From the April 2008 issue of Research Magazine • Subscribe!

Generating Growth

Diversified electric utilities are proving their ability to grow earnings in a challenging environment, analysts say.

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Vikas DwivediMorgan StanleyVikas.Dwivedi@morganstanley.com

Sector Outlook: We continue to view our sector as fundamentally strong ... Our view is driven by our bullish outlook on the five key sector drivers: commodity, capacity, climate change, capital expenditures at the utility and capital optimization.

In particular, we believe that merchant generators and diversified utilities will outperform their regulated peers due to their commodity and capacity price exposure. Diversified utilities with merchant nuclear exposure such as Exelon and Public Service Enterprise Group also have positive exposure to carbon market development and should benefit from higher off-peak power prices. We are less excited about the prospects for regulated utilities due to their heavy dependence on utility capex (and favorable ratemaking treatment) to grow earnings and their lack of exposure to commodity, capacity and carbon market development.

Favorite names include: American Electric Power (AEP), Exelon (EXC), Natural Resource Group (NRG), Public Service Enterprise Group (PEG) and Reliant Energy (RRI)

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Greg Gordon, CFACiti Investment ResearchGreg.Gordon@citi.com

Outlook for Exelon (EXC): We expect EXC to grow earnings from $4.35/share in '07 to $5.00/share in '10 ... However, between the earnings uplift potential when its Pennsylvania jurisdiction goes to market in '11 and the potential earnings impact from the implementation of greenhouse gas caps circa '12, we think earnings "power" could approach $8/share. Given the stock's almost 15 percent decline from its 52 week high on 1/9/08, we think the stock is once again undervalued.

We have updated our "Open EBITDA" model taking in to account more robust assumptions regarding long-term power pricing and have updated our carbon model to reflect the most recent legislation advanced in Congress. Assuming a long-term natural gas price of $7.50/million British thermal unit (BTU) and $15-ton carbon pricing in 2012, EXC could be worth as much as $100/share longer term. Given the back-end loaded nature of the story and the high percentage of the value proposition associated with carbon leverage (over $15 share of potential net present value), we are maintaining our target price of $85/share.

Exelon is the largest merchant nuclear generator in the U.S., and it saw massive margin expansion in FY '07 from a transition to market rates in Illinois.

Over the '07-'10 period, EXC has some leverage to rising power and capacity prices, an assumed "reversion to the mean" on the ROE at [its unit] Commonwealth Edison, ComEd, and a modest level of annual share repurchases. This is offset in the short run by some cost escalation.

However, upside in 2011 from the roll-off of below market hedges in Pennsylvania followed by our presumption of the EPS impact from implementation of carbon caps in 2012, drives a materially higher earnings power estimate, potentially $8.00 share in 2012.

Outlook for Public Service Enterprise Group (PEG): We are raising our target price from $92 per share to $104 per share. The increase stems from higher near-term earnings per share estimates, as well as a higher open EBITDA analysis valuation given a better valuation for PEG and an increase in our long-term gas price assumption from $7.00/million BTU from $7.50 and a higher carbon value, given our views on emerging legislation.

We believe a handful of near-term catalysts will be positive for PEG, including (1) the Reliability Pricing Model (RPM) capacity auction, (2) the Basic Generation Service (BGS) auction and (3) the company's analyst day. We expect that all three will highlight a favorable supply/demand backdrop for PEG, the need for more infrastructure investment, the improving balance sheet and a more strategically focused story.

We note that our estimates are highly sensitive to our assumption about the price of power and our long-term natural gas price assumption. We currently assume that open energy positions are sold at a roughly 5 percent discount to forward power curves. A removal of this discount would increase our estimates by about 3 percent to 5 percent.

The stimulating impact of higher capacity pricing has driven PEG to announce its intention to build up to 400 megawatts of new gas-fired peaking capacity at a cost of up to about $350 million.

The company is currently conducting a feasibility study of the project under the auspices of PJM [Interconnection LLC]. We expect PJM to approve the project in early '08, construction to start in late '08 and [the peaking power plants or] "peakers" to be online by '10. We assume that these peakers will be eligible for capacity payments starting in '11.

If all of this capacity was successfully bid into the RPM capacity auction, we estimate it could add about $0.05 to $0.10 to EPS on a fiscal year basis. We note that the roughly $350 million cost is incremental to the company's latest capex forecast and that PEG is considering adding up to some 1,000 megawatts of gas-fired peaking capacity over the longer term.

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