Our Outlook for Utilities Stocks

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• Deal activity among power producers remains hot, but few targets remain after $9.3 billion of announced deals this year in the United States and GDF Suez's GBP 6.0 billion takeout of U.K.-based International Power.
   
• Although regulated utilities offer historically attractive yields relative to long-term Treasuries, we think prospects for slowing earnings growth leaves most of these utilities fairly valued.
   
• Hot summer weather throughout the eastern U.S. should boost utilities' second-half earnings, especially against relatively cool summer weather in 2009.

Greenhouse gas legislation might have died in the U.S. Congress this summer, but global warming appears alive and well this year, particularly in the eastern United States. Ten states experienced their hottest summers on record including densely populated Delaware, Maryland, and New Jersey. Philadelphia, Washington, D.C., and New York City all set average summer temperature records in the third quarter. Texas set peak power demand records in early August. Overall, power generation was up 4.2% year to date through August and has recovered about 80% of the recession-related demand drop we saw from 2007 to 2009. Because utilities typically earn 40% of full-year income during the third quarter, the hot summer weather could lead many management teams to raise their full-year earnings forecasts.

The favorable weather-driven earnings outlook for 2010, low interest rates, and investors' quest for yield all helped the Morningstar Utility Sector index climb 9.0% on a total-return basis in the third quarter compared with just a 2.5% total return for the S&P 500. The utility index is up 1.6% year to date compared with a 4.6% drop for the S&P 500. The spread between average utility dividend yields at 4.5% and 10-year U.S. Treasuries reached a 19-year peak in late August, surpassing 200 basis points, suggesting attractive relative return potential. However, we think the potential for slowing earnings growth, and thus slowing dividend growth, and the threat of rising interest rates and higher dividend taxes leaves the sector mostly fairly valued and at risk for market-lagging returns during the next three to five years.

Industry-Level Insights
We continue to see the most value potential among independent power producers. A flurry of recent merger and acquisition activity supports our take that top picks such as  Mirant ,  RRI Energy , and  NRG Energy (NRG) are trading at half their implied net asset values as of mid-September. On a cash-flow basis, we continue to believe the three- to five-year outlook for these well-positioned firms is more attractive than the market currently believes. Still-soft natural gas prices have squeezed margins and likely will result in falling earnings for these firms through 2012 as higher-margin hedges roll off. But if the pending Mirant-RRI Energy merger,  Dynegy  buyout, and NRG Energy asset purchases close as expected in the fourth quarter, the consolidated firms will be well-capitalized and able to take full advantage of a cyclical upturn.

Fundamental indicators during the past quarter also support our bullish long-term outlook for power producers. The hot weather highlighted capacity constraints in key regions and the economic value of owning reliable, low-cost power plants. We also continued to see coal-to-gas fuel switching as gas prices remained at multiyear lows. And, importantly, the Environmental Protection Agency unveiled its proposals for noncarbon greenhouse gas regulations. Our initial analysis suggests some 53 gigawatts of U.S. coal plant capacity could shut down in the next five to 10 years, representing 16% of total U.S. coal capacity and 6% of total U.S. power-generation capacity. Already we've tallied 9.5 gigawatts of coal plant closures or accounting book write-downs that utilities have announced in the last year.

Regulated utilities continue working through the record number of rate cases filed in 2009. We saw mixed results from recent regulatory action involving  Northeast Utilities (NU),  Scana ,  Public Service Enterprise Group (PEG),  ConEd (ED),  Exelon (EXC), and  PPL (PPL). We were disappointed with the 9.4% allowed return on equity that Connecticut regulators approved for Northeast Utilities' Connecticut Light & Power; however, it should still contribute to earnings growth in 2011 as the utility improves on its recent 7% earned return on equity in 2009.

Other decisions clustered around the industry's 10.45% average allowed return on equity, but low interest rates threaten to extend the persistent fall in allowed returns that began in the late 1980s. Pennsylvania regulatory decisions for utility subsidiaries of PPL and Exelon were more constructive and support our earnings-growth outlooks for the delivery side of those diversified utilities. We still await decisions affecting  PG&E (PCG),  Southern Company (SO),  Constellation Energy , and  Portland General Electric (POR) this year.

 

Our Top Utilities Picks
Our three 5-star utilities as of mid-September (Mirant, Exelon, and FirstEnergy) posses substantial leverage to a cyclical upturn in power markets. All three face challenging near-term earnings pressure but have long-term growth potential that we think the market is ignoring.

