This Maverick Utility Is No Wild Cowboy


By Sam Jaffe Now that the dot-com and optical telecom hangovers are starting to wear off, plenty of investors are fishing about for the "next big thing." You know -- the one that promises to change the world as we know it and give early investors sky-high returns.

Thanks to the California energy crisis, there's at least one idea that may not make anyone a instant billionaire but is generating a lot of investor interest. That's "distributed power generation," in which businesses build generators of their own that are also hooked up to the public power grid, thereby letting the company with the generator sell power back to the utility. Whereas nearly every other investing sector is either declining or turning in single-digit gains, this nascent industry is boasting double-digit returns, sparking nostalgic memories of dot-com glory days.

The problem with this industry is that it's so new and so small that the stocks resemble Mexican jumping beans. Take Plug Power (PLUG), a maker of fuel-cell systems for residential power generation. As of June 28, its stock was at $20.50 a share, more than 70% off its 52-week high in July, 2000. But that's also more than double its low of $9 a share in December.

Another prominent player, Fuel Cell Energy (FCEL), has seen its shares rise 130% in the past year, although certainly not on an evenly. Fuel Cell's beta, an indicator of volatility compared to that of the overall stock market, is 0.68. A stock that perfectly matches the market's volatility would have a beta of 1.0, and the further away from 1, the higher a stock's volatility.

FAR AHEAD. Investors who like to avoid volatility or have a plain old aversion to risk, have another way to play the distributed-generation trend. Michigan utility DTE Energy (DTE), which comprises the recently merged Detroit Edison electric utility and MCN, a gas utility, is far ahead of other utilities in its push into distributed generation. "It's a way to invest in an otherwise risky area without taking on much risk and with the stability of a major utility behind it," says Raymond James & Associates analyst Fred Schultz, who has a strong buy rating on the stock.

DTE's journey into the distributed-energy business began in 1994 when CEO Anthony Earley took over Detroit Edison. Convinced that the utility industry was on an eventual collision course with customer needs, Earley urged his company to seek out "destructive" technologies that would allow DTE to tear down its current structure and replace it with a more modern one, albeit at a leisurely pace. Distributed generation soon became a strategic goal of the company.

The idea behind distributed generation is that a school, hospital, or office complex can produce its own power just as cheaply as it can buy it from the grid. When rates go up, it can produce extra energy and sell it back to the grid. When rates go lower, it can shut down its generator and buy the cheaper electricity from the utility. This approach allows customers to get slightly cheaper electricity from a more stable source that won't suffer interruptions (which is especially important to computer-intensive companies) and can flexibly meet changing demands.

RECENT ADVANCES. Just as the Internet was invented in the 1960s but didn't take off until the 1990s, distributed generation has been the apple of many an engineer's eye. But it hasn't been until the past few years that technology breakthroughs made possible affordable and efficient microgenerators, whether small turbines or fuel cells.

DTE has been investing in the arena since the mid-1990s through a modest venture-capital fund, best represented by its 32% stake Plug Power. More important, DTE has built its overall growth strategy around distributed generation. It created a separate unit, called DTE Energy Technologies, to specifically create and sell generators to hospitals, schools, and businesses. It also provides centralized oversight of those facilities, as well as maintenance services. "We're well poised to become the dominant player in the distributed energy market," says Bob Buckler, chief operating officer of DTE Energy Technologies.

One reason why distributed generation is such a valuable arrow in the quiver of a traditional utility is that for now it's unregulated, which allows for fatter margins. "The only path to real growth for a company like this is to increase unregulated income," says Raymond James' Schultz. "DTE should have 50% of its earnings coming from unregulated sources by 2005. No other utility is anywhere near that type of diversity."

"SHORT ON LEADERSHIP." No other utility is near DTE's viewpoint of distributed generation either, because most utility executives see it as a threat, rather than a potential source of revenue. That has changed somewhat in the past year as other utilities have begun investing in the area, thanks to the panic resulting from the California crisis. "The utility industry is short on leadership and long on followers," says Fahnestock & Co. analyst Lee Walter, who has a buy rating on the stock. "DTE has been a leader in this area for some time and, as they say, the best view is at the front of the pack."

Distributed generation might seem like a threat to traditional utilities. But it also might offer some advantages. For one thing, the more sources of electricity generation, the less strain there is on the power grid, which leads to fewer service interruptions. In addition to increased stability, the grid also becomes more flexible, giving utilities expanded options in terms of pricing and meeting customers' needs. Considering how difficult and expensive it is to build new power plants these days, traditional utilities may ultimately welcome these generation sources.

Even without its innovations, DTE presents a pretty good picture for investors. In addition to its stable revenue stream from its 2 million electricity customers, it also has 1 million gas customers. Altogether, analysts expect the company to earn $3.48 a share in 2001 and $4.08 in 2002. Its distributed-generation business will lose $8 million this year, but the company expects it to make $46 million, or 34 cents per share by 2005.

PALL ON THE SECTOR. Not everyone is in love with the stock, though. Among the company's weaknesses are the fact that the economic growth of the Michigan area is hardly measurable and that, as a hybrid gas and electric utility, it isn't a pure play. And then there's the specter of the Pacific Gas & Electric bankruptcy, which has cast a pall over all utility investments.

Still, DTE has outperformed the market so far in 2001. Although the stock has already seen a run-up in 2001 of 19.6%, its price-earnings ratio is 13.3, which puts it at a discount to the average p-e of 19 in the Standard & Poor's electricity-utility sector. Meanwhile, all of DTE's management-effectiveness ratios, including return on assets, return on equity, and return on investment, are slightly above the industry average.

Top it off with the final luxury utility investors enjoy by owning DTE shares: a dividend. Although the company's dividend yield has declined to 4.7% as a result of the rise in stock price, it still comes in close to its competitors. It's just one more level of safety for a safe stock in a high-growth area. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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