March 18, 2009
Of the top five utility stocks in 2008, only two ended the year in positive territory. The third best-performing stock, Unisource, was down 6.9 percent. What happened and will it happen again this year? Lots of factors are at play.
Barry Abramson, utility analyst at Gabelli Funds, took a look at five of the worst-performing stocks of 2008 to parse the negatives. Constellation, of course, is a case apart, although companies heavily invested in merchant trading were all hurt. Looking at other underperformers, however, reveals a distinct set of negative factors. New Mexico's PNM was squeezed by a need for rate increases, which hadn't happened for several years, despite rising costs. It got partial relief last year, but not enough to lift earnings anywhere near where they had been five years ago. At the same time, its fuel and operating costs continued to rise. As a result, the stock was punished, down a whopping 53 percent.
Allegheny Power was hit by a big decline in fuel prices, especially natural gas and oil. Increases in oil and gas prices over the past few years boosted profits because Allegheny generates power from coal and sells excess power into the grid. As the spread between coal and oil and gas shrank, so did the demand for Allegheny's coal-generated power.
Nevada's NV Energy was hurt by the big slowdown in its territory's real estate market. NV was for years the fastest-growing electric utility in the United States, driven by Nevada's extraordinary residential growth, the hottest housing market in the country. With the tsunami that hit the housing market, expectations for NV's growth were swept away along with its stock price.
Abramson believes concern about Michigan's industrial base, in the face of the terrible macro-economic conditions, hammered CMS Energy's shares. Even legislation favorable to the company, passed at year-end, didn't help. Nor did CMS's relatively low dividend. "Toward the end of the year, there was a rotation into names with higher yields," Abramson said. "CMS, Allegheny, and NV Energy all have lower yields relative to their peers, and that put more downward pressure on their stocks."
Like Abramson, Ed Metz, director of SNL Financials energy group, cites concerns over safety and dividends as major driving forces in 2008. "The small regulated guys were the more successful companies, since they're more isolated from some of the macro issues. Southern Company performed relatively well, down about 5 percent, because they're highly regulated and also because they benefited from a general flight to quality."
Companies with exposure to merchant trading were hurt and so were companies with a heavy presence in the midstream sector, according to Metz. "The industrial sector is a huge user of natural gas. As industrial activity falls, so does demand for gas, and companies like NiSource, a big midstream player, get hurt."
Defensive Strategy
The same factors that influenced stock performance last year are likely to determine winners and losers this year. Abramson expects the more defensive, regulated names to again lead the sector. But if there reliable signs of an economic recovery in the latter part of the year, he thinks there could be some rotation back into more aggressive names.
What effect the new administration will have on the sector remains unclear, although investment in infrastructure, which could include upgrades to the grid, would likely benefit the sector as a whole. So too would support for renewable energy initiatives, which President Obama has promised.
Although the impact of increased transmission spending may be delayed, Abramson thinks stocks could begin to respond positively by the middle of 2009, because the market would then be trading on 2010 expectations. At the same time, support for carbon cap-and-trade schemes, which were implemented at the beginning of the year and are similar to the Regional Greenhouse Gas Initiative (RGGI), could put pressure on those utilities that are heavily dependent on coal-fired plants.
And since any large moves in oil and gas prices are unlikely until there's a substantial pickup in manufacturing activity, companies invested in the midstream sector and those dependent on selling excess power into the grid are unlikely to do well next year.
As long as credit remains tight, companies facing big capital expenditures could be under pressure going forward. On the other hand, utilities in regulated markets that can pass through capital costs could actually benefit from the economic slowdown. Commodity costs are down and labor is readily available. Metz believes that for a utility in a regulated state with a strong relationship with its regulator, this could be an opportune time to expand nuclear capacity, especially if an existing site is ripe for expansion.
For investors with an appetite for speculation, even in today's market, he thinks basically solid smaller utilities, with a need for capacity expansion but with limited access to credit, could become attractive takeover candidates for larger firms. And for any investor queasy from the market's breakneck plunge, the sector as a whole, with an average dividend yield of 4.5 percent, remains an attractive defensive play.
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Richard Schlesinger
