Supercharged Risks for Electric Utilities

S&P's Justin McCann has a neutral outlook for the industry and believes mergers could slow. Still, his top pick is FPL, and he likes others

From Standard & Poor's Equity Research

Electric power companies may differ in many regards, but they all agree the future holds enormous challenges and risks. A poll of 39 publicly traded and municipal electric utilities and merchant energy companies found that management sees fuel and capital costs, environmental regulations, and mergers and acquisitions as the top overall issues facing the industry.

According to the poll by Cambridge Energy Research Associates (CERA), an independent firm, primary concerns are not only fuel prices but also diversifying sources of fuel.

Supply shortfalls in regional power markets stemming from insufficient investment in generation and transmission over the next five years, the role clean coal will play in new infrastructure, binding carbon emission mandates, and the ability to attract young employees and pay the costs of an aging workforce are the other concerns.


  "With the time for large capital commitments rapidly approaching, and with fuel supply concerns, technological change, and energy policy still evolving, the investment landscape remains uncertain, and the survey results indicate a strong belief that investment will shift back toward the regulated side of the business with a concentration on controlling fuel risks and leveraging new technology," said Lawrence Makovich, managing director of CERA's global power group, in a statement.

CERA found that most managers expect the power business to remain a mix of regulation and competition over the next 10 years and predict most of the new capacity will be added on the regulated side. In the long run, they expect the industry to become more market driven.

Companies also believe it is imperative for the federal government to open off-limits areas to onshore and offshore drilling and define siting authority for liquefied natural gas (LNG) facilities. LNG is expected to play an increasing role in the supply of natural gas to North America.


  Standard & Poor's is neutral on the electric utilities group, which appreciated nearly 12% in 2005 but is expected to perform in line with the market for the next 12 months.

A repeal of the Public Utility Holding Company Act (PUHCA) eliminated some of the restrictions on industry mergers. However, Justin McCann, an S&P analyst covering electric power companies, believes that the recent termination of a merger agreement between Exelon (EXC; ranked 4 STARS, buy) and Public Service Enterprise Group (PEG; 3 STARS, hold) could mean consolidation may actually slow down.

"While the repeal of [PUHCA] was expected to stimulate the consolidation that had been taking place within the industry (as well as open the industry up to acquisitions by nonutility investors, including foreign companies), we believe the recent termination of the merger agreement, due to the increased rate concessions and additional power plant divestitures demanded by the New Jersey Board of Public Utilities, could make companies much more cautious about investing the enormous amount of time and money involved in the regulatory approval process," McCann says.


  S&P's top pick in the electric utility group is FPL (FPL; 5 STARS, strong buy), which is in the process of merging with Constellation Energy (CEG; 4 STARS, buy). The merger was placed on hold after the Maryland State Legislature opposed a rate increase proposed by Constellation's Baltimore Gas & Electric subsidiary. McCann expects more companies to increase their dividends because of the benefits from the tax cuts on dividends and increased cash flow.

"We expect favorable earnings comparisons for 2006, aided by rate increases, more share buybacks, and the divestiture of noncore businesses," McCann says. "These positives should help offset the high pension-related costs utilities face, which have restricted earnings growth for many companies." The most successful utilities, in his view, will be those that pay down debt and are able to increase earnings and dividends in a stable manner.

S&P's other U.S.-based favored stocks in the electric utility group are American Electric Power (AEP), Edison International (EIX), Exelon, PPL (PPL), and Reliant Energy (RRI)—all of which are ranked buy.

U.S. electric utility stocks S&P ranks a hold are Allegheny Energy (AYE), DPL (DPL), Duquesne Light Holdings (DQE), Entergy (ETR), FirstEnergy (FE), Great Plains Energy ( (GXP), Northeast Utilities (NU), Pepco Holdings (POM), Pinnacle West (PNW), Progress Energy (PGN), and Southern (SO ).

S&P has a sell recommendation on ITC Holdings (ITC).

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