Where Natural Gas Is Rising

It's a mixed picture for the sector, says Craig Shere of Standard & Poor's, who thinks Reliant Energy and AES are two of the brighter lights

Rising energy prices and interest rates are having an impact on stocks of natural-gas utilities, energy merchants, and pipelines, says Craig Shere, the equity analyst for Standard & Poor's who covers that area. The higher prices will benefit companies that extract natural gas but could have a negative effect on regulated utilities, in the sense that customers unable to pay higher utility bills could add to the bad-debt burden for the companies. Interest-rate costs will also hurt regulated utilities, whose customer base tends to increase slowly.

However, Shere notes that companies with unregulated operations have fared quite well in the current market. He has buy ratings on two stocks he covers, Reliant Energy (RRI ) and AES (AES ). And in the next category down, accumulate, he lists ONEOK (OKE ), Sempra Energy (SRE ), and Constellation Energy (CEG ).

These were a few of the points Shere made in an investing chat presented May 25 by BusinessWeek Online and Standard & Poor's on America Online (BW Online and S&P are both units of The McGraw-Hill Companies). He was replying to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

Note: Craig Shere is a Standard & Poor's equity analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat.

All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research," and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: Craig, this skittish stock market managed to inch back up today. How have the stocks you cover been doing in this difficult period?

A:

The companies with unregulated operations have actually performed quite well. But, as we expected, the more regulated utilities suffered as interest rates began to inch up recently.

Q: How have the interest rates been pinching? We might need a little education about regulated utilities.

A:

Regulated utilities have normally slow growth because they rely on increases in numbers of electric and/or gas utility customers. And as you know, the population does not grow that quickly. Furthermore, the electric utilities have had increasing expenses with rising pension costs, health-care costs, and even bad-debt expense, given the rising fuel costs. So, in some cases, you could have a stock with a reasonable dividend yield but minimal earnings growth opportunities as 2% to 4% revenue growth is offset by higher costs. These kinds of companies, we believe, are especially susceptible to the higher interest rates.

Q: Buy, sell, or hold El Paso (EP )?

A:

My rating on El Paso is a sell recommendation. I believe EP will be hard pressed to generate operating cash flow in excess of capital expenditures over the next several years. The recent revision down in their natural-gas reserves suggests that additional capital expenditures will be required to sustain those operations over the next couple of years. They have delayed their earnings releases, and their forward-looking [earnings] guidance needs to be revised as a result of their reserve write-down.

Q: Any comments on Reliant Energy (RRI )?

A:

Reliant Energy has been a very successful buy rating for us. The company has strong free-cash flow and presents investors with an option on widening power margins. We see this as a unique combination, because most other energy merchants that have the capacity for significant margin growth in a widening power market environment are not free-cash-flow-positive and present more serious credit and liquidity concerns.

The driving force behind RRI's positive free cash flow is its unique competitive retail supply business in Texas and the fact that its capital expenditures are significantly lower than depreciation.

Q: Comments on Dynegy (DYN )?

A:

Dynegy is probably going to have lower earnings in 2005 than in 2004 as a result of the loss of favorable power contracts that expire this year. The company is also subject to significant cash drains from money-losing power-tolling contracts.

However, new management has done a great job of resolving many regulatory uncertainties and divesting assets. We believe the company has the power to sustain itself until power prices recover, but there's much more risk here than with RRI in our view.... We have a hold opinion on these volatile shares.

Q: Will Duke Energy (DUK ) make a comeback?

A:

Duke is another great example of new management resolving many concerns. We now believe that Duke can maintain its dividend and avoid a credit downgrade to junk status. However, the company's stock has a remarkably high dividend payout ratio.

Furthermore, recent asset sales have significantly reduced longer-term earnings recovery potential. These asset sales, including the recent sales of Southeast merchant power plants, have brought in important liquidity and garnered useful tax-loss benefits. But with limited earnings growth prospects and above-average p-e multiples supported by a high dividend yield, we believe these shares are especially susceptible to higher interest rates. We have an avoid rating -- with a $19 12-month target price.

