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TheStreet Open House

Today's Electricity Sector No Haven for the Squeamish

In recent years, some investors have relied on the big electricity companies to insulate them from the typically unpredictable world of stocks. It's been a hum-drum sector known for conventional business practices, a distaste for risk, minimal growth and, perhaps most important, reliable and constant dividend flows.

Well, the times they are a-changin', and fast.

The sector is getting a major facelift as deregulation opens it up to some giddy growth opportunities and, as a result, plenty of risk.

Before deregulation, power companies were limited to generation and transmission of energy within a specific geographical area. While state regulators put a floor under earnings, they also put a ceiling on them, and a pretty low one at that.

Playin' It Safe
Distribution Stocks
American Electric Power AEP
Enstar ENSR
GPU GPU
Wisconsin Energy WEC
In this brave new world of deregulation, companies are allowed to sell generation and transmission services outside their former monopoly territories. They are no longer guaranteed earnings. And they can expand into natural gas, independent power development, power-line construction, cable distribution, telecommunications and foreign markets.

Several companies are opting to stay in the distribution business, but others are rushing to diversify. The pluckiest of the bunch are focusing on what has become a high-stakes generation and commodity trading market. The first group remains a slow-growth, low-risk investment, while the other two are morphing into high-risk, high-yield growth plays.

And that means investors have to look before they leap.

"The key is that deregulation just changes the total paradigm that a utility operates under," says David Parker, a senior vice president and research analyst at investment bank and brokerage Robert W. Baird.

"The challenge for investors today is understanding that you need to be very careful about what you invest in. It used to be that you could buy any utility because they were all very similar. But you can't do that any more. Today, I divide them into three different groups, each of which is very different in terms of returns and risk," he says.

Second Tier
Diversified Services
DTE Energy DTE
DQE DQE
Florida Progress FPC
Hawaiin Electric HE
Teco Energy TE
MDU Resources MDU
Montana Power MTP

Risking It

Choosing the appropriate risk level may not be enough. Investors have to watch companies, as well as oil and gas prices, carefully. Companies that step into the deregulated arena are going to face a lot of competition, not just from other utilities, but also from interlopers from outside of their industry.

They'll also face pressure from Wall Street, which has worked itself into a tizzy over some of the higher-growth opportunities in the sector. California-based independent power producer Calpine's (CPN) stock, for example, has soared more than 150% since mid-April and is now trading at a price-to-earnings ratio of 64. Some of the recent strength is due to extremely tight supply in California, which has jacked up power prices to unprecedented levels.

"I think the excitement and higher expectations from Wall Street does raise risk. Some companies' managements are trying to keep up with the Joneses. I want companies that really know what they do well and won't have an identity crisis," Parker says.

The different players in each group will likely shift and swing as companies continue searching for the perfect niche. A spate of mergers, acquisitions and spin-offs has been stirring up the sector since last year and is expected to continue.

High Stakes
Commodities Trading
AES AES
Calpine CPN
Duke DUK
Edison International EIX
Energy East EAS
Entergy ETR
FPL Group FPL
Peco Energy PE
Reliant Energy REI
Some recent deals include the acquisition of New Jersey's GPU (GPU) by Ohio's FirstEnergy (FE), a merger of equals between FPL Group (FPL), which controls Florida Power and Light, and Louisiana's Entergy (ETR); and a merger between Philadelphia's Peco Energy (PE) and Chicago-based Unicom (UCM).

"There are only going to be a couple of winners," said Andrew Levi of Credit Suisse First Boston.

The Old Guard

If you're a growth junkie, don't be too quick to scorn the most conservative of the lot. Their best days may still be ahead. Companies in this category grow about as fast as demand grows, which is a meager 3% to 5% a year.

But as the growth-hungry shed their distribution units, those that are left have more space to grow.

"Its not a bad category to be in. Where there were 100 companies before, there are now 20 to 30 with change," Parker says.

And as the baby boomers age, demand for safe and steady yield investments should increase, building an attractive investor base and raising the group's P/E.

The New Wave

Up one grade on the Richter scale of risk are companies that have one foot in regulated services and the other foot in unregulated services. These companies generate 30% or more of their revenues from nonregulated sources. Freedom from caps on earnings means they can grow at between 5% and 10% a year. With this freedom comes more competition, which translates into greater volatility in earnings -- and stock prices.

But the group that is attracting some of Wall Street's most aggressive investors are the Power Brokers, which have decided to focus on generation, but also add knowledge-based services like power marketing and trading and global power development.

In this group, earnings can be significantly helped or hurt by market prices, while earnings growth can run from 10% to 35% a year, according to Parker.

"These companies have attracted a whole new type of investor to the sector," he said.

How long such growth rates can last is not entirely clear. The supply-demand curve for energy is very much in the companies' favor right now, as breakneck growth in technology is generating growing demand for more and cleaner power. Dresdner Kleinwort Benson's Linda Byus estimated it would take three to five years for supply to catch up to demand, while CSFB's Andrew Levi estimates five to 10 years.

Finally, at the frontier's edge lie the commodity/technology players, which are developing cleaner technology, like fuel cells.

"There is no one really solid in this category yet. But it has a lot of promise in the next years," Parker says.

The Favorites

In the meantime, some of the most attractive investments are companies switching to deregulated services that have not yet proven to the market that they are really growth plays, several analysts said.

Companies like Calpine, with a P/E of 64, and Dynegy (DYN), with a ratio of 36, have convinced Wall Street, as evidenced by their multiples, says Andrew Levi.

But others are still reasonably priced and don't reflect their growth potential, he says.

In this category, Duke (DUKE), with a P/E of 16 and Reliant (REI), currently valued at just 5.3 times earnings, are favorites of both Levi and Byus. Duke distributes electricity and natural gas, gathers and processes natural gas and develops, constructs and operates energy facilities worldwide. Reliant calls itself an international energy services and energy delivery company with operations in North America, Europe and Latin America.

Levi also likes Dominion Resources (D), a utility holding company for Virginia Electric and Power and Dominion Energy. It also offers financial services.

And Byus also named Entergy, a domestic utility that also markets and trades power, develops power globally and had domestic nuclear operations.

Today's utility investors can't expect to kick back and watch the dividends roll in. They may be in for a rocky ride.

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