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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

are sending the wrong message as utilities are also being called on to make significant capital investments to improve electric and gas infrastructure. We believe [the Federal Energy Regulatory Commission] and some states understand this, but others don’t and we are concerned that political pressure is driving short-sighted ratemaking.”

In fact, a month ago, Lehman Brothers analyst Dan Ford concluded in a research report that expanding capital programs and increasing cash shortfalls threaten company and shareholder returns. “With average valuations for regulated names at all-time highs as compared to the broader equity market and treasury yields, we see complications ahead,” Ford said. For example, the analyst found that the industry’s robust capital spending program exacerbates cash-flow issues, as capital expenditure levels look to settle above $50 billion a year, almost double the levels of 2004. Furthermore, free cash flows (FCF) appear negative by as much as $16 billion a year post- dividend, and negative $4 billion pre-dividend, in the next few years, according to the report.

“The need for external capital to fund dividends and capital programs is beginning to grow. We estimate that approximately $60 billion of external debt and equity funding will be necessary by the end of 2010,” Ford said. In addition, Lehman also was concerned with the need for regulated utilities to seek more frequent rate increases to fund rate-base growth. “Historically, more trips to the regulator, coupled with rate increase requests to fund larger capital budgets, have resulted in a compression of allowed returns and significant effects from regulatory recovery lag.”