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Goodbye Safe Haven?

Risk avoidance drives utility stock performance.

Fortnightly Magazine - March 2009

Utility stocks historically have been a safe haven, a stable, long-term investment for widows and orphans. However, with banks collapsing and the economy falling into a recession, utility stocks as a whole recently have performed poorly, with our portfolio of 75 companies 1 losing $200 billion in market value in 2008.

While the Dow Jones Utility Index slightly outperformed the Dow Jones Industrial Average, (by 4 percent, -30 percent vs. -34 percent), total shareholder returns (TSRs) were abysmal. Only eight companies in our portfolio produced positive TSRs. Given the impairments in the markets and the significant tightening of credit and cash availability—even for utilities with strong credit ratings—the overriding factor driving individual company performance was perceived risk ( i.e., the amount of unregulated, relatively risky, cash-intensive businesses vs. regulated electric and gas utility businesses).

This thinking is reinforced by an analysis of merger and acquisition activity. While two previously-announced deals were completed (Great Plains Energy’s merger with Aquila closed in July; and Iberdrola, S.A.’s acquisition of Energy East closed in September), the only new activity was related to potential acquisitions of companies requiring additional liquidity, whose stock prices had decreased to the point of making them attractive buy-low opportunities. This was the case for Constellation Energy’s proposed sale to MidAmerican Energy, which was terminated (with a breakup fee) in favor of EDF Group’s offer to acquire just under 50 percent of Constellation’s nuclear business. Another example was Exelon’s proposed hostile takeover of NRG Energy, a deal that continued evolving at the time of this writing.

Figure 1

In evaluating TSRs, 75 utility companies were categorized according to their asset mix, business focus, and corporate strategies, into the same sub-segments analyzed in previous years: energy delivery (companies in the regulated “wires and pipes” business, either electric or electric and gas), gas distribution (companies only in the “little pipes” business), integrated gas (companies operating across the natural gas value chain—gas production and marketing, gas processing, interstate pipelines and storage, and gas distribution), power generation (companies primarily focused on developing and operating unregulated power plants), and integrated gas and electric (companies that have power plant assets as well as electric and gas delivery assets and customers).

Also, given the down market in 2008, the analysis evaluated companies based on their market-to-book ratios, to understand how utility value investors performed in 2008 (or can expect to perform in 2009).

Balance Sheets Matter

In the five sub-segments, TSR performance differed substantially from the 2005 through 2007 period compared to 2008 (see Figure 1) . The integrated gas and power generation companies, with their greater upside and risk, were the strongest performers in the 2005 through 2007 period and the weakest performers in 2008. Similarly, the gas distribution and energy delivery utilities, with their relatively

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