From the April 2007 issue of Research Magazine • Subscribe!

April 1, 2007

Generating Growth

Different utility groups are proving their ability to limit expenses, acquire rivals and meet the challenges of regulation.

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Maury May

Soleil-Power Insights

508-636-9934

maurymay@power-insights.com

Area of coverage: Electric Utilities*

Outlook: From a standpoint of underlying fundamentals, the outlook for the sector is positive. Coming off the implosion during the California energy crisis in 2000 and 2001, the industry went back to basics and decided to invest in regulated activities -- distribution, transmission, and generation. So they are doing what they do best, and so far they are getting a lot of regulatory support because a lot of projects are overdue. There are utilities that haven't built a new power plant in 20 years. Some transmission projects have been on the drawing boards for 30 years. The situation is similar with regards to distribution. Some companies are rebuilding old substations in big inner cities, replacing old cables under streets, etc.

There's a lot of construction going on, and the electric utilities have a lot of good regulatory support these days generally because a lot of these projects are needed. As for the stocks, the utilities have really done very well. They have either kept up with the market or outperformed the market for three or four years. So, they are not as cheap as they once were. As a result, you have to be selective about what you buy. Sometimes the ones that have the value are the ones that have a lot of uncertainties.

Buys: Integrys Energy Group (TEG), PNM Resources (PNM), and (UNS) Unisource Energy

*May serves as a trustee of a family trust that owns Unisource Energy and also owns shares in Peoples Energy.

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Greg Gordon

Citigroup

212-816-2802

greg.gordon@citigroup.com

Area of Coverage: Electric Utilities

Outlook: The Citigroup Utility Index was up 20.5 percent in 2006 vs.15.8 percent for the S&P 500 on a total return basis, beating the market for a third consecutive year. Leadership came from both regulated "defensive" and commodity sensitive "integrated" utilities.

The defensive names still trade at a premium to the more integrated stocks, where valuation is highly disparate. Trading at 14.5 times 2008 EPS as of 1/11/07, the group is at a 1.03 times relative P/E to the S&P 500 on '08 expectations, near a 15-year high. The defensive universe trades at 15.2 times 2008, while the integrated names trade at 13.7 times. The defensive universe offers dividend yields averaging +/-4 percent and earnings growth rates between 2006 and 2008 of 5 percent compared with integrated sub-group yields of +/-3 percent, but EPS growth rates averaging 13 percent, although if commodity prices continue moderating there is risk to the downside on EPS expectations as some of the integrated names have open '08 production volumes.

Defensive stories offer accelerating EPS growth but look fully valued judging by interest rates and regulation. They produce greater than 80 percent of earnings from regulated businesses and do not take commodity price risk, passing it on to customers. EPS growth will be driven by rate-base additions in transmission and distribution, accelerating environmental spending and new base load coal plant expansions, and the potential for nuclear.

Last year, we thought that regulatory exposure would be an increasing risk as new investment and commodity prices would drive rate increases that would put pressure on authorized returns. We continue to be wary of this issue, but it hasn't materialized to date. With dividend yields averaging 4 percent and dividend growth of 4 percent, these stocks exhibit high correlations to interest rates and discount 10-year Treasury bond yields staying less than 5 percent.

Integrated names look only selectively attractive, with positive earnings leverage and reasonable valuations harder to identify. The integrated names have energy-centric businesses that generate -- on average -- 50 percent of 2007 EPS and have just under 3 percent average yields; therefore, their correlation to interest rates has diminished, with earnings and dividend growth tied more to the commodity cycle.

For the majority of these stocks, our 2008 earnings expectations reflect market, which is a risk. This is because: one, several have had below-market hedges roll off and entered new contracts at or above the current curve; two, moderation in forward pricing has compressed the discount we generally assume on un-hedged volumes; and three, for select companies we are using a lower discount because we have a bullish point of view in the markets in which they operate.

We have begun using an "open EBITDA" approach to stress test the valuation of these names at different long-term gas prices and are only recommending stocks that are cheap to the expectations of long-term gas prices at $6/mmbtu, with our favorite ideas in markets where supply and demand is tightening and pushing up market heat rates.

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Ajay Jain

UBS

212-713-9321

Ajay-K.Jain@ubs.com

Area of Coverage: Water

Outlook: We think the domestic water sector in general has strong industry fundamentals and is among the most defensive industries in the U.S. We have a favorable long-term view of the sector, since it has an annuity-based revenue model, and also because the industry remains regulated (which we as a positive since the regulatory framework provides for more predicable earnings growth).

In terms of the most important catalysts in this space, we think that industry consolidation will continue to play a big role over the foreseeable future. The majority of water systems are still run by municipal governments and most of these serve very small communities. Recently, we've seen a lot of demand globally for infrastructure-related assets and in the water sector, in particular. In addition to Aqua America's recent acquisition activity, United Water (owned by Suez Group) recently reached an agreement to acquire Aquarion Water Company of New York from U.K.-based Kelda Group. We also believe that wastewater represents a significant growth opportunity for the industry overall. While not as fragmented as the water industry, the growth potential is compelling. Projected capital spending needs for wastewater are $390 billion over the next 20 years, and the wastewater industry is still 98 percent owned and operated by municipal governments. Since it also offers a regulated rate of return, we view wastewater as complementary to traditional water operations.

The most important development over the next 6-12 months is likely to be planned divestiture of the American Water subsidiary of German-based RWE. Based on the potential for higher liquidity, there could be some near-term headline risk for water stocks, although we would not expect any fundamental, longer-term valuation implications for the sector.

Why Aqua America Inc. (WTR) is rated Buy: We currently have a Buy rating and $27 price target for Aqua America. Although Aqua America's share price generally under-performed in '06, we believe it remains the best-in-class, investor-owned water utility domestically. We attribute the lackluster earnings trends from last year mostly to issue of regulatory lag and, more recently, due to lower water consumption trends in the mid-Atlantic region. Despite the recent headwinds, we expect Aqua America to remain among the fastest growing and highly visible water companies relative its peer group.

The degree of fragmentation in the water industry should also create opportunities for further consolidation. Given that there are very few providers in the industry with meaningful size and scale, we see Aqua America as one of the biggest beneficiaries of this trend.

Recent acquisitions of New York Water Service Company and Aquarion Water Company of Sea Cliff (both in Long Island, N.Y.) highlight the company's strong appetite for acquisitions. We also think much of the long-term success of Aqua America stems from the leadership of CEO Nick DeBenedictis and what we view as the "hustle factor," a key competitive advantage for the company. This stems from management's ability to contain costs, identify and integrate acquisitions, and work effectively with regulators to achieve a high level of cost recovery.

Longer term, we expect that Aqua America will continue to be one of the largest beneficiaries of industry consolidation. The growing infrastructure needs of the nation's water supply (estimated to be $280 billion over the next 20 years) and the unrealized consolidation potential of the water sector should fuel Aqua America's growth platform for years to come. Following a significant phase of geographical expansion that began in the late 1990s, we look for the company to continue to be opportunistic with respect to its acquisition strategy. Additionally, while just 10 percent of the current sales mix is generated from wastewater operations, we believe this represents a significant growth opportunity. Aqua America's financial objectives (7 percent revenue growth, 10 percent earnings, 5 percent dividend growth) are also highly sustainable, in our view.

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