August 22, 2005

Utility Funds Are Keeping The Power On

Returns are hotter than this summer's weather

Utility stocks have been as hot as this summer's weather.

Now that President Bush has signed into law the massive, multi-billion dollar Energy Policy Act of 2005, utility stocks and mutual funds that own them should receive more attention. But, given the current climate of rising interest rates and price gains already recorded, should investors remain enamored with utilities, or will this sector cool down to traditionally unexceptional levels?

To be sure, utility stocks have soared the past three years, rising from the ashes of the Enron disaster to refute the impression that the sector is meant only for widows and orphans, or conservative, defensive investors seeking modest, but stable, returns. For the three-year period ended August 5, the average utility mutual fund gained 33.6% annualized, versus a 17.4% rise for the S&P 500. In calendar 2004 alone, Standard & Poor's Utility Index climbed 32%, versus a 10.9% gain for the broader index.

Barry Abramson, research analyst with the $210-million Gabelli Utilities Fund/A (GAUAX), cites several factors to explain the recent resurgence of utility shares:

*They rose from depressed prices, resulting from the dark period of 2000-2002, when many utilities courted disaster by imitating Enron and Calpine Corp. (CPN) through the purchase of risky, non-utility businesses, like energy trading and marketing. Then, when utilities found themselves with too much debt and overvalued assets, they sold off these ancillary ventures, paid off their obligations, and concentrated on their core utility businesses. Their financial health improved dramatically.

*Utility companies are now flush with free cash flow, generated by robust profits, strong balance sheets and a strengthening domestic economy.

*The May 2003 tax laws, which reduced the average tax rate on dividends to 15% from nearly 39%, made high dividend-paying stocks, like utilities, more attractive to investors. Consequently, utility firms enacted big dividend increases, and still continue with relatively aggressive dividend growth strategies.

*The resumption of M&A activity this year has further boosted the sector, and promises more consolidation. Among the high-profile deals: Exelon Corp. (EXC) plans to buy Public Service Enterprises (PEG) for $15 billion, and MidAmerican Energy Holdings, a subsidiary of Warren Buffett's Berkshire Hathaway (BRK.A), made a bid to acquire PacifiCorp for $9.4 billion.

*The regulatory climate for utilities has vastly improved, particularly following the energy crisis in California and blackout in New York City. Utilities are now encouraged by regulators to increase expenditures on infrastructure like transmission/distribution networks, as well as incentives to invest in nuclear plant construction, alternative energy projects and clean-coal technologies.

Dividends: Higher and Higher

One of the biggest attractions of utilities lies with the steady stream of dividends they provide. John Kohli, portfolio manager of the $1.84-billion Franklin Custodian Fds:Utilities Series/A (FKUTX), believes utilities can keep raising dividends, making the stocks even more appealing to investors.

"Dividend payout ratios are now at about 60% of earnings," he notes. "Back in the early 1990s, before deregulation, the dividend payouts amounted to 85%-90% of earnings. So there is plenty of room for utilities to continue raising dividends."

Outside of utilities funds, a handful domestic equity funds have significant exposure to the sector. As of the end of July, Copley Fund (COPLX) had 55.8% of its assets in utilities, Kinetics Small-Cap Opportunity Fund (KSCOX), 34.5%; New Alternatives Fund (NALFX), 27.8%; Philadelphia Fund (PHILX), 27.1%; and Primary Trend:Income Fund (PINFX), 26.8%.

Consolidation: A Question of Pace

Bush's Energy Bill includes the elimination of the Public Utility Holding Company Act (PUHCA) of 1935, a law that made it difficult for utilities to merge. Also, the 1935 law placed restrictions on how much a non-utility investor could own in a utility. Typically, it was capped at 10%.

There are currently about 100 publicly-traded utility companies in the U.S. -- 70 electric and 30 natural gas. Abramson believes that through consolidation, that number could decrease to about 60 within five years, and down to 40 within a decade. He points out that the utility industry is presently very fragmented. "There are a lot of small- and medium-sized companies, and a handful of large companies," he says. "Consolidation in the sector is inevitable."

