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The Top Utility Stocks: New Challenges Ahead

Utilities showed strong gains last year, but other industries are gaining ground.

Fortnightly Magazine - March 2007

in power generation, either regulated or unregulated or both) also had strong performance.

In comparison, the Gas Utilities and Energy Delivery groups had returns significantly less than the other groups. A significant portion of the TSR for companies in these groups is in the form of dividends. And so, with returns of 48 percent (Gas Utilities) and 40 percent (Energy Delivery), these groups’ stock-price performance significantly underperformed relative to the Dow Jones Utility Index which was up over 70 percent from the 2004 to 2006 period. What does that say about the attractiveness to investors of pure play, regulated energy distribution businesses? Or was the 2004-2006 period an anomaly?

Looking Forward: Another Strong Year?

After Enron’s fall and the collapse of the sector, each utility has its own story. Some need to retrench and rebuild; some highlight the fact that they have always been about the “basics.” However, going back to 2003, some have recorded four straight years of solid stock-price gains.

So, entering 2007, several key questions emerge:

1. Overall, are utilities due for a correction vis-à-vis other sectors?

2. Will the appeal of steady but lower earnings growth and dividends appeal to investors?

3. Are there industry dynamics that will impact the attractiveness of utilities to investors?

There are many issues that may impact any one company. However, there are a few issues that will affect almost every utility company and, potentially, shareholder performance.

The first issue is constraints on greenhouse-gas, or GHG emissions. GHG legislation is anticipated widely within the next couple of years, perhaps linked to changes in Congress and the administration. GHG constraints in the form of cap-and-trade or a tax will have one immediate effect—higher energy prices. The higher prices will force electric utilities (recall the TSR groups considered) to move away from higher-GHG emitting power plants—that is, away from coal-fired power plants. In the long term, higher prices also eventually will lead to lessened demand (Economics 101). But in the short term, higher prices will translate into negative public reaction and related media attention. In other words, coal-burning electric utilities likely will be seen as culprits in terms of both GHG emissions and higher prices. This has the very distinct possibility of translating into TSRs from an investor perspective.

The second issue relates to the need for significant investment in generation capacity in the coming years. The need for new capacity is connected somewhat to the GHG issue but has some additional twists. Last year, most regions of the country experienced new records in terms of peak electricity demand. This summer many regions are bracing for another set of records. Higher demand calls for new power-plant capacity additions. Estimates for required incremental capacity vary, but it’s safe to assume that many new power plants will need to be constructed and, therefore, financed. To finance the new construction, utilities will need to issue new common stock. Although the timing and link between “growth” and new investment, and returns on that new investment are complex, Economics 101 would suggest that an excess supply of new shares could