Q: Recommendation for a natural-gas equity holding?

A:

I have accumulate recommendations for ONEOK (OKE ) and Sempra Energy (SRE ). Also, I have an accumulate recommendation on Constellation Energy (CEG ). CEG has proportionately less contribution from gas utility customers than OKE and SRE, but it still has over 600,000 gas utility customers.

All three of these companies have unregulated operations that we believe will drive above-average EPS [earnings per share] growth. At the same time, all three companies trade at below-average multiples vs. slower-growth peers.

Q: Three accumulates there -- any buys in your coverage area?

A:

My two buy ratings are Reliant Energy, which we spoke about earlier, and AES (AES ). Both of these companies are attractive energy merchants that can benefit from a recovery in the sector without undue risk, we believe.

Q: What natural-gas company has the best dividends on its stock?

A:

Among the utilities that I personally cover, and have a hold or better recommendation on, PSE&G (PEG ) and Peoples Energy (PGL ) have the highest dividend yields. I have hold recommendations on both.

PSE&G has significant unregulated operations in addition to its utility business. However, its unregulated operations are significantly hedged and in many cases serve the utility customer base. Accordingly, it isn't comparable to the more risky energy merchants.

PGL is predominantly a utility operation, but it does also have some wholesale power and exploration and production investments. Again, however, the unregulated investments at PGL tend to be significantly hedged.

Q: Your current thoughts on Dominion Resources (D )?

A:

I have a hold recommendation on Dominion Resources. The shares trade at a slight premium to comparable multi-utilities, based on their 2005 p-e multiple. However, we believe that above-average free-cash-flow growth in the next couple of years justifies this modest premium.

Q: "Energy merchants" -- they got a bad name from Enron. How are they doing now? And is Mirant (MIRKQ ) worth holding?

A:

My last recommendation on Mirant before its bankruptcy was an avoid. After the bankruptcy announcement, I dropped coverage after the shares fell under $1.

For the survivors in this space, the last year and a quarter has generally seen exceptional share price recovery. These stocks had been priced based on some investors' assumption of bankruptcy risk. As asset sales were consummated and regulatory uncertainties were resolved, the immediate liquidity and credit risks began to dissipate.

It's important, though, to not get caught up in the enthusiasm of rising share prices in this space. These are volatile shares with risky business operations, and many companies have yet to prove that they have a viable plan for long-term growth.

Q: What's your take on Natural Fuel Gas (NFG )?

A:

I have a hold recommendation on NFG. Given uncertainty about NFG's natural gas production prospects, we believe the shares are fairly valued at a slight 2005 p-e discount to peers. I like management and believe they run a common-sense operation.

Q: Craig, your thoughts on Calpine (CPN ) -- would you buy?

A:

We recently downgraded Calpine to hold from accumulate. We failed to take our profits when the shares were as high as $6.30, within 10% of our 12-month target price at that time. Calpine's first-quarter earnings missed Street estimates, and its cash flow was worse than we expected.

If power margins don't recover sufficiently over the next couple of years, Calpine would likely have a strong bankruptcy potential. But the upside in the shares, should power margins recover, could be dramatic. The stock trades at only one-third of book value.

Q: You've spoken of the impact of rising interest rates -- what about the effect of high energy prices on the stocks you cover? Do you have a price forecast?

A:

We do have a 2004 natural gas price forecast of $5.60 [per million Btu] and a 2005 forecast of $5.01, vs. a 2003 average of $5.38. Our targets are derived from Global Insight. We believe natural-gas prices will remain around the mid-$5 range in the second half of this year, falling to the below-$5 level by the second quarter of 2005. In general, high natural-gas prices will benefit the companies that extract natural gas out of the ground. These unregulated operations are referred to as exploration and production.

Gas utilities that simply deliver the fuel to consumers normally cannot benefit from changes in the price of the commodity -- they simply charge customers for whatever the cost is. However, as you can imagine, these high gas prices are creating utility bills that are difficult for some people to pay. Utility companies are susceptible to rising bad-debt expense when their customers fail to pay their bills.

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