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Utility Stocks Decline: Are the Bears Taking Over?

Some say the five-year love affair with the industry is at an end.

Fortnightly Magazine - July 2007

The Dow Jones Utility Index and C Three Index lost 5.84 percent and 4.63 percent, respectively, during the first six days of trading in June 2007—the steepest decline since February 2003. Surging Treasury yields primarily drove the early June losses.

Table 1 shows there were very few winners in the first eight days of June 2007 and many losers. Generally, the gas LDC sector was affected less by the increasing Treasury yields, while larger companies with more debt exposure were hurt the most.

While eight days does not make a trend, unless the Treasury market stabilizes, it is likely that the five-year market love affair with the sector in general could be over.

The late May and early June losses came on top of May losses from a specific sub-sector—those companies with significant coal exposure. During May 2007, those companies with the largest monthly losses were dominated by companies with significant coal exposure as Table 2 indicates. However, this issue has now been over-shadowed by the impact of the recent bond-market volatility.

Decoupling continues to gain steam in the LDC universe, driven by decreasing natural-gas unit sales per customer. However, the stock market continues to highly value this sector. Seven of the top 20 annual gainers are LDCs, and The C Three Group’s LDC index continues to outperform all but the Merchant Index for the past 12 months.

The old news is that the merchant sector remains hot. Rumors are now swirling about which utility will next go private, after Calpine rejected a privatization offer in early June.

Analysts: Down on Utilities

Is the party over? That’s the tough question posed in a research note by Wachovia equity research analyst Samuel Brothwell. He says robust valuations are out of step with falling ROEs, and regulated returns are under increasing pressure.

“While 11-percent allowed ROEs were the norm for utilities in 2003, allowed returns have consistently dropped in each of the past three years. Two rate orders [a month ago] continued this trend, with Allegheny Energy receiving a 10.5-percent allowed ROE and Sierra Pacific Resources getting 10.7 percent. Meanwhile, on May 24, an ALJ in New Mexico recommended a 9.53-percent ROE in a gas rate case filed by PNM Resources, according to the report.

Furthermore, Brothwell says valuation multiples have hit historic highs. Even as allowed ROEs were declining, the P/E (price-to-earnings) multiple (on a trailing 12-month basis) on the S&P Electric Utilities Index rose above 20x in 2006, up from about 12.7x in 2003.

“In our view, the recent divergence in movements of these two statistics could suggest it will be difficult for utilities to continue to outperform, absent some kicker from non-regulated businesses such as generation on the electric side or upstream exposure on the gas side,” Brothwell said in the report.

Brothwell believes that by doling out sub-par returns, “State regulators

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