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The Power and the Story: Breaking Down the Alternative Energy Plays

So, new power's the next new new thing. But will the end of the story be the old old nightmare?

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Seems everyone's mad, mad, mad for this investing theme these days and that's understandable. Silicon Valley gurus are working by oil lamp and CNBC's talking heads are gushing over alternative energy stocks' gains. Two weeks ago we told you fund shops were jumping on the bandwagon with a gush of "new power" or "energy tech" funds bursting from their product pipelines.

Let's take a closer look at why everyone's jazzed, and where these funds will be investing. Although most of these companies have a utilities or energy label, they aren't for widows and orphans. In fact, some are "story stocks" -- unprofitable companies with a great story or concept that has made them Wall Street darlings -- which lends them an eerie similarity to now-fallen Net angels.

Even if you're not interested in buying these stocks or new-power funds, they're probably starting to turn up in growth funds you already own. For that reason alone, it's probably a good idea to check out this basic overview of the most popular industries in this theme. While they're hot stocks now, not all of these story stocks will have happy endings.

The Excitement

The buzz about the new-power theme is driven not just by California's current power debacle. The broader idea is that we haven't built enough power plants in recent years to run our prized digital economy. For instance, servers in beautiful Jersey City, N.J., run this Web site and there are seemingly endless floors of similar servers out there. They all can be seriously disturbed by outages that last just a second or less.

The upshot: We don't just need more power, we need more reliable power. And because the utilities industry is deregulated, there could be a messy and profitable scrum to meet corporate and consumer power needs.

"The hook to this whole thing is that the infrastructure of this country isn't correctly designed for this massive demand," says John Hammerschmidt, who will be the lead manager of the Turner New Energy & Power Technology fund when it launches on Feb. 28. "We need more power, more uninterruptible power and cleaner power. There are solutions and they're expensive, but they're cheaper than the problems that come with losing power."

Now let's look at a few packs of companies that are seen as providing these solutions, starting with the most mature and ending with the most speculative.

Independent Power Producers

These companies typically have newer and more-efficient power plants that run on natural gas, rather than coal. Some do sell power to local customers, but in varying ways they all are in the business of selling power at peak times to utilities that can't meet their customers' needs. The upside is that they can charge steep rates for this peak-time power, and because it takes five years to build a new power plant -- if the plants' neighbors grant permission -- these folks should be shoring up shortages for some time. Their efficiency can also help these shops compete for customers on price.

"If you're a low-cost producer in a large, consolidating industry, you can attract more customers," says Justin Craib-Cox, a utilities analyst at Morningstar.

On the other hand, these shops could have a tough time if they have to pay higher prices for the natural gas that runs their plants. They reduce their risks by signing both short- and long-term agreements.

"The risk, in my view, is that natural gas prices will keep running up. Then you've got these plants out there that will have to pay two to three times as much as usual for gas. The other problem is that we're going to run out of natural gas supply if we keep using it up at this pace because all of the new generation is based on it," says Robert Loest, manager of the (IPSMX) IPS Millennium fund, where he holds shares of several independent power producers like Calpine (CPN) and AES (AES).

Here's a watchlist you can use to track this industry -- including powerhouse Enron (ENE), which is loved by growth investors everywhere, including growth-fund titan Janus. Many of these stocks have had steep run-ups, but some have been knocked down recently as California haggles over what prices it will pay for the energy it needs.

"We think these companies have tremendous opportunity for earnings growth over the next few years," says Roger Mortimer, co-manager of the (GTNAX) AIM Global Resources fund, which had Enron and Dynegy (DYN) among its top-10 holdings at the end of the year. "These companies are more expensive than they used to be, but valuation isn't an easy assessment. There isn't enough generating capacity and they solve that problem."

Down With IPP?
These independent power producers have drawn
attention in the race for new energy sources
3-Year Average Return Price-To-Next Four Quarters' Estimated Earnings
Calpine (CPN) 168.5% 30.9
Dynegy (DYN) 87.4 26.4
Enron (ENE) 57.8 47.0
AES (AES) 38.5 30.5
Duke Energy (DUK) 14.4 15.6
S&P 500 13.1 23.2
Source: Morningstar, BulldogResearch.com and Baseline/Thomson Financial. Data through Feb. 1.

From these established companies, new-power investors could also move into technologies long on promise, but often short on profits: microturbines and fuel cells.

Microturbines

These are essentially tiny jet engines that can convert up to nine types of fuel into clean power. These are being used, on a limited basis and in beta tests, in buses, and they could be used in cars. But they also can help solve the uninterruptible power problem by taking up the slack when power dips or is lost altogether in a home or big company.

"Microturbines are used most typically as backup systems for customers who can't lose power, like hospitals, for example," says AIM's Mortimer. "We're fairly young in the commercial deployment of the technology, but it's reliable."