We think most regulated utilities in our coverage universe are fairly valued right now. The only fully regulated utilities in our coverage universe that we think are undervalued as of Sept. 17 are Westar Energy,  National Grid (NGG), and Portland General. These firms have dividend yields higher than 5% and strong earnings-growth potential from projects such as environmental controls, renewable generation, and transmission lines that are less economically sensitive than traditional demand-driven growth projects in generation and distribution.

On a market-capitalization-weighted basis, the average sector price/fair value ratio is 0.96, up from 0.90 last quarter after the third-quarter sector rally. Several large undervalued diversified utilities such as Exelon,  FirstEnergy (FE), and  Entergy (ETR) skew this average lower. The median price/fair value ratio for the sector is 1.06. This reflects our view that the smaller, fully regulated utilities could underperform the large diversified utilities and IPPs in the next few years.

The utilities we highlight below feature high-quality assets, strong management teams, and good earnings-growth prospects. The 3- and 4-star picks reflect names we think investors should keep high on their watch lists.

Top Utilities Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Dividend Yield
Mirant		$21.00	None	High	NA
NRG Energy		$39.00	None	High	NA
Exelon		$67.00	Wide	Medium	5.0%
Westar Energy		$27.00	Narrow	Medium	5.1%
Southern Company		$36.00	Narrow	Low	4.8%
Data as of 09-17-10.

 Mirant 
Open power positions in 2010 and 2011 could result in margin contraction of 50% or more. But a rebound in power demand and energy prices has a leveraged effect on earnings in 2012 and beyond. Our power price and margin assumptions are based on near-term forward power prices and a midcycle natural gas price of $7.50 per thousand cubic feet in 2013. We also expect production increases in 2010 and 2011 as Mirant completes its environmental-control construction program and improves its economic dispatch. The company's $2 billion cash position gives it financial flexibility that other IPPs do not have. We think its proposed merger with RRI is slightly value-dilutive, but aggressive cost savings could negate that impact.

 NRG Energy (NRG)
We think NRG is an excellent pick for investors looking for an independent power producer with a high-quality management team and asset profile that will benefit from an improving U.S. economy and rising power demand. Its low-cost legacy power plants in Texas, California, and the Northeast still represent the bulk of the long-term value we see. But after nearly $3 billion of acquisitions during the past year, management has diversified its earnings profile with more natural gas generation, renewable energy, and countercyclical retail businesses. We think these moves preserve the firm's optionlike upside in more favorable commodity cycles while reducing its exposure to tighter environmental regulations. We expect the firm will finish 2010 with about $1 billion of cash after closing its announced deals.

 Exelon (EXC)
Operating leverage to rising power prices is huge at this wide-moat utility, the only one in our coverage universe. With its low-cost nuclear fleet, Exelon benefits more than any other utility from all of the long-term industry trends we're following, including post-recession demand rebound, tighter environmental regulation, rising natural gas prices, and higher power prices from tighter supply in constrained regions. With an enterprise value that is just 6 times our trough 2013 earnings before interest, taxes, depreciation, and amortization estimate, we think the market is ignoring this upside. We are most focused on the company's ability to hedge in favorable economics for 2012-13. A rebound in Midwest industrial power demand, higher gas prices, and normal summer weather would help. A 10% move in 2012 power prices from today's levels can translate into $800 million of incremental EBITDA. If politicians revive carbon-cap legislation, we estimate it could add $900 million of incremental EBITDA and $6 per share of value. The company's $1.2 billion of cash as of June 30 and management's long track record of value-creating stock buybacks and dividend hikes give us additional comfort.

 Westar Energy (WR)
After suffering its coolest summer in 40 years in 2009, this fully regulated Kansas utility, in our opinion, has some impressive earnings growth stored up for 2010 and 2011. We expect earnings to rebound some 35% in 2010 given the favorable summer weather and improving industrial demand. 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. Of its three-year $1.5 billion investment plan, $1.1 billion will be spent on projects that have preapproved annual-cost-recovery rate structures or are flexible enough to postpone if market conditions remain unfavorable. A current 5.1% dividend yield is well above the industry average.

 Southern Company (SO)
Southern's total-return proposition is among the more appealing in our coverage universe, especially for patient investors. At current prices, the dividend yields 5%, substantially above parent-company debt yields. Although economic growth in its service territories remains uncertain, the primary driver of our 5% earnings-growth forecast through 2012 is an enviable investment program revolving around environmental upgrades and transmission and distribution investments, much of which close to rates annually based on constructive regulatory mechanisms. This minimizes lag, protects equity returns, and justifies our premium 14 times 2011 earnings multiples at our fair value estimate. Southern's $615 million Georgia rate request filed in 2010 will be key.

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