We Buy Energy And Avoid Water

2/9/2009


Subscribers have asked us, “Why don’t you recommend any water utilities?”

On the surface, it’s a good question. After all, everybody uses water, so the stocks must be safe, right? But you don’t have to look very hard at the industry to realize it has little investment potential and is not that safe. Consider the following:

Shares of water utilities on average have substantially underperformed other utilities over the last five years.

Despite that underperformance, the average water utility in our Utility Update trades at 23 times trailing earnings, 71% above the average for all utilities.

Water utilities average a Quadrix® Overall score of 36 on a scale of 0 to 100 and score even lower in our sector-specific Quadrix scores.

The numbers tell a dreary tale — it’s hard to get excited about the total-return potential of water utilities. On the other hand, utility/energy hybrids that produce natural gas and oil have outperformed in recent years, yet are much cheaper than most traditional utilities. They also earn very high Quadrix scores. For a peek at the characteristics of utility industries, which vary widely in investment appeal, check out the chart below.

Our Long-Term Buy List contains only two utilities — hybrids Questar ($35; STR) and Energen ($30; EGN). Our Top 15 Utilities portfolio is diverse by design, but still contains no water utilities.

This week, we are making a change to the Top 15 portfolio, as discussed in the following paragraphs.

Quadrix scores for Duke Energy ($15; DUK), one of the largest and best-known U.S. utilities, have fallen in recent months, hurt by weakness in a variety of areas. Per-share profits missed the consensus estimate by 27% in the September quarter and were expected to decline for the full year. Duke was slated to declare December-quarter and 2008 results Feb. 5. Moreover, the stock’s indicated dividend represents nearly 75% of estimated 2009 earnings, leaving little room for error. A dividend cut is possible. Duke is being removed from the Top 15 Utilities portfolio and cut to a B rating in our Utility Update. It retains its Neutral rating on the Monitored List and should not be owned.


Natural-gas utility AGL Resources ($31; ATG) pays a generous 5.4% yield well-covered by earnings. The stock earns solid Quadrix scores of 65 Overall, with higher ranks in our sector-specific scores. In recent months, AGL has received favorable regulatory rulings that allow the company to recoup the cost of pipeline replacement and decouple 90% of its operations from weather and gas prices. AGL generates nearly three-fourths of its profits from traditional utility operations but also has units that market, transport, and store natural gas. AGL earns an A rating in our Utility Update and is being added to the Top 15 Utilities portfolio.

INDUSTRY ANALYSIS
The data below reflect averages for the stocks in our Utility Update, broken down by industry group. Based on Quadrix scores, valuations, and growth histories, it is easy to see why we find stocks in the hybrid category more appealing than traditional utilities.
— 12-Mo. Chg. —
——–— Quadrix Scores —–——
Industry
Div.
Yield
(%)
Trailing
P/E
Sales
(%)
Per-
Share
Profits
(%)
Overall
Sector
Reranked
Overall
Electric
5.5
13
5
(9)
39
35
33
Natural Gas
4.7
13
15
9
55
38
55
Water
3.1
23
6
2
36
32
16

Hybrids

2.6
11
17
27
81
93
92
Diversified
4.7
13
15
(6)
50
52
53
All 82 Utilities
4.5
13
10
2
50
50
50
Notes: Averages exclude growth rates of more than 100% and P/E ratios of less than 0. Quadrix scores are percentile ranks, with 100 the best. The sector score is derived from 12 factors that work particularly well for utilities, while the reranked Overall score uses the same category scores as the Overall score, but weighted to favor scores that work better for utilities. Independent power is not broken out, as the group only contains two companies.

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