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
|American Electric Power||AEP|
Risking ItChoosing 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.
The Old GuardIf 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 WaveUp 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 FavoritesIn 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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