November 10, 1998

SECTOR SCOPE by James A. Anderson


They had to wait until the swelter of August this year, the widows and orphans, but they finally got their revenge on Wall Street. In that month electric utilities -- the safe, income-producing stocks nearly every broker has routinely recommended to the vulnerable and frail -- led the market with a 7.62% total return even as the Standard & Poor's 500-stock index nosedived 14.46%. Thanks to dropping interest rates and to yearlong worries about the global economy, moreover, power producers have continued to put a new shine on their image as a safe haven. S&P's utilities index has risen 11.63% this year, a respectable increase compared with the 14.63% total return of the S&P 500.

But these stocks aren't just a shelter from the storm anymore. Thanks to deregulation, electric utilities are leaner and meaner than they've been in decades. And for the first time in years, utility investors aren't just savoring their dividend yields: They're enjoying earnings growth as well. David Kiefer, a portfolio manager with Prudential Utility Fund, thinks the electric-utility industry should notch earnings growth of 3% to 5% next year. That, coupled with the sector's solid dividends, could make utilities a market beater.

True, dividends are still the bedrock of utilities' appeal. As the interest rate on the 30-year Treasury bill has sunk to around 5%, electric utilities have turned heads. That's because their average dividend yield is 4.4% compared with 1.5% for the broad market. A recent rise in investor confidence has deflated the sector over the past month, but the group stands a good chance of rallying should the rate on the long-bond decline toward a 4.5% yield. That's because utility stocks usually mimic the movement of long bonds, which means that if interest rates go down, utility shares will go up. In addition, declines in rates help utilities refinance the massive debt -- also known as stranded costs -- they took on to build excess generating capacity back in the '70s.

There's one more plus for the utilities. Even after this year's rally, the group still trades at a fair-size discount to the overall market. Historically, the electric-utility sector has traded at price-to-earnings multiple of about 70% that of the S&P 500. Currently, however, electrics fetch a 15.4, about 60% of the S&P's 24.5 multiple.

This isn't to say that business is easy for the folks who keep the lights on. Deregulation, a bugaboo that haunted utility stocks a few years back, is now more than a threat on the horizon -- it's taking hold in states like Massachusetts, California, and Pennsylvania. That spells changes ahead in the way the turbine turners make money. Until recently, your local utility was a pampered monopoly. It served up dependable electricity and in return was allowed to charge a certain rate. To keep the juice flowing, state regulators permitted electric companies to earn a fixed rate of return on funds spent on new generators or on purchases of power from others. Enter deregulation, which for much of the decade has brought to the business the harsh reality of competition. In places like California, for instance, it has crimped profits and made it hard for utilities to recover stranded costs.

That hard truth has divided utilities into two groups. Some power companies can produce electricity cheaply enough to compete with all comers. Analysts say that members of that group are looking to snare additional generating capacity, then land industrial companies or other utilities as customers. That should boost earnings for these utilities toward the low double digits, and ultimately may help some of them fetch a multiple in line with the S&P 500 instead of the skinny p-e utilities historically have had. The growth spurt comes at a price, however. Since most of the increase in profits will be used to fund expansion, investors in these utilities may have to kiss dividend growth good-bye.

The second group of new utilities is made up of companies looking to shed costly generating capacity that hurts their profits. These companies are likely to become primarily transmission and distribution networks that shoot electricity to factories and homes. The money from plant sales will go not only toward lowering electric rates but also for share buybacks and investments in new lines of unregulated business, such as overseas power plants and water utilities at home. Analysts say the majority of this group's profits will remain regulated. Not only that, but the distributors will likely stick to the formula of dividend growth to lure investors.

For the short term, CIBC Oppenheimer analyst Jon Raleigh says the distribution group looks to be the best bet. While there isn't yet a pure distribution company, some utilities are starting to look like one. Take DQE Inc. (DQE), for instance, which according to Zacks Investment Research offers up a 3.7% dividend yield. The parent company of Duquesne Light Co., the Pittsburgh utility has been ordered by Pennsylvania regulators to auction its generating assets, which have a book value of $1.3 billion. Raleigh says part of the proceeds of the sale, which is expected next year, could go toward a share buyback or be invested in one of the company's unregulated businesses, which include municipal water-service facilities and a fiber-optic communications network. Those businesses could grow 25% to 30% a year, according to Value Line estimates and contribute more than 30% to the company's bottom line.

Another emerging distributor is New England Electric (NES). The Massachusetts utility currently trades at 13 times 1999 projected earnings and has a dividend yield of 5.8%. NES sold its non-nuclear generating assets in September to Pacific Gas & Electric affiliate U.S. Generating for $1.59 billion. The sale will help NES slash debt and buy back shares. Meanwhile, NES is setting up alliances to build transmission lines abroad and to sell oil and natural gas.

Of the generating companies, CMS Energy Corp. (CMS), the holding company that operates Consumers Energy, has won analysts over with its aggressive plans to expand beyond its home turf of Detroit. CMS currently trades at 14 times next year's predicted earnings, according to Zacks, and has a 3% dividend yield. CMS is a utility in search of a makeover. It has sought to expand its reach in gas transmission, most recently by purchasing the Midwest pipelines of Duke Power. It is also building generating capacity overseas and by 2003 could get half of its operating profits outside the U.S., up from 10% in 1997. Analysts think such moves should help stoke earnings growth of 13.5% next year, vs. 7.6% for the industry, according to Zacks. Longer term, Wall Street thinks CMS is good for average annual earnings growth of 8.6%. Some 15 of the 18 analysts who follow the stock rate CMS a strong buy or buy.

Another generating company worth keeping an eye on is North Carolina's Duke Power (DUK), which trades at a p-e multiple of 18 times 1999 projected earnings and pays a dividend of 3.4%. Duke has invested heavily in projects ranging from gas transmission lines in New England to generating capacity in California and across South America. "Historically, Duke has been rather good at both constructing and operating power plants," says Wheat First Union analyst Tom Hamlin.

Should you opt for a utility fund, keep one thing in mind: A pure electric fund play is next to impossible to come by. Most utilities funds these days are top-heavy with telephone stocks, including risky plays like Qwest Communications (QWST) and Teligent (TGNT). The fund with the highest three-year average annual total return and the heaviest weighting in the electric sector is the Prudential Utility Fund (PRUAX). Kiefer says that 40% of his portfolio is in electric utilities, with gas next at 28%. The fund has returned 17.7% over the past three years and has a dividend yield of 2.6%.

Whether you buy individual stocks or funds, these electrics aren't your father's utilities. But they still maintain a margin of safety when the broader stock market shows signs of instability -- and they do well, too, when the market is going strong.

James Anderson, who teaches journalism at the City University of New York, writes Sector Scope every other week.


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