Why TXU Could Power Up a Portfolio


By Heesun Wee The Texas energy market still has plenty of action -- and not all of it has to do with the Enron scandal. On Jan. 1, 2002, the state deregulated its electric-power market, which means roughly 4.5 million Texans can now choose their electricity provider. The change also puts TXU Corp. (TXU) in a different light to investors with an eye on the energy sector.

Based in Dallas, TXU is growing far beyond the Lone Star State (where it began in 1882). It boasts $43 billion in assets and $28 billion in annual revenue, serving 11 million customers in the U.S., Europe, and Australia. Management recently projected annual earnings growth of 9% to 11% beginning with 2002, which has made certainly made Wall Street take notice.

"That's pretty ambitious for an energy company," says David Burks, an analyst who follows TXU for Hilliard Lyons. Average earnings growth for energy companies is 6% to 7%. And Standard & Poor's included TXU on its annual list of 35 stocks expected to outperform the S&P 500-stock index in 2002.

OPPORTUNITY KNOCKS. S&P electric utilities analyst Justin McCann says the stock remains attractively valued and offers a better-than-average annual earnings growth potential of roughly 10%. Based on a price of $48 a share and S&P's 2002 earnings per share estimate of $3.80 (excluding $0.60 that will be added due to the elimination of goodwill amortization), TXU's forward price-earnings ratio is 12.6. While that multiple is on the low end for energy companies, analysts say it represents an opportunity for investors to buy into a growing energy company at an affordable price.

The stock now trades $2 shy of its 52-week high of $50 posted July 3. But Burks of Hilliard Lyons -- who has a buy rating on TXU and a 12-month price target of $52 -- notes that it finished 2001 at $47, up 9.3% for the year. That's a notable feat since many energy companies took a hit in late 2001, and the S&P Utility Index declined 32% last year.

Stock appreciation aside, TXU has offered a 5.3% dividend yield, which has grown an average of 3.3% annually for the past five years. Indeed, TXU's dividend has been higher compared to that of other energy companies. However, in November, 2000, TXU's board froze the dividend at $2.40 per share to focus on generating cash as it ramps up growth.

AGGRESSIVE STRATEGY. TXU's profits have also been rising. For the third quarter ended Sept. 30, the company reported earning per share excluding nonoperating items of $1.42, a 14% hike over the $1.25 reported for the same period a year earlier. Nonoperating items for the most recent quarter included regulatory adjustments for U.S. operations and restructuring costs in Europe. Burks believes the nonoperating items don't auger problems and are related to ordinary changes within the energy industry.

TXU anticipates EPS of $3.65 to $3.70 for 2001, and it remains comfortable with analysts' reduced estimates for 2002 in the general range of $4.35 to $4.45, following the sale of its British distribution business. The company is scheduled to release its fourth-quarter earnings and host an analysts' conference call on Jan. 31.

How does TXU do it? With an aggressive growth strategy that largely hinges on ramping up its merchant energy business, which accounts for about 75% of earnings and, unlike at other energy companies, houses its retail business, generating plants, and wholesale trading operations under that one business unit. TXU also plans to expand its delivery business -- the wires and pipes used to transport power and gas -- by managing other energy companies' deliveries. This business accounts for roughly 25% of TXU's profits.

"SUSTAINABLE GROWTH." The company recently signed its first such contract with Sempra Energy, based in San Diego. David Schanzer, an energy analyst with Janney Montgomery Scott, says the move makes sense since TXU has such a solid reputation for managing its physical assets. "As a fully integrated energy merchant, TXU is expected to deliver more sustainable growth, particularly vs. the pure generators," notes Steven Fleishman of Merrill Lynch. Pure generators are dependent for growth on commodity prices, which are volatile and cyclical. Diversifying beyond power generation allows an energy company to ride out down cycles for commodity prices.

TXU executives also say they're eyeing new markets. "We will follow deregulating markets in the early stages to establish a position," says David Anderson, head of investor relations for TXU.

The company won't disclose market-share numbers, but Schanzer says TXU is the largest provider of electricity in Texas, so it is "well-positioned." And more than half its 11 million electricity and natural-gas customers reside outside the U.S. Roughly 5.5 million live in Europe, 4.5 million in the Northeast, Texas, and the Midwest, and 1 million in Australia.

ENRON EXPOSURE. The company stepped into Europe and Australia because those regions began opening markets to competition roughly 10 and 5 years ago, respectively. While laws and regulations vary by country, many U.S. power companies including TXU went abroad to cut their teeth in competitive markets. There, they learned valuable lessons before the U.S. began deregulating markets several years ago, explains Ahmad Faruqui, an energy expert at Charles River Associates, a consultancy in Oakland, Calif.

Some wary investors point to TXU's exposure to Enron as a possible risk. The two companies sold natural gas and electricity to one another in the U.S., Britain, and Australia. In early December, TXU disclosed its potential earnings exposure to Enron and then formally discontinued its relationship with now-bankrupt company. "When you look at positions across world and after assessing legal ramifications, the bottom line comes down to $20 million in profits we won't realize from Enron after deducting for a loss," explains Anderson of TXU. Analysts don't anticipate the Enron exposure to have a material impact on the company's growth prospects.

Plus, TXU faces the constant challenge of flighty commodity prices. Lower natural-gas prices are hurting some energy companies as unusually mild winter weather has driven down demand. And the company, like many of its rivals, became highly leveraged as it paid for investments. TXU acknowledges it got overloaded and has since sold some $5 billion in assets the past two years to raise cash and pay down debt. Management says it aims to reduce the ratio of debt to capital to 55% by midyear in 2002, leaving it a touch higher than its peers.

TXU's Anderson says the company won't pursue an ambitious building campaign of new power plants. Instead, it intends to contract out for additional power needs and preserve capital. And if the company can deliver on its growth projections, TXU could appeal to investors looking for an energy company whose future prospects aren't tied solely to generating assets or to retail customers. TXU is tied to both. Wee covers financial markets for BusinessWeek Online in New York


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