Nothing could be finer
Than to be in Carolina
In the morning.
-- Gus Kahn

This is a scary time for investors in utility stocks. The Philadelphia Utility Index is off nearly 10% from its October highs after slipping 0.6% to 397.75 on Thursday. With expectations for higher interest rates, many on the Street presume the group will continue heading lower.

But for investors who want exposure to utilities, Scana ( SCG) is an unloved defensive play that may be ripe for a takeover.

The Consensus Story

Wall Street is not enamored with Scana, an energy provider to customers in North and South Carolina as well as parts of Georgia. The electricity and natural gas provider's projected 4% to 6% earnings growth is not the stuff of lofty multiples. Scana operates in a heavily regulated industry, and that puts a cap on earnings; in addition, the company is, of course, sensitive to interest rates, which have risen sharply of late (in case you hadn't heard).

The Real Story

Scana operates in a geographic location that is seeing an influx of new customers. The Carolinas have experienced tremendous growth in population -- in part due to northerners looking for a less expensive and warmer place to live, while Floridians search for a cheaper home (or refuge) that is relatively safe from hurricanes.

According to Robert Hinckley of Rochdale Securities, customer growth in Scana's South Carolina electricity markets averaged 2.6% over the past five years, a full percentage point above the national average. Natural gas customer growth averaged 2.5%, almost double the national average. CarolinaLiving.com estimates that nearly half a million families will relocate to the Carolinas in 2006.

While more customers mean more demand, utilities are challenged to keep demand high in the face of rising energy prices. Scana's rates are among the lowest in the nation because of inexpensive production methods. Nearly all of its generation comes from coal, nuclear and hydroelectric plants. Paul Justice of Morningstar notes that the lower cost of energy to the end user means lower levels of customer defaults and keeps the company in good standing with politicians.

The latter point is critical, as Scana is dependent on rate increases when its own costs rise. While the industry is heavily regulated, Scana "serves reasonably enlightened and fair regulatory jurisdictions," says Rochdale's Hinckley. Scana had rate increases approved in 2005 and is expected to request another later in the year.

Scana earned $2.78 per share in 2005. The First Call consensus estimate for the current year is $2.90, representing growth of 4.3%. Management has guided EPS growth of 4% to 6% and net income growth of 6% to 8%. However, one doesn't invest in a regulated utility for growth prospects. Earnings are stable, and that's important, but utilities are income plays. Where the earnings really count for utility investors are in the dividends they produce. Scana's current dividend represents 58% of net income. The company would like to increase the payout to 60%. The stock's current yield is a healthy 4.2%, or $1.68 per share annually.

Rising interest rates can hurt a utility stock in several ways. If investors can achieve higher returns by investing in risk-free government securities, the yield from a utility stock becomes less attractive. Utility companies also carry a lot of debt. The rising rates usually increase their interest expense. While Scana is no exception, the company is expected to generate $100 million in free cash flow in 2006 and use some of the proceeds to pay down debt.

While Morningstar's Justice believes higher rates would lead to underperformance of the utility sector, he thinks Scana can hold up fairly well because of its ability to push rate increases through. "Until it the 10-year's yield goes past 6%, we're not all that worried about the structured utilities," he said. "For the companies like Scana who have to go back and file rates fairly often, they get shielded from some of the upswings in interest rates because their allowed returns usually go up with that."

Takeover Candidate?

There are several aspects to Scana's business and stock that could make it an attractive takeover candidate. The favorable demographic trends and regulatory environment would certainly be appealing to a larger entity. Additionally, Scana owns and operates a nuclear energy facility near Jenkinsville, S.C. Construction on a second nuclear plant is expected in several years, assuming the company gets its license approved in 2007.

The president has been a big supporter of "nucular" energy. It is also likely that whoever is in control of the legislative branches after the next election will lend support to the industry in order to produce cheaper energy that is not reliant on foreign regimes.

There are currently 103 operational nuclear reactors in the nation. Four new ones are under construction or have had licenses approved. Ten more, including one from Scana, have licenses pending. The process is arduous and takes years. A larger utility interested in increasing its nuclear capabilities could be very interested in a company like Scana that already has one reactor operational and the licensing process started on another.

The stock is appealing from a valuation perspective as well. Compared with its peers such as Ameren ( AEE) and TECO Energy ( TE), Scana trades at a 5% discount on a forward P/E basis and a 23% discount on a price-to-book basis. It trades right in line when comparing price-to-sales and price-to-cash flow, and at a 19% premium when you look at PEG. However, Scana's debt-to-equity ratio of 110% is below its peer average of 139%, and its yield of 4.2% is sharply higher than the average 3.5%.

I believe Scana can trade up to (or be taken out at) $44, a 10.6% return. You also get that 4.2% yield while waiting. I suspect that would make most utility stock investors feel just fine.
In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback; click here to send him an email.