The many faces of utilities


Once upon a time, investors seeking attractive valuations, high yields, and low volatility could find what they wanted in most utility stocks.

Today’s utility stocks are not as easy to characterize, often generating much of their profits from businesses other than traditional regulated utilities. While these differences make the sector more difficult to analyze, they also present opportunities for investors willing to take a wider view.

The table below illustrates differences between five utility industries as measured by yield, valuation, growth, and volatility of returns. While not every investor will find what he seeks in every industry, utility stocks can satisfy a variety of investment objectives:

Yield: Investors seeking yield will find it in traditional electric, gas, and diversified utilities.

Quadrix® scores: As a whole, utilities do not score well in our Quadrix stock-rating system, although there are some exceptions. Utility/energy hybrids boast the highest Quadrix Overall score of 74, while water stocks lag all other utility groups with an average of 33. Our utility sector score, derived using 12 statistics that work particularly well for utilities, now favors electric utilities.

Growth: While the utility sector is not known for its growth potential, the average water utility and utility/energy hybrid are expected to grow per-share profits at double-digit rates this year. Hybrids have historically offered by far the best profit and dividend growth.

Value: As a whole, the utility sector is not cheap. The average stock in our Utility Update on pages 9 and 10 trades at nearly 17 times estimated current-year profits. But within the sector, electric, natural-gas, and diversified utilities are the cheapest options, with an average valuation of less than 16 times estimated current-year earnings.

Stability: Natural-gas utility stocks average the lowest standard deviation in the sector, while water utilities and hybrids are more volatile than the sector average. Standard deviation measures the volatility of stock returns.

Our Utility Update lists 84 stocks, broken down into six industry groups. We are not fond of any stocks in the water or independent-power industries, but an intriguing selection from each of the other four groups is discussed below.

DPL’s ($27; NYSE: DPL) March-quarter earnings jumped 53% to $0.66 and topped consensus estimates by $0.14 per share. The sale of pollution credits provided the unexpected boost.

The Dayton Power and Light electric utility serves more than half a million customers. A series of regulatory rulings have boosted utility revenue in recent years, and DPL is poised to hold onto its favorable rate structure at least until the end of 2010.

By the end of this year, the company should have completed a $500 million capital-spending program to reduce emissions at its coal-fired power plants. DPL already completed work at one station and has installed one of four emissions “scrubbers” at another. Work should be completed by the end of the year, leaving the company some extra cash. The upgrades should allow DPL to use cheaper, high-sulfur coal. The company raised its dividend nearly 6% in the March quarter, the largest increase in at least 15 years. DPL, with a healthy 4.0% yield, earns an A rating and is a component of our Top 15 Utilities portfolio.

The bulk of Questar’s ($68; NYSE: STR) profits come from its energy operations. The production, processing, and gathering of natural gas and oil contributed 83% of net income in 2007. Exploration-and-production profits grew 25% in the March quarter on a 13% increase in production.

Questar is drilling new wells in the Pinedale Anticline, a section of the Rocky Mountains in Wyoming accounting for more than 30% of the company’s production. A pending environmental-impact study could allow for year-round drilling at Pinedale, potentially doubling drilling activity.

Pipelines typically provide slower-growing but steadier profits than production businesses, and Questar is expanding its pipe network. Questar and a partner are building a natural-gas pipeline from Wyoming to the Canadian border. Scheduled to open in 2011, the pipeline will allow the sale of natural gas produced in the Rockies to other markets in Canada and the American Midwest, potentially boosting realized prices. Questar is a Long-Term Buy.

UGI ($27; NYSE: UGI) continues to transform itself from a natural-gas distributor into a diversified utility with a large propane business and operations in Europe and China. In March, UGI agreed to acquire PPL Gas for $268 million in cash. The deal will add 76,000 customers in Pennsylvania and Maryland and should begin contributing to earnings in 2009.

UGI provides gas (478,000 customers) and electricity (62,000 customers) in eastern and northern Pennsylvania. The division provided 21% of revenue in 2007, and the customer base is expanding at a 2% to 3% clip, well above the industry average of 1.2%.

AmeriGas, the largest retail propane operation in the U.S., generated 42% of 2007 revenue. Warmer weather last winter hurt performance at UGI’s international propane division, which provided 15% of 2007 revenue. Energy Services (24% of 2007 revenue) has added two new plants that mix propane with air, selling the natural-gas alternative during times of peak demand. UGI earns an A rating in the Utility Update and is part of our Top 15 Utilities portfolio.

WGL ($35; NYSE: WGL) is reaping the benefits of recent rate increases. March-quarter per-share earnings topped consensus estimates by 19%, and the company increased its profit guidance for fiscal 2008. The improved earnings performance came despite warmer weather.

WGL operates a natural-gas utility serving more than a million customers in Washington, D.C., Maryland, and Virginia — the fourth-largest regional market in the U.S. The business provided 57% of fiscal 2007 revenue and 80% of profits. The company expects to add 17,500, or nearly 2%, to its customer base this year. Nonregulated businesses include energy marketing and a unit selling products and services for heating and air conditioning.

The company targets annual growth of 6% to 8% in per-share earnings through 2012. While consensus estimates project 16% earnings growth in 2008, helped by rate increases, profits are expected to decline slightly next year. Cost controls have already begun to fatten profit margins and should help WGL meet the long-term earnings-growth target. WGL earns an A rating in the Utility Update and is a component of our Top 15 Utilities portfolio.

Strength in numbers
Having trouble picking one or two winning utilities? It’s not just you.

The Forecasts isn’t keen on many utilities, and only two utility stocks are members of our Buy List or Long-Term Buy List — both utility/energy hybrids that generate more than half of their profits from natural-gas production.

Investors looking for income and growth superior to that of the average utility should consider the Top 15 Utilities portfolio shown above. The Forecasts recommends that investors who want traditional utilities purchase equal-dollar amounts of each of the 15 stocks to constitute the utility portion of their portfolio. The Top 15 Utilities portfolio is up 3.5% this year, through June 24, versus a 3.5% decline for the S&P 1500 Utilities Sector Index.

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