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Quarter-End Insights

Our Outlook for the Utility Stocks

Record energy prices, slowing demand rock the utility sector.

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Volatile energy prices grabbed all the headlines this summer and have been the topic du jour among utility executives and investors. By late June, spot oil and natural gas prices had nearly doubled since June 2007 and coal prices were up 160% year-over-year. These three fuels generate more than 70% of U.S. electricity production, leading to skyrocketing power prices, profits, and future outlooks for many merchant power producers.

However, several head winds have kept power producers from taking full advantage of this commodity price runup. Average retail electricity prices in the U.S. rose only 5% year-over-year in the second quarter. First, demand started to fall due to the economic slowdown, public awareness of high energy prices, and mild summer weather nationwide. Residential power use was down 4% year-over-year and total power consumption was flat. For a full year, power demand has not fallen since the 2001 recession. Second, firms' substantial hedges and contracted fuel purchases meant average fuel costs rose only 38% year-over-year through May 2008. Since market power prices are set at marginal costs, the more muted rise in actual fuel costs limited power price increases. Third, most generators with the most costly, oil-fueled plants shut down. Oil consumption at power plants was down 32% year-over-year through May, limiting the power price spikes--and large power generation profits--that can occur when oil-fueled plants must run to meet demand.

The subsequent fall in energy prices since reaching record peaks in early July should have a similarly muted effect on most of the well-hedged producers--with one exception. Coal prices have remained high while natural gas and oil prices are down 40% as of mid-September. As natural gas increasingly sets marginal power prices across the country, power producers with large coal fleets are seeing a sharp contraction in the so-called dark spread, the profit margin between realized power prices and coal fuel costs. Additionally, power prices for coal plants came down in July after a Washington, D.C., Court of Appeals ruling vacated certain environmental standards. For some coal plants, the ruling meant lower costs, but for others, it only meant lower prices and lower margins.

Among those companies experiencing the biggest stock price declines as a result of these contracting spreads are  Mirant (MIR) (down 38% from early July),  PPL Corporation (PPL) (down 27%),  Edison International (EIX) (down 20%),  Reliant Energy (RRI) (down 33%), and  NRG Energy (NRG) (down 28%). We believe this spread contraction along with continued mild weather should limit earnings growth during the critical third quarter when merchant generators typically make one-third of their annual profits. In the long run, we expect these spreads to widen again as natural gas fundamentals and power supply shortfalls in key areas of the country drive power prices higher.

For regulated utilities, lower new housing demand, higher energy prices and mild weather also is limiting earnings growth. Regulated returns for delivery utilities typically depend on base usage levels. If that usage level is not met, returns can sink below allowed levels. This demand reduction is even more critical for utilities that are experiencing rising costs for labor and infrastructure commodities such as wire and steel. If usage growth does not keep pace with cost inflation, utility returns suffer.

Internationally, two key trends have resulted in lower valuations for several of the Latin American utilities we cover: a strengthening of the U.S. dollar against the Brazilian real and Chilean peso, and rising inflation across the region. The former impacts ADR valuations as local currency-denominated earnings translate into fewer dollars for U.S. shareholders. The latter poses a risk to profitability. Utilities depend on regular tariff adjustments to cover rising costs. But as inflation picks up, government regulators may be inclined to limit rate increases in order to shield consumers from the rising cost of living. Brazilian utilities  Sabesp (SBS) and  Copel (ELP) are pertinent examples. Sabesp was granted a 5% tariff boost this quarter. But with inflation in Brazil pushing 6%, the increase was slightly negative in real terms. Copel, whose tariffs were reduced by over 3%, fared even worse. We still view the overall regulatory environments in Brazil and Chile as constructive but may revise our position if future tariff adjustments fail to keep pace with inflation.

Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.87, which is 11% lower year-to-date. At current prices, we view the sector as undervalued on the whole. Specifically, we think merchant power producers, a sub-industry within electric utilities, offer the most attractive value given their share price declines since July as natural gas prices have fallen 40%.

These valuation metrics show the market divergence that has developed between electric and natural gas utilities. Natural gas utilities, which are often thought of as the most stable, recession-proof utilities, have not suffered the same market price declines as their brethren in the power industry. We think this could be the market's flight to safety in uncertain economic times or a forecast of rising consumer demand in coming months based on falling gas prices. For example,  Piedmont Natural Gas (PNY) reported first-half results in line with our expectations yet its stock has jumped more than 20% since June. Big jumps like this can have a large effect on the industry metrics for this relatively small group.

Meanwhile, we think electric utilities could offer a compelling value for investors. Leading the way are the more-volatile merchant power producers, which we think will benefit from rising power, gas, and oil prices as demand begins to outstrip available supply. Regulated electric utilities also should benefit from growth investments in new infrastructure, rising long-term demand, and renewable energy requirements. Many states are adopting more accommodative utility regulation to support these growth opportunities.

Utility Stocks for Your Radar
In the long run, we think bullish fundamentals for natural gas and electricity will lift power prices and increase profits. This should reward companies with low-cost assets in key geographical areas. Among the more stable regulated delivery companies, we continue to direct investors toward those firms with stable regulatory structures and growing demand such as  Southern Company (SO) and  NSTAR (NST).

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

Yield (%)

Sempra Energy  $68 Narrow Medium 2.6
Southern Company $41 Narrow Low 4.4
NSTAR $36 Narrow Low 3.9
PSEG $53 Narrow Medium 3.6
Exelon $90 Wide Medium 2.9
Data as of 9-22-08.

 Sempra Energy (SRE)
Sempra's deployment of capital into energy trading and leading natural-gas infrastructure leave the company with few true peers. The firm's timely investments have translated into high returns on invested capital, a rarity in the utility space. We believe that today's share price is allowing investors to grab a piece of an attractive enterprise with several years of double-digit earnings growth.

 Southern Company (SO)
Southern has garnered envious regulatory relationships--which in turn result in industry-leading allowed returns on equity--by providing comparatively cheap, reliable power to its customers. 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 options available.

 Public Service Enterprise Group (PEG)
Public Service Enterprise Group, which is the largest utility in New Jersey, benefits from rising power prices in the Mid-Atlantic. The company's merchant generation segment derives rising profits from its low-cost nuclear and coal plants primarily located in New Jersey. As demand for power generation in the state rises and no new power plants are built in the region, PSEG is best-positioned to capture higher returns. We expect near-term earnings growth to exceed 10% annually. With the recent fall in natural gas and power prices, we think this presents a good buying opportunity for long-term investors.

 Exelon (EXC)
Exelon, our only wide-moat utility because of its low-cost nuclear power plants, recently fell below our "consider buying" price on concerns about falling power prices. However, we believe strong long-term fundamentals remain intact and shareholder returns should receive a boost from the company's recently announced $1.5 billion stock repurchase. This follows a $1.75 billion buyback executed since last September and a 14% dividend hike in December. As of July, Exelon had hedged substantially all of its power production for 2008 and had a higher percentage of forward power hedged than in recent years. A favorable regulatory decision in September for its Illinois subsidiary, ComEd, should remove concerns there.

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