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Why Utilities Lack Spark

By Justin McCann and Craig Shere, CFA On Aug. 5, Standard & Poor's lowered its recommendation for the utilities sector to underweight from market weight. Although the sector outperformed the S&P 500-stock index in the first half of 2003, we expect it to underperform the index over the next 6 to 12 months. The boost from the tax cut on dividends has faded, and we expect significant dividend increases only from the financially strongest companies. Rising interest rates are also a negative factor.

We see normally modest growth for regulated operations restricted by an unfavorable regulatory environment and rising pension, health-care, and insurance costs. We also see limited near-term benefits from unregulated units. Our decision to lower our recommendation on the sector is based largely on the electric-utilities industry - which makes up about 70% of the entire sector.

We changed our outlook for electric utilities from neutral to slightly negative. We expect these stocks in 2003 to gain in the mid- to high-single digits, which would indicate a slight to modest rise from current levels. As of Aug. 1, the S&P Electric Utilities index was up 5.5% year-to-date, after declining 18.2% in 2002.

WEATHER WASHES OUT. Earnings per share are being diluted for those electric utilities (or their parent holding companies) that issued new equity in order to strengthen their balance sheets and maintain their investment-grade credit ratings. And while the weather can have a very significant impact on a utility's earnings, the better or worse than expected "weather-related" result rarely has an impact on the stock price.

Virtually all EPS projections are based on "normal" weather, and the "above normal" or "below normal" tend to balance each other out over the long term. It's the unexpected major announcement, be it positive or negative, that usually has the biggest impact on the price of the shares, in our view. S&P does not have any 5 STARS (buy) recommendations on the electric-utility stocks we cover.

We're more optimistic about prospects for multi-utilities comprising natural gas distribution and exploration and production (E&P) operations (see BW Online, 5/1/03, "More Juice for This Utilities Sector"). In addition, we think the beleaguered unregulated energy merchant group has begun to show both fundamental and technical signs of recovery. Our favorite position in the volatile energy merchant group is Williams Cos. (WMB), which we see as a leader in asset sales, risk-management, and longer-term business planning, and rate 5 STARS. McCann follows electric utilities and Shere follows natural gas utility and independent power company stocks as analysts for Standard & Poor's

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