Two Utilities That Have What It Takes

01/12/2010 11:00 am EST

Focus: STOCKS

Roger Conrad

Founder and Chief Editor, Capitalist Times

Roger Conrad, editor of Utility Forecaster and associate editor of Personal Finance, says the environment is good for utilities, and he picks two he thinks will prosper.

Not everything survived the historic economic and credit stress tests of the past two years-plus.  Many weak and debt-burdened businesses found once-outsized dividends too heavy to bear. But as the economy bounces back, the risks of strong companies stumbling are diminishing.

[Also,] credit risk continues to fall. A year ago, BBB-rated companies were forced to offer yields as much as ten percentage points above US Treasuries. Today, BB-rated debt spreads are less than half that. Low interest rates also mean higher earnings, as companies refinance existing debt and launch new projects more cheaply.

Electric utilities were the last major sector to succumb to the economic/market meltdown that began in mid-2007. Half a decade of cutting debt and operating risk—coupled with recession resistant businesses—left balance sheets and dividends the strongest and best protected in half a century.

Ironically, despite solid business performance, utes have lagged the broad stock market since the rally began in March. To some extent, that’s because they didn’t fall nearly as far during the downturn. But it also begs the question whether the market is reacting to challenges the sector faces.

Chief among these head winds is the substantial capital expenditures electrics face to feed growing demand and to reduce power plant emissions over the next decade. Carbon dioxide regulation is wending its way through Congress. But even if that effort fails, the Environmental Protection Agency is already planning new rules.

Meanwhile, 33 states and the District of Columbia have mandates in place for utilities to convert up to [one-third] of their generation to renewables in the next ten to 20 years. If utilities can recover this capital spending in electricity rates and prices, it will boost their earnings and dividends. If they can’t, the result will be lower credit ratings, dividend cuts and, in some cases, bankruptcy.

The difference-maker is regulation. Electrics operating in predictable regulatory environments will be able to make the investment profitably. Those in states with a so-called pro-consumer bias are headed for trouble.

Dominion Resources (NYSE: D) and Xcel Energy (NYSE: XEL) increased dividends this year by an average of 6%. Meanwhile, credit ratings and earnings guidance have remained steady, and borrowing rates have plunged.

The bad news is the recession has toughened regulatory environments across the nation. The good news is that’s still not true where Dominion (Virginia) and Xcel (Colorado, Minnesota, six Midwestern states) [operate]. The best sign is rate settlements [they] have forged in recent weeks.

As long as that’s the case, our utes’ share prices will eventually catch up with the market. In the meantime, [both] are Buys—Dominion up to $40 and Xcel Energy to $22. (Dominion closed above $39 Monday, while Xcel closed at around $21—Editor.)

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