Power plays
The low-voltage utility sector suddenly has plenty of juice. We've found three stocks to plug into now.
By David Stires

(FORTUNE Magazine) – FOR DECADES, UTILITIES WERE CONSIDERED one of the safest and most reliable investments around. Then came the deregulation of the electricity markets in the 1990s. Intoxicated by the lure of easy money, utility executives went on a building binge and embarked on risky ventures such as energy trading--leading to massive overexpansion and a raft of bankruptcies. Suddenly the ultimate safe-haven stocks became downright dangerous.

Over the past few years, however, utility executives have gotten back to basics. Forced to sober up, they have taken advantage of low interest rates to refinance or pay off much of the debt they accumulated during their spending splurge. With cleaner balance sheets, they have been reinstating and raising dividends--which yield-starved investors have eagerly gobbled up. As a result this once-stodgy sector has become--dare we say it?--hot.

Consider the numbers. The S&P 500 utilities index rose 65% between Dec. 31, 2002, and March 31, 2005, including dividends. That easily beats the S&P 500's 40% return during the same period. And the strong showing has spawned a number of big takeovers, including Duke Energy's $9 billion acquisition of Cinergy in early May.

Whether the run can continue is a topic of much debate. After such a sustained upward move, bears say utility stocks are significantly overvalued. The S&P 500 Utilities index now trades for about 17 times the previous 12-months' reported earnings. That's about 10% below the S&P 500's multiple of approximately 19 times reported earnings. The problem is that the utilities index typically trades at a 25% discount, according to Sam Stovall, S&P's chief investment strategist. And the unusually rich valuations are a big reason utility shares have recently become a favorite target among short-sellers.

Bulls freely admit that utility stocks seem overvalued, but they still believe there's another leg up from here. Basically, they're betting that utilities will outperform because they're classic defensive plays that do well when the economy cools--something that appears to be happening now. When growth slows, companies think twice about buying new computers. But they still need to switch on the lights.

In a new report, longtime utility bull Richard Bernstein, chief U.S. strategist at Merrill Lynch, crunched some numbers to back up his case. Bernstein measured the performance of utility stocks during previous periods of slowing corporate profit growth. If the historical pattern holds, he says, electric and gas utilities are now at a 25% to 40% discount to the S&P 500.

Indeed, Bernstein actually considers utilities to be something of a backdoor growth sector. He points out that stocks in the group typically rise by 25% when overall profit growth is slowing, whereas tech stocks fall by 15%. "I think utilities could have a real good time for the next 12 months," he says.

Still, given the lofty valuations, investors will want to choose carefully. Judy Saryan, manager of the top-ranked Eaton Vance Utilities fund, which gained roughly 25% in each of the past two years, follows a conservative playbook. She recommends that investors steer clear of distressed securities and focus on companies with clean balance sheets and cash flow that's strong enough to fund dividend growth.

One of her favorites right now is Xcel Energy (XEL, $18). With $8.3 billion in sales, the Minneapolis company has been licking its wounds after its failed foray into the largely unregulated wholesale energy market. CEO Wayne Brunetti oversaw one of the largest write-offs in utility history--$2.8 billion--when the company's wholesale subsidiary NRG Energy filed for bankruptcy in 2003. With NRG out of the way, Brunetti has been rebuilding Xcel around its core electric and gas utilities, which serve customers in ten Midwestern and Southwestern states.

What appeals to Saryan, besides the company's improving financials, is Xcel's substantial asset base and low-cost fuel mix. Its 15,000-megawatt generation portfolio runs primarily on coal and nuclear power, a big advantage in the current high-priced natural gas environment. To increase revenue, Brunetti is now looking to leverage these assets by raising rates in Minnesota and Colorado, Xcel's biggest markets, where it serves cities such as Minneapolis and Denver. He's targeting 7% to 9% annual returns from a mix of slow-growing earnings and a rising dividend. At 14 times trailing earnings, the stock sells for about a 25% discount to the S&P 500. And it has a dividend yield of 4.8%, well above the 3.7% industry average.

Another company whose stock has yet to fully recover from the deregulation debacle is American Electric Power (AEP, $35), an Ohio-based company with $14 billion in sales. In the wake of the previous CEO's leap into businesses such as energy trading and foreign power generation, new boss Michael Morris has been shedding noncore assets and using the proceeds to buy back stock and pay down debt. Earlier this year he unloaded a natural-gas pipeline in Houston for about $1 billion, eliminating the final major drag on earnings from unregulated investments. With the balance sheet in better shape, he can focus on AEP's core electric-utility business, which delivers power to customers in 11 Midwestern and Southern states.

Now Morris is spending $3.7 billion to reduce emissions from the company's coal-fired plants to keep them in compliance with increasingly strict environmental regulations. The sum has given some investors a jolt. But Ohio recently allowed AEP to recover almost half of these expenditures through rate increases. And Franklin Utilities fund co-manager John Kohli believes other state regulators will do likewise. He points out that AEP is seeking recovery in major coal-producing states such as West Virginia and Kentucky, where lawmakers are reluctant to discourage coal consumption. Shares now trade for 14 times trailing earnings and yield 4.0%.

Exelon (EXC, $47) is poised to become the industry's 52,000-megawatt gorilla. The Chicago-based company announced last December that it would buy Public Service Enterprise Group, the New Jersey holding company for Public Service Electric & Gas, in a $12 billion deal. Pending regulatory approval, which is expected in the first half of 2006, the new company, Exelon Electric & Gas, will be one of the largest utilities in the country. With annual sales topping $25 billion, it will serve about nine million electricity and gas customers in Illinois, New Jersey, and Pennsylvania.

What's most appealing about the deal is that it strengthens Exelon's lead as the nation's dominant nuclear-power producer. With natural-gas prices expected to remain stubbornly high for the foreseeable future, nuclear-fired electricity has huge financial advantages for utilities. It currently costs about a third as much to produce electricity from nuclear power as it does from natural gas. The difference goes directly to the company's bottom line. "As a low-cost producer, Exelon gets the best margins," says Franklin's Kohli. Perhaps best of all, Exelon's $1.60-a-share dividend offers a bit of that old-fashioned safety.

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Energy Boosters

Solid growth and big dividends make these utilities attractive.

[This article contains a table. Please see hardcopy of magazine or PDF]

*Prices as of May 12, 2005. **Based on trailing 12-months' earnings.