Powering Up


Q Two firms are pursuing natural-gas-pipeline concern Southern Union Group ($40; SUG). Duke Energy ($19; DUK) and Progress Energy ($47; PGN) announced a merger earlier this year that will create the nation’s largest electric utility company. Private equity firm Blackstone Group and investor Carl Icahn have attempted to acquire power producer Dynegy ($6; DYN). Given the deal activity surrounding power-related companies, is power a sexy investment area?

A “Sexy” may not accurately describe the power sector, but investors have shown interest in power assets. Indeed, the number of deals in the North American power sector jumped 15% in 2010, with the dollar value soaring 167% to $32.8 billion. Deal flow has continued strongly this year. But investors are not chasing growth.

Total electricity sales (megawatt hours) in the U.S. have been relatively flat over the last six years, with 2010 sales below peak 2007 levels. The recession trimmed electricity demand in 2008 and especially 2009, but electricity sales are expected to rise at an annual rate of less than 2% for the foreseeable future. So, why the deals?

Many U.S. utilities must fund major generation and infrastructure improvements, partly because of regulatory mandates. Utilities expanding through mergers can spread the cost of complying with environmental regulations or building new power plants across more customers.

Utilities’ steady returns on invested capital attract buyers. Relatively stable cash flows appeal to such investors as private equity groups.

Q Isn’t there a growth story for power overseas?

A Yes, and the tale in emerging markets is particularly compelling. Many markets should see power demand rise at least twice as fast as in the U.S. The increase in incomes and the urbanization of populations will drive healthy demand in such countries as China, India, and Brazil.

Not surprisingly, this growth is drawing investors. For example, State Grid Corporation of China purchased seven Brazilian transmission companies in 2010. The globalization of the power infrastructure makes for an interesting M&A trend to watch in the years ahead.

Q What about the outlook for nuclear power?

A The pro-nuclear argument has always been difficult to sell, and the Japanese disaster has further muddied the waters. The big question is how long nuclear energy will remain in the penalty box. Germany has been most aggressive in moving away from nuclear power, saying that all nuclear plants must close by 2022. The U.S., home to more nuclear plants than any other country, will likely step up oversight and regulations. That increased scrutiny will drive up costs.

The push to get bigger, making it easier to handle increased regulatory costs, should continue to drive consolidation among utilities using nuclear power. Such thinking probably helped to spark the Duke Energy/Progress merger, as both firms have exposure to nuclear generation.

Q How do alternative and renewable power sources fit in?

A According to the Department of Energy, power generation from renewable and alternative sources will double over the next decade. That type of growth will draw investment. However fossil fuels still account for about 94% of power generation in the U.S. and 90% worldwide, and will remain the dominant source of power for the foreseeable future.

Q What does the investment landscape look like?

A At least in the short term, it looks pretty good. Power generators, especially utilities, are considered “defensive” stocks, and defensive sectors have done well over the last quarter. The Dow Jones Utility Average is up 4% since March 31, versus declines of 1% for the Dow Jones Industrial Average and 2% for the S&P 500 Index. The above-average yields of utilities add to their appeal.

The Forecasts does not recommend any power generators on its buy lists. However, investors who want exposure to the sector should take positions in our Top 15 Utilities portfolio, listed at www.DowTheory.com/Go/Top15. The Top 15 portfolio does not contain any pure-play generators, but many of the utilities have substantial power interests.

Investors can also play power through companies that provide the fuel generators use, such as coal miner Walter Energy ($114; WLT) and oil and natural-gas producers Apache ($120; APA), Exxon Mobil ($80; XOM), and Hess ($71; HES). Exxon Mobil and Hess are rated Focus List Buy and Long-Term Buy. Walter is a Focus List Buy. Apache is rated Buy and Long-Term Buy.

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