Utility Funds Are Keeping The Power On

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*

TOP FIVE UTILITY FUNDS FOR 3-YEAR PERIOD*

TOP FIVE UTILITY FUNDS FOR 5-YEAR PERIOD*

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

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