September 22, 2008

At a shareholder meeting in May, FPL Group Chief Executive Lew Hay III told investors that pending carbon legislation could within a few years boost the company's annual earnings by $690 million a year, depending on how greenhouse gases are priced. FPL is the country's biggest supplier of wind and solar power and a favorite of analysts.

But all the potential in the world can't reverse a general business slowdown. FPL's share price was basically flat in the first half of 2008. Ironically, the utility with the biggest share price gain in the second quarter of 2008 was TECO Energy, which rode the increase in coal prices via its coal production businesses and un-hedged coal positions.

Utilities have used their return to financial prudence, steadily rising demand for energy and profitable deregulated businesses to transform themselves into growth stocks while keeping some of the old aura of reliability. The sector can "no longer virtually guarantee steady returns or a safe haven," writes Don Dion, a fund manager and publisher of the Fidelity Independent Adviser newsletters, in a recent blog. But it does "have the potential to continue growing."

Caught between two conflicting identities during a precarious period on Wall Street, it's not easy to tell which companies will win investors' hearts in the coming year. Roger Conrad, editor of the Utility Forecaster newsletter, says investors tend to look at the industry monolithically. While new and retooled generating plants, value-chain enhancements and promising handholds in renewable energy all appeal to investors, another appealing story, one that Conrad likes to tell, is a basic blocking-and-tackling strategy of expanding the local rate base.

Perhaps nothing will help utilities more than continuing the 15 percent tax rate on dividends past 2010. Since adoption in a 2003 tax act, that rate has allowed utilities to raise dividends, attract investors and put debt and equity back in rough balance. Duke Energy pays one of the highest dividends, 5.4 percent. With blood flowing in the financial sector, "I don't think you'll see anyone slashing dividends in utilities," says Christopher Muir, Chief Gas Utility Analyst at Standard & Poor's.

There are worries in addition to the housing and financial troubles and general economy. Over the long run, rising fuel and commodity prices will put some pressure on earnings. For the past three years, the Dow Jones Utility Average returned 9.2 percent through July 15, almost eight full points better than the Dow Jones Industrial Average and seven points better than the S&P 500. But the Dow Jones Utility Average was down 3.9 percent for the year, through July. And as a group, analysts believe the good times are done for a while. "We are primarily neutral on the utility industry now as far as dividend yield and capital appreciation," says Jon Kolb, a senior equity analyst for Zack's Inc., the investment rating company. "Utilities should benchmark the broader S&P."

Local Economies

That said, analysts believe the shares of several companies have potential for gains as 2008 fades into 2009. Distributor-generators Edison International and Sempra Energy both are flourishing with expanding rate bases in a supportive California regulatory environment. John Bryson, Edison's chief executive, says that the positive outcome involving pending rate cases will allow it to lock in an 11.5 percent return through 2010.

Big investments in solar and wind energy also bode well for Edison International. And profits from its unregulated generation and energy sales unit, Edison Mission Energy, are tied to commodity prices and the company's hedges.

Sempra Energy has gas and electricity distribution companies in and around San Diego and both agreed to rate case settlements that will add $197 million in 2008 and $96 million more each year thereafter until 2011. Sempra also has a pipeline and storage business, including liquefied natural gas terminals in Louisiana and Mexico whose services and revenue are already heavily booked, locking in revenue, says S&P's Muir. "It doesn't matter if the LNG flows through, they still will get paid."

Sempra should also profit from its commodities trading venture with Royal Bank of Scotland. Under the agreement, Sempra receives $350 million of the first $500 million in pretax earnings on the invested capital. "I like that and think that will be an important growth driver," Muir says. He set a target price of $70 for the company's shares when it was trading at $56.26 in early July.

One often-overlooked factor in a utility stock price is the local economy in which it operates and the willingness of regulators to pass on fuel price increases to consumers. While many states have automatic fuel price adjustment clauses, no two states are the same. Wall Street rarely recognizes the differences in local economies and regulatory relationships, but "companies unable to handle that can get really whacked," Conrad says.

There are other reasons some utilities and generators should gain value.

Entergy, which successfully rebuilt its local distribution companies in Louisiana and Mississippi following Hurricane Katrina, also has a big nuclear fleet that it plans to spin off. The nuclear fleet and overall effective rebuilding has convinced Zack's Kolb that its share price in 2008 could hit $130, up from $121.06 at the end of May.

But with many companies, the biggest asset is their customers. FPL Group, even though it had to scuttle its proposed merger with Constellation Energy Group, serves fast-growing and stable Florida utility markets. Zack's Kolb believes FPL Group can add more customers and expand generating assets and that they will drive earnings higher.

The overall utility sector has evolved from a steady, dividend-paying player to one that now provides a host of generation and delivery options. Shareholders will have fewer guarantees but they will have more growth potential.

More information is available from Energy Central:

• Utilities Dress up for Wall Street, EnergyBiz, May/June 2007

by Richard Korman
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