Utilities shined in 2004, but rising interest rates could slow them down.

    It's about five minutes into a conversation about utility stocks when Maura Shaughnessy, manager of the MFS Utilities fund, suddenly suggests that last year's surge in performance for the utility sector could change the stodgy perception of the group, even if the industry changed a long time ago. "You know, it hasn't been a grandmother's utility market since the late 1980s," she observes in reference to the juncture when the companies that supply power, heat, water and telecommunications services began to morph from stodgy regulated monopolies into more competitive, deregulated companies. "The industry has been changing for quite awhile."
    Her point is well taken. Still, last year's unusually strong performance for the group relative to the overall stock market was somewhat out of character, even in an industry where almost nothing has been business as usual for some time. As the year began, many utility stocks were selling at depressed levels and valuations relative to the rest of the market, and sporting attractive yields compared with bonds. The latter feature, which has always been a strong draw for investors in an environment of low fixed-income yields, helped funds that invest in utility stocks gain 22% for the year as of mid-December, compared with 10% for the S&P 500 Index.
    But 2005 could well be a year of more subdued returns. "We're seeing less attractive valuations than we did a year ago," says Judith Saryan, manager of the Eaton Vance Utilities Fund. "Historically, utilities have traded at a discount of anywhere from 15% to 40% of the market multiple. Right now, it's close to the low end of the range. That's about as narrow as we've seen it for a while."
    Robert Strauss, manager of the ICON Telecommunication & Utilities Fund, points out that utilities had their strongest showing relative to the overall market between March and mid-August 2004, a time of uncertainty and volatility. But since the late summer market upswing, he says, "Telecommunication and utility stocks have more participants than leaders. They tend to do better in uncertain markets, when people are looking for safe harbors."
    The probability of rising interest rates also clouds the picture for a group whose dividend yields, currently in the 4% range, compete neck-in-neck with yields available from fixed-income investments. While rising interest rates typically hurt the stock market, high-dividend stocks, including highly leveraged utilities, often feel the pinch even more. "Utility stocks are not overpriced or underpriced compared to bond yields," says Shaughnessy. "But that could change if the yield on ten-year Treasuries goes up. On the other hand, falling bond yields would give the group a push."

A Changing Image
    Regardless of what the future holds, last year's strong showing drove home the notion that, beyond the changes brought by deregulation, utility stocks are likely to put even more distance between themselves and the "widows and orphans" investments they once were. After deregulation ushered in a new era of competition, some utilities jumped in with both feet by making acquisitions, restructuring and entering new areas of business, with varying degrees of success.
    Perhaps none was more visible than utility giant Enron, whose downfall tainted a broad swath of companies. "When Enron got hit three years ago, anyone with a similar business mix got hammered even if the businesses themselves were sound," Shaughnessy says. "People forgot that Enron went bankrupt because of fraud."
    That debacle, along with several other high-profile bankruptcies and lawsuits, helped change the risk profile of utilities from a broad-based, defensive play to a sector in which the performance and risk characteristics of individual stocks can diverge widely. And by some measures, the below-average volatility that once marked the group has become a thing of the past. Over the last five years, the standard deviation of utility sector funds has been comparable to broad market averages such as the Standard & Poor's 500 and the MSCI Europe, Australia, Far East Index, and has exceeded that of defensive sector funds such as financial services and real estate.
    "For an industry that was once stodgy and conservative, the last few years have been quite hair-raising," says Dorothea Matthews, a senior utility analyst with CreditSights, an independent fixed-income and equity research firm in New York. "And the problems are not over. There is still massive overcapacity in many parts of the country. Credit downgrades have far exceeded upgrades. Overall, I think deregulation has helped the consumer. But in terms of the health of the industry, it has hurt."

Areas Of Opportunity
    Despite those reservations, Matthews believes that over the last couple of years many utilities have been mending their ways by returning their focus to serving their home markets and shoring up their balance sheets. They're also using free cash flow to increase dividends or buy back stock instead of making ill-fated acquisitions or launching new operations in tangential industries. "Starting in 2003, some utilities sold off their bad assets, changed management and started raising dividends again," she says. "The theme now is getting back to the basics."
     "Companies are returning to plain vanilla mode by investing in transmission and distribution business to make sure the lights don't go out," says Shaughnessy. "Some will still get into trouble. But it's not as scary as it was three years ago."
    Even with these recent steps toward stability, analysts and utility fund managers caution that anyone who thinks that utility stocks march to the same drummer, or that plugging into a local favorite is a fairly safe bet, is using outdated assumptions. The widely divergent returns of stocks in the group last year magnified the importance of selective investing within the sector. "You had some companies like Texas Utilities that were up over 100%," says Shaughnessy. "But others stayed virtually flat. It was truly a stock picker's environment."
    She believes the gap between the haves and the have-nots likely will widen even further. "Over the next year or two, we will see further separation of the girls from the women in the industry," she observes.
    Rising interest rates would certainly accentuate the differences between the two camps. But even if interest rates go up, stocks of utilities that can grow dividends and earnings at above-average rates will be less correlated with bond yields than other high-dividend stocks, Saryan predicts. In the world of utilities, she says, a slow-growing utility might grow earnings at a rate of 2% a year, while a fast grower would clock in earnings growth at 5% to 8%.
    Saryan points out that growth is important for utilities because they pay out an average of 62% of their earnings as dividends. While some companies have much lower payout ratios and faster growth rates, utilities have the advantage of higher yields to begin with, she says. "If a company has a 20% payout ratio and 15% earnings growth, it is likely to have a faster rate of dividend growth than a utility. But its yield will still be significantly lower."
    Shaughnessy believes that even with other types of companies raising their dividends, investors will continue to recognize both the higher yields and the consistency of income that utilities provide. "At the end of the day, people who buy high-dividend stocks want to know that management understands how important consistent dividend payments are," she says.
    Some of the names in the MFS Utilities fund that she believes will reward investors over the long-term are what she calls "special situation" stocks emerging from bankruptcy that are not well understood by the investment community. One of them is NRG Energy, which owns and operates a diverse portfolio of power-generating facilities in the Northeast, South Central, and West Coast areas of the U.S. With a new CEO, the company is bringing leverage down and shoring up its balance sheet. Another special situation play is NorthWestern, one of the largest providers of electricity and natural gas in the upper Midwest and Northwest.
    She also has positions in faster-growing utilities such as Entergy, which provides electricity to Louisiana, Arkansas and Mississippi, and is the second-largest nuclear power plant operator in the country. A large stake in overseas utilities helps provide geographic diversification.
    For Strauss of ICON Telecommuni-cation & Utilities Fund, the corners of the sector with the best upside potential include utilities with a broad product base that provide a combination of electricity, water and gas. One of his holdings, Oneok, based in Tulsa, Okla., is a diversified energy company that should be able to generate earnings growth of about 5% a year. Strauss calculates that the stock trades at a 10% discount to fair value.
    Another fund holding, Teco Energy, is selling at an even steeper 50% discount to Strauss's fair value estimate. Although the stock plunged in 2003 after the company reported disappointing earnings, Strauss thinks it's a short-term setback. "Wall Street analysts didn't change their view of its five-year growth rate," he says. "It's a typical situation where investors become gripped with fear because of a short-term story, even when longer-term prospects remain reasonably good."