Greg Gordon, CFA
Citigroup Global Markets
The Citi utility index was down 24.4 percent in 2008 vs. 36.1 percent for the S&P 500 on a total-return basis, beating the market for a fifth consecutive year.
Lacking conviction on a “theme,” we are recommending a barbell approach. Weak power-market dynamics continue to be an overhang on the outlook for integrated utilities. Our favorite ideas in this space can either still grow earnings due to below market hedges rolling up over time, or are credit-worthy and the stock is inexpensive enough to argue that investors are paying very little to get leverage on a future economic recovery.
Looking at the financing picture for the industry, access to the credit markets over the last two quarters has allowed the net liquidity position for the group to improve markedly (under a worst-case scenario most companies have adequate cash flow and access to capital to “ride out” ’09 with minimal capital market access).
One of the supportive factors we are seeing is a (modest) improvement in authorized return on equity over the past 12 months after a seven-year decline.
Public Service Enterprise Group Inc. (PEG): Like most integrated utilities, PEG looks undervalued to us. Despite an earnings profile that grows only modestly over the next several years due to several headwinds, we believe that the stock has relatively low downside risk at current levels and provides an expected total return of greater than 15 percent to our target prices of $32, which is 11.5 times ’09 utility earnings, a nominal value for holdings, and 6.2 times our “open” EBITDA estimate for PSEG Power based on a long-term gas price assumption of $7.25/mmbtu.
Despite current market conditions, we believe PEG will be able to maintain a strong balance sheet throughout our forecast horizon.