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Our Outlook for the Utilities Sector

Interest-rate-driven jitters have unearthed several buying opportunities.

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Carbon taxes, an aging transmission grid, renewable portfolio standards, demand-side management initiatives, and the possibility of a nuclear renaissance are topics that have donned the covers of several major news publications during the second quarter. They also had utility investors running on a euphoric high as the possibility of permanently higher power prices and an unprecedented infrastructure boom presented opportunities to all players within the industry. Consequently, our fair value estimates were running below market valuations for most of the quarter until an old trump card was pulled from the deck--rising interest rates.

As 10-year Treasury rates quickly jumped from 4.75% to 5.25% in early June, the utility sector dove nearly 10%, and regulated utilities fell more than their diversified peers. Regulated utilities have long been regarded as bond substitutes for many reasons. Their income streams are highly predictable, allowed returns are typically indexed to Treasuries, and their dividend yields generally ebb and flow in tandem with bond yields.

However, we believe the sell-off was overdone, and we now see a considerable opportunity for income-oriented investors to scoop up some shares of below-average-risk companies while they are cheap.

Valuations by Industry
The median price/fair-value estimate for utilities now stands at 0.97, and while it is only modestly undervalued as a whole, it is now the most undervalued sector in our coverage universe. While the table below illustrates that there is no single subsector that stands head-and-shoulders above the rest, electric utilities now hold the highest number of, and most attractive prices for, 5-star plays in the industry.

 Utilities Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Electric Utilities 3.12 0.97 63
Natural-Gas Utilities 3.06 1.00 17
Water Utilities 2.50 1.06 2
Data as of 06-15-07.

We remain long-term believers in electric utilities' ability to deploy unprecedented amounts of capital into infrastructure investments in North America over the next decade. We also believe that regulated utilities will be able to fetch allowed returns on equity greater than or equal to about 11%, because the need to attract capital to the industry remains high. Although we will readily concede that rising interest rates pose a threat to the relative attractiveness of these investments--and that we are not in the business of predicting where rates will go--we have found several bargains in this market, all the while using a risk-free interest rate assumption of 5.5%, or some 40 basis points higher than today's 10-year Treasuries.

Utilities Stocks for Your Radar
The market's recent sell-off of quality names has created selective buying opportunities that we believe offer both strong growth and dividend yield prospects. Recurring themes within these investment opportunities include strong rate-base growth opportunities, improving regulatory structures that are lowering operating risk profiles, and Wall Street's tendency to overlook smaller regulated companies as it keeps both eyes focused on the more volatile merchant power sector.

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

Yield

AGL Resources $48 Narrow Below Avg 3.9%
Hawaiian Electric $28 Narrow Below Avg 4.8%
Great Plains Energy $35 Narrow Below Avg 5.7%
Consolidated Edison $57 Narrow Below Avg 5.0%
PG&E $54 Narrow Below Avg 3.0%
Data as of 06-22-07.

 AGL Resources (ATG)
Our only 5-star natural-gas distribution company carries below-average risk along with growth prospects that are stronger than those of its peers. AGL's innovative rate designs largely shield the company's cash flows from consumer consumption habits, including weather and price-induced conservation. Despite the resulting income stability, regulators have still allowed the company to collect returns commensurate with its peer average. Given its strong dividend yield with above-average growth prospects, we think investors should strongly consider buying the shares while they are still cheap.

 Hawaiian Electric (HE)
A combination of rate relief, new generation capacity, and an upward-sloping yield curve should improve the fortunes of this troubled utility/bank over the coming years. There are pending rate cases at each of its electric subsidiaries, and interim relief has so far been supportive. On the bank side, we anticipate net interest margin expansion as the yield curve normalizes. Although we do not expect any near-term dividend increases, Hawaiian Electric yields a relatively attractive 4.4% at our fair value estimate.

 Great Plains Energy (GXP)
Great Plains will increase generation capacity at twice the rate of load growth over the next five years, helping to fuel solid earnings expansion. The firm's upcoming acquisition of Aquila's electric assets will further strengthen its competitive position, in our view. Because these assets lie in an adjacent concession area, Great Plains should be able to integrate them more effectively than any other potential purchaser could have. Moreover, as a greater proportion of Great Plains' business comes under the regulated fold, the overall risk to future cash flows will diminish.

 Consolidated Edison (ED)
Con Ed is poised to invest heavily in its aging utility infrastructure and, in turn, generate higher regulated earnings. Given the firm's outstanding reliability record and New York's strategic national importance, we expect regulators will accommodate the bulk of the company's recent request for a $1.2 billion rate increase. Con Ed's dividend yield--4.1% at our fair value estimate--is above average in our utilities universe.

 PG&E (PCG)
California state regulators have reversed course since the energy crisis of 2000, and so have the fortunes of PG&E. Regulators have called upon the company to deliver $10 billion of infrastructure investments that should earn an attractive 11.35% return on equity.

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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.