Our Outlook for the Utilities Sector
Interest-rate-driven jitters have unearthed several buying opportunities.
Stock Strategist
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After the Enron and California energy crisis lows shortly after the turn of the century, a five-year rally in utility stocks surged on the heels of an industrywide trend toward risk aversion and improving balance sheet integrity. With dividend payout and debt/capital ratios at decade-lows, and cash flow integrity that is largely unaffected by recessionary factors, regulated utilities today embody the defensive characteristics for which they've traditionally been known.
Fundamental events that have been garnering headlines--such as upgrading an aging and fragmented transmission grid, adding much-needed generation capacity, and planning for carbon legislation--took a back seat to the turmoil in credit markets during the third quarter for utilities. When 10-year Treasuries ramped up to 5.25% from 4.75% in early June, the broader utility industry fell by 10%, unearthing several bargains, in our view. However, when 10-year Treasuries subsequently dropped to 4.4% in August, utilities fell even further. This perplexing deviation from historical correlations, which we view as a temporary increase in market risk aversion, left us with a dozen 5-star utility stocks. While many of our favorite names have rallied above our Consider Buying prices since the Fed's most recent 50-basis-point rate cut, we still have a few names left that appear both cheap and defensive in a tumultuous market.
Valuations by Industry
The median price/fair-value estimate for utilities now stands at 0.96, which is only modestly undervalued as a whole and little changed from the second quarter. While the table below illustrates that we currently favor natural-gas distribution companies, selective opportunities remain in the electric sector as well.
| Utilities Industry Valuations | |||
 | | | |
| Segment | Average | Median Price/Fair Value | Stocks Covered |
 | |||
| Electric Utilities | 3.18 | 0.97 | 65 |
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| Natural-Gas Utilities | 3.60 | 0.93 | 16 |
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| Water Utilities | 3.50 | 0.93 | 2 |
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| Data as of 09-19-07. |
No matter which path the economy takes in the near term, we see no other cure for America's aging electrical infrastructure than significant capital investment. In the fourth quarter of 2007, we expect to see the first wave of new nuclear plant applications to hit the offices of the Nuclear Regulatory Commission. We also expect further investments in renewable energy sources, mandated largely by individual states' renewable portfolio standards, to address our needs for additional electric capacity while maintaining a minimal carbon footprint. Although we'll readily concede that rising credit spreads and the threat of inflation increase the risk of these multibillion dollar projects, regulators that wish to ensure grid reliability have no appealing alternative to granting adequate allowed returns that compensate utilities fairly.
Utilities Stocks for Your Radar
Despite the sector's rally following the Fed's most recent rate cut, selective buying opportunities remain that we believe offer both strong growth and dividend yield prospects. Recurring themes within these investment opportunities include strong rate-base growth opportunities and improving regulatory structures that are lowering operating risk profiles.
| Stocks to Watch--Utilities | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | Yield |
| |||||
| AGL Resources |  | $48 | Narrow | Below Avg | 4.0% |
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| Hawaiian Electric | | $25 | Narrow | Below Avg | 5.8% |
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| SCANA | | $46 | Narrow | Below Avg | 4.5% |
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| Atmos Energy | | $33 | Narrow | Below Avg | 4.5% |
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| PG&E |  | $54 | Narrow | Below Avg | 2.9% |
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| Data as of 09-25-07. |
AGL Resources
This 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's yield remains considerably higher than many of its utility peers'.
SCANA
SCANA's fleet of highly efficient nuclear and coal plants in South Carolina allows it to supply electricity that is far cheaper than market-rate electricity produced from natural-gas power plants. By sharing some of this profit spread with customers to keep power bills low, SCANA has been granted reliable regulated rates of return that are amongst the highest in the U.S. As SCANA builds out its infrastructure to serve one of the fastest-growing populations in the U.S., it will be able to capture these high returns over a much larger capital base and grow profits and dividends at an above-average rate.
Atmos Energy (ATO)
Atmos Energy is the nation's largest utility focused solely on natural-gas distribution, with a growing Texas pipeline division to boot. By diversifying its earnings across 12 states, shareholders are insulated from adverse regulatory rulings in any single state. With weather-normalized rates in most of the company's jurisdictions, we believe the company's operating cash flows are safer than most utilities we cover. Throw in continued strong performance from the company's competitive businesses, and Atmos continues to find growth avenues that do not require immense capital expenditures.
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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