Adamant: Hardest metal
Monday, February 3, 2003

Utility Stocks Viewed As `Toxic'

www.theledger.com

WASHINGTON If President Bush gets his way, investors will receive their dividends tax-free. You'd figure that one sector to benefit would be gas and electric utilities, which, through the years, have offered consistently high dividends.

Right now, the yield on the average utility stock is 4.5 percent. Compare that to the 2.9 percent yield on a five-year Treasury note. Now imagine that the utility's dividends, which historically have risen a bit each year, aren't taxed. Investors in an average tax bracket would be able to put about 21Ú2 times as much money in their pockets with the utility as with the Treasury security.

"The timing of a dividend tax change could not be better for the utility sector," wrote Steven Fleischman, of Merrill Lynch, in a letter to clients. There's no guarantee Bush's proposal will pass Congress, but, even so, utility stocks ought to be soaring. They're not.

Franklin Utilities A (FKUTX), a mutual fund that invests mainly in U.S. electric companies, is down 2 percent this year. Exelon Corp. (EXC) of Chicago, the only Midwest or Eastern utility that's rated above-average by the Value Line Investment Survey, has dropped 4 percent, and Dominion Resources (D) of Virginia, the only utility among the 43 stocks in Morgan Stanley's U.S. model portfolio (and a favorite, as well, of Fleischman's), is down a few cents.

What's wrong with utilities? A lot. Many investors view them as downright toxic, and even the prospect of tax-free dividends doesn't seem to help. But it is the very fact that utilities are being shunned that makes them attractive. It's no accident, for example, that Berkshire Hathaway Inc. (BRK), chaired by super-investor Warren Buffett, has purchased Mid-American Energy, with 5 million gas and electric customers.

But most investors want nothing to do with such companies, and for apparently sound reasons. The main problem is that utilities are no longer safe, defensive stocks, producing a secure stream of income. They are something else, but no one is quite sure what.

In the past, utilities accepted strict regulation in return for geographic monopoly franchises. They generated not just electricity but a delightful flow of cash, dispensing about 80 percent of their profits to shareholders. When the economy was good, demand for power increased, so profits rose; when the economy was poor, demand fell, but, since borrowing costs dropped, too, utilities maintained decent profits.

In the early 1990s, this cozy little world began to change with deregulation. Ending monopolies, allowing utilities to expand beyond local borders and into new businesses, and reducing price controls -- all of those steps are ultimately good for consumers and for the economy. But the steps also threw this conservative industry into turmoil.

Suddenly, as Vincent Muscolino wrote in a recent letter to clients at the Cambridge, Mass., investment firm of David L. Babson & Co., companies gained the authority to "unbundle and repackage the three basic components of service: power generation, transmission and distribution." Especially with a rash of mergers, it became hard for investors to determine the strategic direction each utility company would take, or the competition and continuing regulatory obstacles it would meet along the way.

In addition, utilities lost much of their financial security. Instead of being content to disgorge their profits as dividends, they were pressured to reinvest them in new plant and equipment to achieve the double-digit earnings increases that investors were now expecting from a transforming industry that had gained sex appeal.

Despite these uncertainties (or maybe because of them), utility stocks started to rise powerfully in the mid-1990s. They were behaving almost like technology stocks. The Dow Jones Utility Average rose 129 percent between the start of 1995 and the end of 2000, then lost all of its gains by October 2002. The stocks rallied over the next three months, but they have since leveled off or dipped. The utility average today remains nearly 50 percent below its high.

Here's what happened: In the early years of deregulation, Wall Street was impressed. New capital arrived, and -- not surprisingly -- the industry became overbuilt. Supply exceeded demand; profits dried up. Old-fashioned managements couldn't handle the changes. As Fleischman says, the industry is "still digging out of excess leverage, a difficult credit environment, and a spending binge on power plants."

Meanwhile, the angry political reaction to electricity shortages and manipulation in California in 2000 and the Enron scandal in 2001 (which involved a pipeline company that decided to make a living trading energy futures and anything else it could get its hands on) added still more regulatory uncertainty.

It's a miserable situation, but that's precisely why you should pay attention. Many of these stocks are absurdly cheap. In a recent roundup, Dow Theory Forecasts found that 14 of 62 electric utilities had price-toearnings (P/E) ratios of 9 or less. The average was 12, or slightly more than half the P/E of the Dow Jones Industrial Average.

Of course, many of these companies deserve their low valuations. Aquila Inc. (ILA), for example, earned $2.35 in 2001 but trades today at just $1.85(down from $37.80) after a disastrous year. Stay away.

On the other hand, Wendell Perkins, who manages the Johnson Family Small-Cap Value Fund (JFSCX), which has returned an annual average of 8 percent over the past three years (whipping the S&P by 22 points), has lately been buying shares of Alliant Energy (LNT), a utility that also suffered a big drop in earnings last year. Alliant made what Perkins calls "some dumb, dumb international purchases," particularly in Brazil, but the company, with a solid Midwest franchise, is returning to its senses.

For total return (that is, dividend plus potential price appreciation), Dow Theory Forecasts recommends Duke Energy (DUK), a battered North Carolina-based electric utility yielding 6.4 percent; KeySpan (KSE), a Brooklyn-based gas utility with a yield of 5.2 percent; Questar (STR), a solid company whose stock has actually doubled over the past three years; and Vectren (VVC), which distributes natural gas in Indiana and Ohio and yields 5 percent. With the potential for so much volatility among the 80-plus electric and gas utilities, diversification is essential. Unfortunately, most mutual funds with "utilities" in their names are loaded with telecommunications stocks -- another sector entirely. Franklin may be the best pure play. The "A" shares carry a 4.25 percent load but has annual expenses of only 0.8 percent. Average annual return for the five years ending Dec. 31, 2002, was 1.5 percent, about two points ahead of the S&P.

No, utilities aren't what they used to be. The idea of sitting back and enjoying a tax-free dividend of 5 percent really isn't in the cards. These companies, undergoing massive changes, carry major risks. But where there are major risks, there are often major rewards.

James K. Glassman's book, "The Secret Code of the Superior Investor," was recently published in paperback. His e-mail is jglassman@aei.org. He invites correspondence, but cannot answer everyone.

Last modified: February 02. 2003 12:00AM

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