Thursday, April 29, 2010

Utility Stocks

I went to go see Dan Ford yesterday afternoon. Dan follows the Power and Utilities area for Barclays, and is a very good analyst.

For the first time in at least a couple of years, Dan is positive on the group, in particular the regulated utilities.

Many investors buy utility stocks as yield vehicles, so it makes sense to compare the group relative to corporate bonds.

At the present time, the relative yield of utilities versus Baa-rated corporate bonds is nearly 1 standard deviation outside of historic norm. Put another way, Dan figures utilities are 13% undervalued compared to a comparable yield vehicle.

Part of the reason may the possibility that the tax rate on qualified dividends may go to 40%, which was proposed by the Senate Budget committee last week. This figure caught the market by surprise - President Obama's 2011 budget had proposed dividends be taxed at 20% (compared to 15% currently). However, Dan's contacts in Washington told him earlier this week that it was unlikely this large increase would be imposed, since it would hit retirees disproportionately hard.

Even if the tax hike were approved, in my opinion, it would not necessarily mean a problem for investors who hold utility stocks in tax-deferred accounts.

Besides yield, Dan cited several other reasons to be bullish:
  • Typically utilities lag at the beginning of a market upswing as investors chase lower quality, higher beta names. The market rally over the past year has followed this pattern. Utilities were star (relative) performers during the market swoon, but have since lagged, making their comparative valuation attractive. Dan figures managers will begin to move to higher yielding utilities later this year;
  • The utility industry raised $7 billion in equity money last year, which was far beyond their actual needs but a "panic" reaction to the tight capital markets. With cap ex budgets being slashed (too much excess capacity), there will be only $3 billion in equity raised this year, reducing the supply pressure;
  • Electric demand - which had fallen off a cliff during the recession - has slowly began to recover, helping the revenue line;
  • Energy (input) prices have remained low, especially natural gas, which should help margins;
  • Rate case decisions (with the exception of FPL in Florida) have generally been favorable, as commissions seem to recognize the need for utilities to earn competitive returns.
The one part of the utility industry that Dan remains cautious on is the pure power generators (e.g. Calpine). There is still too much capacity in this sector, and it will probably be several years before reserve margins shrink enough to allow premium pricing.

Dan has made a lot of money for my clients in the past, so I think he is worth a listen.