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Dividend Power from Utilities

By Justin McCann President Bush said the compromise version of his drastically reduced tax-cut plan would be "good for American workers [and] good for American families." It might also be a good thing for investors in select electric utility stocks.

On May 21, the House and Senate hammered out a compromise agreement on the President's economic stimulus plan that includes a reduction in taxes on dividends as one of its key features. The $350 billion tax-cut package is expected to pass both houses of Congress and be signed into law on May 26. As part of the plan, the tax on dividends, now at the earned-income rate, would be cut to 15%, before a reversion in 2008 -- which we believe is unlikely -- back to the earned income rate.

While the cut is a plus for electric-utility stocks, which income investors have historically favored for their above-market dividend payouts, our outlook for the overall group remains neutral. After declining 18.2% in 2002, vs. a 22.5% decline for the broader S&P 1,500 index, the S&P Electric Utilities Index was up 7.7% year-to-date through May 16, compared to a 7% advance for the S&P 1,500. Assuming an improved economy in the second half of 2003, we expect the index to perform in line with the broader market.

BUCKING THE TREND. Dividends on electric-utility shares have actually been in a downtrend in recent years amid a spate of industry problems: economic weakness in their service areas, high levels of debt, severe liquidity problems, issuance of new equity that dilutes earnings per share, and federal investigations into their trading and accounting transactions.

We at S&P expect dividends for much of the industry to either remain flat or to increase slightly over the next several years, as companies attempt to balance their desire to enhance their dividends' appeal with the need to reduce their

payout ratios to below 65% of their earnings. Such a reduction would give them greater flexibility to lower debt and strengthen their credit ratings.

Against that backdrop, though, we believe some outfits will buck the trend, namely, the financially strongest members of the group. Because of their superior operating performance and balance sheets, we consider the dividends for these companies not only secure but likely to be increased. With attractive yields, we like Public Service Enterprise (PEG) with a yield at 5.4%, Progress Energy (PGN) at 5.1%, and DTE Energy (DTE) at 4.9%. Each of these companies is ranked 4 STARS (accumulate) by Standard & Poor's.

Given the multidecade lows in interest rates -- the current yield on the benchmark 10-year Treasury note is 3.35% -- the tax rate reduction lends added appeal to those shares for income investors. All in all, it pays to power shop. Analyst McCann follows electric utility stocks for Standard & Poor's

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