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Quarter-End Insights

Our Outlook for Utilities Stocks

Few attractive yields remain after the sector's fourth-quarter run.

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Going into the fourth quarter, utilities were the forgotten sector of 2009. They had largely missed out on the post-March market rally, and by early November, we thought utilities offered income investors an attractive total return prospect. Many dividend yields approached 5% and higher, and the spread between U.S. Treasury yields and utility sector dividend yields climbed to near-historic highs. But the market did not miss this anomaly for long. Since November, the utility sector has rallied 10%, and we no longer feel the sector offers the compelling total return package that was available just a few months earlier.

Inflation remains the biggest threat on the horizon for utilities. The U.S. industrial production report in November showed a fifth consecutive monthly gain. Absent the negative contribution from weather-affected utilities, we think this indicates strong signs of an economic recovery. That can be both a boon and a bear for utilities. An economic recovery should drive increased electricity demand, especially from the industrial sector where power demand fell more than 10% in 2009. But if the recovery spurs inflation, utilities could find it more costly to raise capital and procure raw materials for infrastructure investment. As bond yields start to climb, we are increasingly worried that utilities--especially the fully regulated, high-yield utilities--will underperform the market again in 2010.

We continue to see two distinct paths for firms within the utility sector. Those with significant exposure to market-based commodity power prices should have opportunities to boost margins as natural gas prices rise from lows reached in 2009. A return to more normal (warmer) summer weather in the Eastern U.S. also should boost power demand in 2010. Additionally, we expect that more regulation from Washington, D.C., could lead companies to start shutting down small, inefficient coal-fired power plants. All of these factors should boost demand and tighten supply for electricity, lifting power prices.

Our favorites to benefit in this scenario remain  Exelon (EXC),  NRG Energy (NRG),  Mirant (MIR), and  Allegheny (AYE).  Entergy (ETR) and  Public Service Enterprise Group (PEG) also could be worth revisiting if valuations improve. Each of these firms possesses low-cost generation assets in supply-constrained regions that could realize substantial margin expansion as power prices rise. We will be watching closely as Entergy prices the spin-off of its nuclear operations late in the first quarter, pending New York regulatory approval in February.

We see less upside among the fully regulated transmission and distribution utilities. These were the primary beneficiaries during the sector's recent two-month run, and we now think most are fairly priced for a return to a normal inflationary environment. Within the group, we favor those utilities with topnotch regulatory structures that can adjust for inflation and rising finance costs. Utilities such as  Westar (WR),  National Grid (NGG), and  NSTAR (NST) have rate structures that either explicitly adjust for inflation or allow annual rate increases for major expenditures, reducing the need to finance lags between cash invested and cash collected.  Southern Company's (SO) strong regulatory relationships and measured growth plans would make the stock attractive if prices dipped 10% from current levels.

Valuations by Industry
The median price/fair value estimate for the utilities sector now stands at 0.98, up 4% from September. We consider utilities slightly overvalued (on a price/fair value basis) relative to other sectors in our coverage universe. Ongoing macroeconomic headwinds and regulatory uncertainty, balanced against what we think are still-attractive yield spreads over U.S. Treasuries, lead us to consider the industry fairly valued on the whole.

Given our bullish outlook for power prices in 2011 and beyond, we think independent power producers and diversified utilities, which include companies with large merchant power generation exposure, offer the most attractive valuations. Fully regulated utilities are fairly priced, in our opinion. As such, we see limited opportunity for capital appreciation. We note, however, that several utilities offer attractive current income and dividend growth potential. On a market-weighted basis, we assign a relatively high certainty to our fair value estimates for utilities. We give the sector a 10.8 fair value uncertainty rating out of 100, with 100 being the most uncertain. This is in line with our uncertainty ratings last quarter.