Young is right. Capstone Turbine (CPST), the major pure-play microturbine shop that's publicly traded, isn't profitable. The firm had its initial public offering just last year and the fast-growing firm currently trades at more than 130 times its sales, compared a 2.1 price-to-sales multiple for the S&P 500, according to Baseline/Thomson Financial.

Big Capstone
This microturbine company's price-to-sales
multiple is anything but micro
3-Month Return Price-to-Sales Multiple
Capstone Turbine (CPST) -25.6% 145
S&P 500 -4.4 2.0
Source: Morningstar and Baseline/Thomson Financial.
Data through Feb. 2.

Of course, bigger shops like General Electric (GE) dabble in microturbines too, but GE is hardly a microturbine play. That said, the behemoth could make a big splash if it wished.

"Capstone is the first mover and what they have is superior to what GE has, but GE could catch up," says Turner's Hammerschmidt. While investors are intrigued by microturbines' ability to shore up power inconsistencies, there's no certainty as to when or if they will find the wide audience some predict.

Fuel Cells

There are many different types of fuel cells, but most convert hydrogen to electricity with next to no emissions. This process has been known and used for years, but there's excitement about it now because they could be used to power everything from electronics to cars. Like microturbines, they could also be used as back-up systems for consumers and major corporate customers.

"My standard line is that the market for fuel cells will either be huge or large," says Gregory Dolan, deputy executive director at the U.S. Fuel Cell Council, the industry's trade association. He points out that 60 million cars are sold each year, paving the way for a big market if fuel cells can crack it.

That said, Dolan says most of these applications are in beta testing and most commercial introductions are slated to start over the next three years. Even Turner's Hammerschmidt, a fuel-cell fan, is cautiously optimistic.

"I think they're still kind of pie in the sky, but they do have some beta sites that are working well. I think they'll end up in cars. They're real and they're doing deals with automakers that are exciting. We're talking about years down the road, but it's out there," he says.

Power Plays
Here are the fuel-cell companies that
investors are getting a charge out of
3-Year Annualized Return Price-to-Sales Multiple
Ballard Power Systems (BLDP) 46.5% 272
FuelCell Energy (FCEL) 134 54
Plug Power (PLUG) N/A 104
S&P 500 13.1 2.0
Source: Morningstar and Baseline/Thomson Financial.
Data through Jan. 24.

As often happens with young technology shops, investors have gotten excited about its potential without necessarily factoring in a distant payoff. Last year shares of Ballard Power Systems (BLDP), the consensus leader, rocketed up 124.1% and FuelCell Energy (FCEL) rose nearly 450%. Neither shop is profitable and not everyone is sold on their bright future.

"There are a lot of companies out there like Ballard, FuelCell Energy and Plug Power (PLUG) where I think people got a little carried away and frankly, so did we. We recently sold Ballard and FuelCell because we realize they probably aren't going to be used in autos," says IPS Funds' Loest. "These prices reflect a lot of optimism but we don't know what they're worth yet, kind of like Net stocks."

If you're looking for a company with fuel-cell operations and profits, you have to check out the likes of behemoth United Technologies (UTX).

As you can see, there are a range of ways you can play this "new power" theme, but what technologies and companies will win out or how long it will take for them to get traction and reach a broad market is far from certain. One certainty, however, is that it's probably best to use a fund to invest in these complex industries and if they take off you'll have no shortage of funds to choose from.

The Junk Pile

The odd, small world of shareholder-run funds is planning to join the tony hedge fund club.

StockJungle.com, the online money management that brought you the (SJCIX) Community Intelligence fund, where pros choose among amateurs stock picks, is sifting through the 20,000 folks that run virtual portfolios on its Web site to find regular folks with an irregular knack for picking stocks. The idea is to cull 10 amateurs with the best returns running portfolios with different styles and, after a background check, give them each up to $2 million to invest. The best will eventually get their chance to run a hedge fund, according to a company press release.

Because hedge funds, which fly under regulators' radar screens, typically are only available to millionaires, it's logical to wonder if many well-heeled types will really want to give that much money to the winners of this investment talent show -- the first amateur the firm picked is Dr. Chirag Amin, an orthopedist, medical textbook author, and investing junkie.

The Community Intelligence fund, launched in November 1999, only lost 1.7% last year, beating 90% of its big-cap growth fund peers, according to Morningstar. But it seems few of the folks pitching the stock ideas in the fund actually own shares given its $4 million asset base, compared to $1.5 billion for its average competitor. Whether this concept succeeds or fails, I think it's probably a better marketing idea than an investment idea.

Fund Junkie runs every Monday, Wednesday and Friday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com, but he cannot give specific financial advice. Editorial Assistant Dan Bernstein contributed to this article.

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