The New Juice in Utility Stocks

With less regulation, some electric companies are taking off

Last March, about the time the stock market started to crumble, investors began piling into their old rainy-day friends, utilities stocks. Ever since, the Nasdaq's loss has seemed to be the utilities' gain. The Standard & Poor's 500 Utilities Index is now up 44%, while the Nasdaq is off 62%. Does that mean that if the broader market bottoms out and turns up, these traditionally defensive stocks will plunge?

It's no longer that simple. Sure, part of the gain came from investors seeking the shelter of stable earnings and a reliable dividend. But other, savvy investors were bidding up prices for a new breed of utilities capable of logging double-digit earnings gains.

If you haven't looked at electric utilities in a while, you may be in for a surprise. This once stodgy industry is undergoing a transformation. Deregulation is forcing change and reshaping companies, making huge winners of some and hapless losers of others.

Just look at what's going on in California. Calpine (CPN ), a wholesale power producer selling electricity at whatever the market will bear, has been a big gainer. Its 2000 profits are up 163% from the year before, its stock price has gained 80% from last March, and analysts like Brian Hayward of INVESCO Funds think it can add 30% over the next 12 to 18 months. Meanwhile, PG&E (PCG ), which distributes electricity to customers, is in dire straits thanks to a deregulation plan that doesn't allow it to pass soaring wholesale power prices on to its users. PG&E's stock is down 30% over the past 12 months.

Electric utilities have not shed all their defensive armor, but many are looking a bit like growth stocks. Veteran utilities investor William H. Reaves, president of the money management firm W.H. Reaves, says the best-run utilities are focusing on lines of business beyond the regulators' grasp, like power generation and specialized services for industrial customers. These are areas where innovation and good business practices can add to the bottom line--not just get passed along to customers in the form of lower rates. In this new, more competitive environment, utilities are merging with others and lopping off their own slow-growing, regulated units. So, just like regular companies, those must now be evaluated based on their efficiency, resourcefulness of their management, and by how well-positioned they are in the marketplace--not just on the reliability of their dividends.

LOCATION, LOCATION. With earnings growing faster, many of these companies are plowing a bigger chunk back into their businesses rather than plumping up dividends. Mark D. Luftig, executive vice-president at Reaves, says electrics now pay out 53% of their earnings as dividends, vs. an average 75% in the 1980s. As the companies come to behave more like regular stocks, the market will treat them that way, affording higher price-earnings multiples when they please, and slamming them when earnings come up a few pennies short of investors' expectations.

Some will outperform others simply because they operate in a more favorable regulatory environment. The federal government encouraged competition at the wholesale level for generators with the Energy Policy Act of 1992. Since then, about half the states have enacted laws or regulations to let electricity generators begin competing for retail customers on price, rather than having monopolies with rates set by a governmental body.

Some of the most industry-friendly deregulation can be found in Ohio, Illinois, Pennsylvania, and Virginia, according to Luftig. That's why he favors companies like FirstEnergy (FE ), with customers in Ohio and Pennsylvania, and Dominion Resources (D ), with operations in Virginia. FirstEnergy is a bargain, adds Luftig. He figures the company's shares will gain nearly 20% over the next 12 months--substantial even before you throw in a 5.4% dividend yield. Luftig sees a similar play in Texas-based TXU (TXU ), with the Lone Star state scheduled to complete its deregulation process early next year.

There's another reason the electric business is a little like real estate: location, location, location. Those that operate in fast-growing states have a brighter near-term outlook, says Justin McCann, senior industry analyst at Standard & Poor's Equity Group. Progress Energy (PGN ), at $42.72 a share, is well-positioned for growth, with its newly acquired power plants in Florida and new ones going up in North Carolina. The company, the result of CP&L's acquisition of Florida Progress, should outperform the market in the next 9 to 12 months, says McCann. And that's before its 5% dividend.

The agility of a company's management and the soundness of its strategy also count for a lot these days. McCann praises Michigan-based CMS Energy (CMS ) for selling assets to pare debt. That will free up cash for growth businesses--which include overseas operations. North Carolina-based Duke Energy (DUK ) is also an international powerhouse. It's renowned for sophisticated power-plant engineering, which it exports around the world. Luftig is looking for a 13% price gain over the next year, in addition to a yield of 2.7%.

PENDING MERGERS. Exelon (EXC ) is looking smart. The Chicago electricity and gas company has increased the output at its nuclear plants 6% while cutting employees more than 10%. Luftig estimates that its stock will post a 9% gain over the next year, along with its 3.4% payout. Industry watchers say prospects for Houston-based Reliant Energy (REI ) and Baltimore-based Constellation Energy Group (CEG ) are bound to improve as they divorce themselves from their regulated operations, becoming separate companies. Other players are seeking efficiencies by buying fellow utility companies and spreading costs over a larger base. FirstEnergy, for example, is in the process of acquiring New Jersey's GPU. Another 11 mergers or acquisitions are pending, and 24 have been completed since the beginning of 2000, according to the Edison Electric Institute, a trade association for publicly traded electrics. "You're seeing straight electric-electric consolidation. You're seeing electric and gas," says EEI spokesman Tony Anthony.

With their new look as competitive companies, such electric utilities may not be in full retreat the next time the bulls run down Wall Street. They might never be the next dot-coms (probably a good thing), but companies that can deliver double-digit earnings growth to their investors don't have to hide behind their dividends.

By Carol Marie Cropper

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