A Few Utilities Find Their Niche

Power companies that pursue specialized businesses will lead the industry in the year ahead.
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Utility investors have cause for cheer -- if for no other reason than the fact that the doors are closed on a perfectly dismal 1999. With the S&P Electric Utility Index down 19.4% -- and that's after adding in a hefty 3.8% dividend yield -- the envy of those who feel they missed out on the great technology bull market can only be greater.

But several companies bucked the trend, and they did so because they recognized the fact that although power deregulation has proceeded at a slug-like pace over the past five years, enough progress has been made to make power generation and transmission/distribution two distinct businesses, each requiring a unique set of skills in order to compete.

As a result, a few forward-thinking companies are beginning to recognize their specialties and reshape themselves in order to pursue the one business that offers the best use of their strategic strengths. Expect this trend -- call it "niching" -- to continue as the key issue driving corporate strategies and stock prices in the new year. What's interesting about these companies is that they aren't limited to one geographic area, or even one subindustry; rather, they're seeking out opportunities wherever they may lie.

Specialization

Expect

Montana Power

(MTP) - Get Report

to spin off its telecom business and possibly merge with a regional sibling. The company's

Touch America

subsidiary, which provides advanced fiber optic-based services to businesses, caught the eye of investors last year as the company inked an alliance with

AT&T

(T) - Get Report

to expand the reach of its fiber-optic network to more than 23,000 miles.

Last year, Touch America contributed $100 million in revenue, nearly a quarter of the revenue generated by the electric utility. As a result, Montana Power stock gained 28%. One analyst expects the spinoff to be announced at the company's January board meeting. If so, the share price will surely be pushed higher.

The Entrepreneurs

While the average electric utility lost nearly 20% in 1999,

AES

(AES) - Get Report

soared 58%. In the coming year, the company will continue its aggressive push into making money from deregulated markets, and particularly from an emphasis on merchant power plant development in the U.S. This is more lucrative than the basic generating business -- it involves selling power to industrial users or other utilities in the wholesale market in areas where the peak load demand exceeds supply. That way, the price they receive is market-based, not capped by the regulators.

To do this, AES is de-emphasizing its focus on power projects in the emerging markets of the Middle East, Near East and Far East. While fast-growing, political and economic instability, combined with currency volatility in these countries, increased the risks and reduced the return potential of these projects. Still, CEO Dennis Bakke says annual earnings should grow nearly 30% over the next three years. A test of AES' progress will be the integration of

Cilcorp

, an Illinois utility purchased last year in hopes of selling its power more attractive market rates.

Enron

(ENE)

, whose shares were up 56% last year, will continue weaning itself from the power business. The company has thrived by focusing on the opportunities spawned by newly deregulated markets. These include risk management services such as weather derivatives, or contracts that help companies control the variations in power costs based on demand swings. In addition, as overseas markets open, Enron is expanding its wholesale power trading operations -- the industry it pioneered in the U.S. -- in Europe.

Finally, the company is keen on launching a new series of telecommunications products, including bandwidth futures, which will allow telecommunications providers and their customers to control blocks of "space" for transmitting data over the new fiber-optic networks. The company made a strategic retreat from a regulated business by selling in

November the

Portland General

utility it purchased less than two years ago.

The strategy represents management's attempt to push Enron's double-digit growth rate even higher and maintain its current 30-plus earnings multiple, which is more in line with risk management of diversified financial services companies. Traditional electric utilities generally see multiples in the low teens.

Power Trading

As the wholesale power markets mature, so the trading of power contracts will continue to evolve. In addition to power contracts on the

New York Mercantile Exchange

, 2000 will be the year in which online power trading takes hold. And it will extend beyond the traditional players to upstarts like

HoustonStreet.com competing head-to-head with established yet evolving companies such as

Enron Online . As liquidity increases and standardized contracts emerge, expect trading to be frenetic but orderly. Summer electricity prices will surge again, although

price spikes will be more rational. Unlike last year, however, the chance of $10,000 spot power prices are slim: High prices should peak in the low four digits.

Let's Go Nuclear

Consolidation of nuclear generation in the U.S. will continue. However, the dominance of the

Peco

(PE) - Get Report

-

British Power

partnership, coined

AmerGen

, is likely to be challenged as

Entergy

(ETR) - Get Report

emerges as a serious competitor.

Recent developments in New York provide an initial indication of Entergy's ability to compete with the more established Peco partnership. In partnership with

Rochester Gas & Electric

(RGS) - Get Report

, Entergy trumped AmerGen's bid for the Nine Mile nuclear plant on Lake Erie. "If Entergy wins control of Nine Mile, competition for control of other nuclear plants in New York and elsewhere all of a sudden become much more fierce," says one buyside analyst. "These two competitors will begin to bid prices for nuclear plants much higher."

Given this bidding competition, prices for nukes will undoubtedly firm, with the current "fire sale" prices of about 25% of carrying value increasing to nearly 50% of carrying value. Despite the increase, this would still represent a bargain.

Turnaround Play

Proof, perhaps, that the average utility may have to experience stress before it embraces the new world order, expect

El Paso Electric

(EE) - Get Report

-- the once-bankrupt utility -- to shed its generation assets and instead focus on transmission and distribution. Having regained its footing, the company is looking for ways to maximize value. It has been talking to utilities and power marketers about selling its power plants, and purchasing electricity under long-term contracts. A handful of Texas utilities and others appear interested. While El Paso may make the headlines first, look for a number of small regional utilities to follow the lead to unlock their value in a rapidly changing industry.

Hope these ideas are enlightening. Have ideas of your own that deserve to be on the list? If so, shoot me an

email and we'll devote some press time to you. And, just to juice your brain turbines, your best ideas will earn a

TSC

T-shirt or cap, both guaranteed to power you well into 2000.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.