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Our Outlook for Utilities Stocks

Utility demand and dividends come under fire.

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Dividends at several struggling utilities no longer proved sacred this quarter. Falling demand and tight credit markets led three utilities-- Constellation Energy (CEG),  Ameren (AEE), and  Great Plains Energy  (GXP)--to chop their dividends while many others left investors with no raise. We think this illustrates that not all utilities possess the defensive characteristics that marked the industry through much of the 20th century. Still, we think several utilities can provide defensive returns for investors through these challenging conditions.

Economically sensitive energy use continues to hamstring utilities in this cycle. Officially, electricity demand fell 0.3% in 2008, only the third time in the last 60 years that electricity demand has fallen. Industrial demand was off the most, falling 2.6% in 2008 back to levels last seen in the early 1990s. Particularly in the Midwest and parts of the Southeast, we saw double-digit declines in industrial usage in the fourth quarter as the weak economy led to manufacturing plant shutdowns. Any additional deterioration in U.S. manufacturing could further erode utilities' bottom lines in certain regions.

Falling demand and more costly credit markets are leading utilities to pare back capital spending plans. Recent reports suggest half of the utilities in the U.S. have cut or deferred capital spending plans for the next several years, representing some $8-$12 billion of investment per year. Utilities are canceling new power plant projects that are no longer necessary as demand has flattened, and they are delaying network upgrades to conserve cash. All of this could lead to slower growth in utilities' asset bases and earnings.

The one area of utility investment that remains resilient is transmission. Federal government incentives for these projects still offer value-creation potential, even in more expensive financing markets. These projects are less sensitive to demand and can provide customer benefits through lower power prices. Many of our current favorite utility picks, such as  Westar (WR),  Northeast Utilities (NU),  American Electric Power (AEP),  Allegheny Energy (AYE), and  NSTAR (NST), are forging ahead with large transmission projects that should boost earnings regardless of demand trends.

Plans also remain intact in several states for the first U.S. nuclear power plants in more than 20 years. Georgia passed a law allowing for ongoing recovery of costs in February, a measure similar to one in South Carolina that is essential for such expensive projects.  Southern Company (SO) and  Scana Corporation (SCG) should benefit from these regulations. Illinois and Missouri are both considering similar provisions.

Falling demand, stagnant natural-gas prices, and political uncertainty around environmental regulations in Washington, D.C., also have created more uncertainty for independent power producers. We still think low-cost producers such as  Exelon (EXC),  Entergy (ETR), and  Public Service Enterprise Group (PEG) should benefit even in this challenging market. Other companies with strong near-term hedge positions such as  Mirant (MIR) and  NRG Energy  (NRG) could benefit if energy prices begin to rally beyond 2009, as the futures markets and our research indicate they should.

Despite the challenging market conditions, we think several utilities listed below possess those defensive characteristics that many investors expect from the industry. Strong regulatory relationships, credit market access, and low-cost operations are some of the keys we think will separate the best utilities from the rest of the pack and help investors earn strong returns through the bear market.

Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.77, down 9% from December. Although we view utilities as significantly undervalued, we also consider it the most expensive sector (on a price/fair value basis) in our coverage universe.   

 Utilities Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%)

Uncertainty
Percentile**

Electric Utilities 4.0 0.76 0.86 -11.6 26.0
Natural-Gas Utilities 3.6 0.81 0.84 -3.6 23.6
Water Utilities 3.5 0.80 0.95 -15.8 31.5
Data as of 3-13-09. *Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

Demand patterns and energy prices are key in determining which utilities will outperform in 2009. The sharp fall in spot natural gas prices during the last three months and President Barack Obama's unveiling of an aggressive environmental policy proposal ( ) led to a drop in stock prices for most of the independent power producers. However, we generally maintain our opinion that many of these power generators have substantial upside beyond 2010 because of the supply-demand imbalance that could emerge in the power and natural gas markets.

A faster-than-expected economic recovery could produce considerable upside for both independent power producers and regulated electric and natural gas delivery firms. Even favorable weather conditions in 2009 could lift earnings for many of these companies. Currently, we expect a second consecutive year of falling electricity demand in 2009 followed by a recovery in 2010. Those utilities serving areas with resilient energy demand or that have less demand-sensitive earnings should outperform.

Our Top Utilities Picks
Independent power producers with low-cost operations and strong near-term hedges are in a strong position, in our opinion. That group includes 5-star picks  Exelon (EXC) and  Mirant (MIR), and 4-star picks  Entergy (ETR) and  Public Service Enterprise Group (PEG). Among regulated utilities, we think historically high dividend yields and cash flow growth potential at  Westar (WR),  Southern Company (SO),  Northeast Utilities (NU), and  NSTAR (NST) can provide strong investor returns through this downturn.  

Although we believe the long-term fundamentals for the utilities industry are solid, we have assigned a 5-star rating to only seven of the firms we cover. As the economy recovers, however, we could see more-attractive opportunities emerge among some of our top merchant and regulated utilities. As such, we recommend keeping these stocks on your radar screen.

 Top Utilities Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Dividend
Yield %

Exelon $76 Wide Medium 4.7
Westar $27 Narrow Medium 6.9
Southern Company $34 Narrow Medium 5.5
NSTAR $35 Narrow Medium 4.8
Northeast Utilities $26 Narrow Medium 4.4
Data as of 3-19-09.

 Exelon (EXC)
Because of its low-cost nuclear power plants, Exelon is the only utility we cover that has earned a wide-moat rating. Despite a fall in power prices, we believe Exelon's long-term fundamentals remain intact. Management has demonstrated a long-standing commitment to creating shareholder value through stock repurchases and dividend hikes. As of March, Exelon had hedged substantially all of its power production and fuel costs for 2009 and 2010. This should lend stability to Exelon's earnings in today's turbulent market.

 Westar (WR)
A stable, constructive regulatory environment in Kansas underpins a 10-year, $3 billion capital investment plan Westar began in 2006. Two thirds of that build-out is either complete or fully approved, and the company is only now beginning to collect the higher returns on those projects. As rates adjust higher in 2009 and 2010, we expect Westar will post industry-leading earnings growth and returns.

 Southern Company (SO)
Southern has garnered envious regulatory relationships by providing comparatively cheap, reliable power to its customers. As a result, the firm enjoys industry-leading allowed returns on equity. 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.

 NSTAR (NST)
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 firms available.

 Northeast Utilities (NU)
Transmission investments are the primary growth driver at Northeast Utilities. It recently raised its dividend 12% behind the cash flow being generated from just-finished transmission lines stretching across Connecticut. New projects with incentive regulated returns throughout New England could provide earnings growth for the next five years regardless of economic conditions. Tough New England renewable energy goals provide additional growth opportunities.

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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.