New Spark In Utility Stocks

Why the once-staid sector is generating breathtaking returns.

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With major stock market indexes in record-high territory, a once ho-hum sector has been turning in electrifying results. The 15-stock Dow Jones utility average gained 226% from October, 2002, through the end of April, 2007, walloping the 82% rise in the more diversified Dow Jones industrial average.

Even more interesting, in an industry that used to be the ultimate safe choice for income investors, the outsize return came solely from stock price gains and does not factor in an additional 20% from dividends, calculates Raymond James & Associates strategist Jeffrey Saut. So far in 2007, the Dow utilities index has gained 17%, vs. 9% for the industrial average, and the overall utilities industry has given the best performance of the 10 major market sectors tracked by Standard & Poor's (MHP ).

What gives? While the utility sector still contains some old-fashioned stable-income plays, a decade of deregulation has given rise to a racier breed of independent power producers that are dividend-free, along with a middle group of hybrids that offer modest payouts at best (table). The indies, which own power plants but have no guaranteed base of customers, are the riskiest companies.

Utility-stock buyers need to pay close attention to the differences or they may find their investments are out of whack with their financial goals and tolerance for risk. "The thought process that ruled the day five years ago is no longer with us," says Matthew Smith, co-manager of the Franklin Utilities Fund. "We're in a different environment because of deregulation."

Utilities have been on a roll for the past few years despite a boom-and-bust cycle of power-plant construction and the high-profile bankruptcies of Enron in 2002 and Calpine in 2005. Five years of growing demand for electricity at a time of diminished production capacity has pushed up prices and profits for power producers. The massive blackout that started in Ohio and hit much of the Northeast on Aug. 14, 2003, also helped by focusing attention on the need for infrastructure improvements. Regulators reacted by allowing utilities to raise rates to cover the cost of building new transmission lines and still show a healthy return on investment.

Smith thinks the environment will continue to be favorable for the next few years. Because of past underinvestment in infrastructure, a lot more transmission-line projects will be approved. New power plants will be much slower to come online because of increasing construction costs and environmental challenges. The strength in utility stocks "can go on a lot longer than some skeptics are predicting," he says. "We have the fundamentals to support current valuations."

Deregulation also has helped stock prices by allowing utilities more flexibility in pricing. In the old days, if energy prices rose, utilities were at the mercy of local regulators. Now companies can more easily pass along higher costs to consumers.


Despite all the changes, companies such as NSTAR (NST ) and Consolidated Edison (ED ) have largely stuck to the traditional model of selling electricity. As a result, they still pay high dividends, and their share prices are more stable than the overall market. With electricity demand growing and an increasing number of infrastructure projects on tap, the outlook for old-line utilities remains strong. ConEd just asked its regulator on May 4 to approve an $8 billion rate hike for transmission improvements, a 48% increase from a previously approved plan.

The most volatile stocks in the utility universe are the independent power producers. Companies such as Mirant (MIR ) and NRG Energy (NRG ) build and operate power plants, selling the electricity generated to others who deliver it to customers. When the economy is booming and electricity demand is rising, power producers can charge premium prices. But if the trends reverse, the independents have no captive base of customers forced to buy their electricity, unlike traditional utilities. "They're going to be more cyclical than other utilities have been," warns T. Rowe Price utility analyst Mark Finn.

By one historical measure, the rally has left utility stocks looking overvalued. The 2.9% yield on the Dow's utility index is far below the 4.75% yield on the 10-year Treasury bond. In the past, that has signaled utilities were in danger of a pullback. But analysts and fund managers insist the changing characteristics of the industry have diminished the importance of dividend yield. While traditional, highly regulated utilities still pay yields close to the 10-year Treasury, more diversified companies with better growth prospects tend to pay out less than they did in the old days.

Some utilities could be hurt by an expected increase in clean-air regulations, as more states move to curb emissions that cause global warming. Even the federal government, which has been slow to act under the current Administration, is starting to talk about reducing emissions. Most vulnerable to such policy shifts are companies that rely on coal, such as Southern Co. (SO ) and American Electric Power (AEP ). Meanwhile, those with gas, nuclear (see, 05/21/07, "Nuclear Power: A Bad Reaction"), and hydroelectric generation facilities, such as Exelon (EXC ) and PG&E (PCG ), could see their returns enhanced. Still, a major White House initiative is far from imminent, leaving most of the industry in a position to increase profits and keep powering their stock prices higher.

By Aaron Pressman

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