Tech-Free Friday: Power to the Power Producers

Gimme Shelter could well be the theme song of U.S. investors these days as former safe havens and highflying techs alike are battered by a slowing economy. The list of resilient sectors got even shorter this week as fears about troubled foreign economies added to growing domestic market woes.

Amid the widespread stock selloff, some investors are homing in on power producers, betting that increasing demand for electricity will make the sector a bright spot in the months ahead. "We like how the trends in this area are shaping up," says John Babyak, portfolio manager at WHB/Wolverine Asset Management in Stamford, Conn. "There is no question that we have a lack of supply in terms of electric power."

Indeed, Thursday, U.S. Energy Secretary Spencer Abraham said blackouts in California appear "inevitable" this summer. And a report from a New York agency says its state must build more plants to avoid the type of problems, including the rolling, or planned, blackouts that have hit California. Meanwhile, power companies got a boost on Thursday after independent producer Mirant (MIR) said first-quarter earnings would be more than double analysts' forecasts.

Getting Hyped

The news from Mirant, a spinoff of Southern (SO), sparked a slew of positive comments from Goldman Sachs, Lehman Brothers and Credit Suisse First Boston, as well as price target hikes for a handful of other independent producers.

Babyak of WHB Wolverine says he has been focusing on large independent power producers including AES (AES), which he says is a well-run business with a unique position, considering its operations in the U.S., Europe and Asia. AES has a "legacy of being totally independent as opposed to an offshoot of larger utilities," Babyak says.

Power Plays Companies stand to benefit from increased demand
Company	Comments	Recent Price
AES (AES)	Deutsche Banc Alex. Brown rates strong buy and a "favorite idea" in energy.	$50
CMS Energy (CMS)	Company backs a 2001 EPS growth forecast of 8.3%.	29.59
Duke Energy (DUK)	Merrill Lynch's 12-18 month price target is $51.	38.18
Dominion Resources (D)	Sees 2001 earnings growth of 23%.	63.01
NRG Energy (NRG)	Goldman Sachs lifted 12-month price target to $39.	29.21
Mirant (MIR)	CSFB raised its price target to $45 from $38.	29.93
Source: Research reports, power companies.

On Wednesday, AES purchased its first Italian power plant, pushing it toward its goal of entering the country's deregulating markets. Babyak also likes NRG Energy (NRG) and says the independent producers have more of a "profit mentality" than some of their larger counterparts.

Which isn't to say the heavyweights won't reap the benefits of increasing demand as well. Duke (DUK), Dominion (D) and CMS Energy (CMS) should provide stability also.

With demand increasingly so rapidly, "There's no quick fix -- it's not like you can ramp up and build a power plant," says Babyak. "There is a huge capital investment requirement. Unless [they are] already established," companies will be slow to respond to the changes in the market place.

Merrill Lynch analyst Steven Fleishman stepped up on Duke Wednesday, lifting his 12- to 18-month price target to $51 and saying in a research note that the company's "balance sheet is the strongest of the large energy merchant companies and is now fully recharged to meet the spate of growth opportunities in the sector." The stock currently trades at about $38.

Dominoes?

California's ongoing power woes can be traced back to a 1996 state deregulation law that stopped utilities from passing higher costs to customers. Sharply higher wholesale costs have devastated the state's two largest utilities, Pacific Gas & Electric (PCG) and Edison International (EIX).

Now New York is being warned of the increased probability of blackouts if it fails to keep state-mandated power supply requirements. "I have a feeling what we've seen in California is really the tip of the iceberg," says Babyak. "It could very well happen in New York."

Babyak says in the case of both Duke and Dominion, the parent is a regular utility but that the companies have created "spinoffs that are more independent." Dominion, for instance, is the holding company for Virginia Electric & Power and Dominion Energy. In the case of the spinoffs, the company often issues either a common stock or convertible preferred, which are corporate bonds or securities that are exchangeable for a set number of another securities, such as common shares, at a preset price.

"We're buying the convertible preferred because it gives us a little bit of equity participation in the market," Babyak says. "We are happy to do that, especially with yields around 8% or 9%."

Babyak, who has focused on financials and technology in the past, says his firm is keeping an eye on technology stocks but is making more conservative types of bets these days, such as those on energy companies. "We don't want to go out there and buy some beaten-down highfliers that are never going to move," he says.

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