However, Kohli is skeptical about a potential flurry of M&A deals amongst utilities. Some observers believe that big companies like General Electric (GE), or major banks with a lot of cash, could buy electric utilities now that they can. But Kohli is not convinced this will happen. "I'll believe it when I see it," he says, adding that the recent spate of merger announcements "surprised" him. Despite a favorable new regulatory climate, things tend to move slowly in the utility business, he says. "Each merger could take 18 months to two years to complete.".

Gary Russell, senior analyst, with the $278-million AIM Utilities Fund/A (IAUTX), doesn't think the President's Bill goes far enough to alleviate the problems of the utility industry, nor will it necessarily speed up the pace of mergers. "Realistically, after 20-30 years of underinvestment and undercapitalization in the utility industry, there's not much that a single piece of legislation will do to help the industry," he said. "It will take a decade or more to properly recapitalize the entire sector, but the Energy Bill is at least a step in the right direction. "

Outlook for Utility Stocks

Perhaps the biggest obstacle facing utilities lies in the Federal Reserve's commitment to continue hiking interest rates, given the sector's heavy dependence on borrowing and credit ratings. Utilities flourished during a sustained period of historically low interest rates.

While higher rates will likely hurt the future performance of utility stocks, Abramson thinks the damage will be limited "because most utilities now have net free cash flow, so they're not borrowing as much as they used to." He believes the utility sector is now "fairly valued," but can continue to perform well due to higher dividends, steady and predictable earnings growth, and increased M&A activity. Utility shares can rise even further, "though their performance will not be great as in the past few years," he says. Abramson forecasts annual total returns of about 10%.

Kohli believes that given the current interest rate environment, utility stocks look "fairly valued to slightly cheap relative to where long-term Treasuries rates are today." Although utility shares may deliver modest returns from now on, he thinks more investors are willing to accept this type of performance in an era of spotty returns for equity markets as a whole.

Despite his reservations about the impact of Bush's Energy Bill, Russell maintains a bullish outlook on utilities. "The strong economic recovery in the U.S. is driving energy demand ever higher," he says. "Combined with very tight available supply and capacity, we're seeing strong pricing across entire energy spectrum."

While some observers are concerned that utility shares may have become too pricey, Russell thinks the greater demand for dividend-payers partly justifies richer valuations on utility stocks, and that the sector should continue to outperform the S&P 500 for the near term.

TOP FIVE UTILITY FUNDS FOR 1-YEAR PERIOD*

FUND

RETURN (%)

ProFunds:Utilities Ultrasector/Inv (UTPIX)

49.9

Jennison Utility Fund/Z (PRUZX)

49.0

Evergreen Utility & Telecom/I (EVUYX)

44.7

MFS Utilities Fund/I (MMUIX)

39.6

JHT Utilities/III

38.0

S&P 500 Index

17.4

Average Utility Fund

33.6

TOP FIVE UTILITY FUNDS FOR 3-YEAR PERIOD*

FUND

RETURN (Annualized %)

Jennison Utility Fund/Z (PRUZX)

31.3

MFS Utilities Fund/I (MMUIX)

29.8

Evergreen Utility & Telecom/I (EVUYX)

28.3

ProFunds:Utilities Ultrasector/Inv (UTPIX)

25.3

Eaton Vance Utilities/A (EVTMX)

24.6

S&P 500 Index

14.3

Average Utility Fund

21.3

TOP FIVE UTILITY FUNDS FOR 5-YEAR PERIOD*

FUND

RETURN (Annualized %)

Franklin Custodian Fds:Utilities Series/Adv (FRUAX)

10.9

Jennison Utility Fund/Z (PRUZX)

8.1

Eaton Vance Utilities/A (EVTMX)

6.3

FBR Gas Utility Index Fund (GASFX)

6.3

S&P Select Utilities SPDR Fund (XLU)

5.8

S&P 500 Index

-1.9

Average Utility Fund

2.3

*Source: Standard & Poor's. Data through Aug. 5, 2005.

InvestmentAdvisor.com has more mutual fund news from Standard & Poor's available here.
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