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

Uncertainty Percentile**

Electric Utilities 2.92 1.02 0.97 5.2 27.3
Gas Utilities 2.93 0.98 0.94 4.3 15.9
Water Utilities 3.00 1.15 1.07 7.5 20.5
Diversified Utilities 3.46 0.90 0.85 5.9 13.6
Data as of 12-14-09.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of each industry's underlying stocks.

The utility sector rally in November and December resulted in a 4% increase in our sector market-cap-weighted price to fair value estimate since September. In general we think the market now is accurately discounting utilities' earning potential. However, we think the market is missing the growth potential in diversified utilities such as Exelon and Allegheny and independent power producers such as NRG Energy and Mirant. In our view, the bullish fundamentals for natural gas and electricity demand could lead to significant margin expansion for these utilities during the next three years. On the regulated side, we think the market is fully valuing an uptick in demand in 2010 and regulatory risk that faces those firms with aggressive growth plans.

One area of utility investment that we continue to monitor with interest is power transmission. Federal government incentives for these projects offer attractive value-creation potential. These projects hinge less on demand and more on the need to ensure the long-term structural integrity of the power grid. Several of the utilities we regard highly--such as Westar, National Grid,  American Electric Power (AEP), Allegheny Energy, and NSTAR--are pursuing large transmission projects that should boost earnings regardless of demand trends.

Our Top Utilities Picks
Although we believe the long-term fundamentals for the utilities industry are solid, we have assigned a 5-star rating to only one of the firms we cover, and a 4-star rating to five. Eighteen utilities have a 2-star rating. As the economy recovers, we could see more-attractive opportunities emerge among some of our top independent power producers and regulated utilities. As such, we recommend keeping these stocks on your radar screen.

 Top Basic Materials Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Dividend
Yield (%)

Exelon Corporation  $73.00 Wide Medium 4.2
NRG Energy  $37.00 None High NA
Allegheny Energy  $31.00 Narrow High 2.6
Westar Energy $27.00 Narrow Medium 5.5
National Grid  $58.00 Narrow Medium 5.7
Data as of 12-21-09.

 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 today's weak 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. Exelon hedged substantially all of its power production and fuel costs for 2009 and 2010 prior to the recent collapse in margins, which should lend stability to the firm's earnings in today's turbulent market. We now are most focused on its ability to hedge in favorable economics in 2012.

 NRG Energy (NRG)
With one of the best near-term hedge profiles among independent power producers, NRG should have strong earnings momentum going into what we think will be a more favorable commodity cycle in 2011 and beyond. Its power plants in Texas, California, and the Northeast are located in supply-constrained markets that should benefit from an economic rebound and continue producing strong margins even with the threat of carbon-emissions restrictions looming.

 Allegheny Energy (AYE)
We think Allegheny offers significant upside potential via its unregulated generation operations, while retaining a solid earnings platform through its regulated utility assets. Given its low-cost generation fleet and largely unhedged position in 2011 and beyond, we think higher power prices could be a massive profit driver for Allegheny's merchant business. On the regulated utility side, new transmission and distribution investments, coupled with ongoing cost control, lend further support to our positive outlook for the company.

 Westar Energy  (WR)
After suffering through its coolest summer in 40 years, we think this fully regulated Kansas utility has some impressive earnings growth stored up for 2010 and 2011. We think earnings should rebound some 35% in 2010 if summer weather returns to normal and industrial demand starts to pick up again. Beyond 2010, earnings growth from regulated investments in clean coal and renewables-related transmission should flow directly to shareholders through the company's favorable regulated rate structures. A current 5% dividend yield is well above the industry average.

 National Grid (NGG)
This U.K.-based regulated utility should benefit substantially from a shift away from fossil fuels and toward renewables in the U.K. and U.S. Northeast. Building high-return transmission grids on both sides of the Atlantic should drive strong earnings growth while favorable regulated rate structures protect those earnings from inflation through automatic adjustments. With a dividend yield near 6% and management's 8% dividend growth target through 2012, we think National Grid is one of the most attractive regulated utility investments still available.

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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.