy markets, as well as its geographical isolation. Furthermore, the firm has a favorable customer mix: Most revenue (54%) is derived from residential customers. FPL also has great relations with its regulators, which boosts its returns. The firm's unregulated merchant power business also offers good growth prospects. Although wholesale generation has been hurt by the glut of new power plant construction in the United States, FPL's portfolio enjoys the advantage of being the leading producer of wind energy in the nation, with nearly 3,000 megawatts of wind assets. Wind is increasingly important because of renewable portfolio standards, which mandate the use of "green" energy by various states. Wind energy should also benefit handsomely from Congress' extension of the production tax credit for alternative fuels.

KeySpan (KSE)
Analyst: Paul Justice
Fair Value Estimate: $40
Consider Buy Price $34.10
From the  Analyst Report: KeySpan continues to sharpen its focus on its bread-and-butter regulated utilities by shedding noncore assets. The high-quality earnings of its remaining regulated segments and an improving balance sheet make us enthusiastic about this solid utility. KeySpan is the largest distributor of natural gas in the Northeast and the largest electricity generator in New York State. Recently, the company cashed out of noncore businesses through the sale of its exploration and production subsidiary, the Houston Exploration Company, as well as Canadian transmission assets. We think the timing of the sales was optimal for KeySpan, given the recent run up in oil- and gas-related asset prices. Location is a primary driver of KeySpan's value as the company's assets lie in several generally desirable areas in the Northeast, including New York City, Long Island, and Boston. There are several reasons the Northeast offers an attractive platform. Rates in the region have historically been stable, and population growth in urban markets such as New York City is above average. In addition, low saturation in Northeastern gas markets--most residential users still rely on heating oil or electricity for heating--means that KeySpan could steal market share from competing fuels.

WGL Holdings (WGL)
Analyst: Elizabeth Collins
Fair Value Estimate: $31
Consider Buy Price: $26.40
From the  Analyst Report: WGL has an enviable customer base and is working on reducing the volatility of its earnings and cash flows. These factors, plus a steady and growing dividend, could make WGL a compelling investment. The company delivers gas to about 1 million customers in the Washington, D.C., area. It's an attractive market from the perspective of a utility company; It includes a growing number of affluent customers. Therefore, WGL has not been plagued by the bad-debt problems that many utilities have faced because of sky-high gas prices. In addition, WGL has relatively few industrial customers. While WGL shouldn't see many of its customers switching to other fuels, demand can slacken with warm weather or high prices. Progress on the regulatory front should alleviate some of the bad effects of conservation, however. The majority of WGL's latest regulatory rate increases will be added to the fixed charge on customers' bills; Weak demand won't hurt this portion of revenue. WGL is also working with regulators to include normalization adjustments. Finally, WGL plans to install a liquefied natural gas (LNG) storage facility to reduce the cost of obtaining gas. WGL's customers should benefit from lower gas prices, and the company avoids the ill effects of high prices--weak demand and bad debts.

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