Institutional Equity Strategy
The Recent Utilities Sector Surge
March 22, 2002 SUMMARY
* Industrial production generally drives electric power
Tobias M. Levkovich demand
* Utilities still appear attractively valued on a P/E and
dividend yield basis
* Integrated electric utilities' balance sheets are
pretty strong but got tainted by Enron
* Maintaining our slight overweight posture on Utilities
OPINION
One of the surprisingly stronger sectors in the equity market recently has
been the S&P Utilities sector, which has climbed 14.2% since February 19th,
2002 (helped along by gas utilities' stocks price performance) vs. a 6.5%
gain in the S&P 500, a 6.8% rise in the Nasdaq Composite and the 7.5%
appreciation in the Dow Jones Industrial Average. Hence, this sector, which
we have assigned a slight overweight posture, has been a key market leader
alongside the 10.4% in the Financials sector and most Industrial names. Yet,
many have questioned why we would be so positive on a generally perceived
defensive sector like Utilities. While we have designated Utilities as
"cyclicals in disguise," we think that some needed explanation might make
this view more understandable.
Utility stocks have benefited from four key factors, in our opinion:
* Utility demand, specifically for electricity is very much affected by
industrial activity since the industrial sector accounts for one-third
of electric power usage and should be starting to rise along with
industrial production recovery. Electric power demand had softened
considerably in the past 18 months as industrial production collapsed
in the now successful effort to reduce inventories;
* Valuation, which has been a key hurdle for many investors recently,
appears very reasonable in the Utilities arena, in our view, with the
sector trading at only 11.3x fiscal 2002 consensus EPS estimates, a
roughly 50% discount to the market -- indeed, this sector carries the
lowest P/E multiple of the 10 S&P GICS sectors, and trades at a P/E
that is less than 25% of the Information Technology sector's multiple;
Figure 1 (Figures can be seen in PDF format)
Source: FactSet and Salomon Smith Barney
* Utilities were the worst performing sector in 2001, due to the
collapse of Enron and the sharp drops in names such as Dynegy, Calpine
and AES Corporation, and, in some respects, all Utilities were
besmirched by the taint even though many utility companies were not
involved in trading operations or meaningful new power plant
construction activity that stretched balance sheets -- thus, the
strong integrated utility companies have been able to purchase
generating assets from distressed sellers at very attractive prices,
creating the likelihood for some profitable growth; and,
* In an environment where income is becoming a greater factor in stock
price selection than it has been in years (due to the realization that
stock price appreciation is not the only way to make money),
attractive dividend yields in the Utilities sector is also playing a
role, in our opinion.
Figure 2 (Figures can be seen in PDF format)
Source: FactSet
As a side note, we have heard that many power plants that had been on drawing
boards have been deferred indefinitely as independent power producers cannot
raise the funds to build them anymore. In fact, we have even heard (from
engineering contractors) that some recently started plants (in terms of
construction activity) will not even be completed due to developer cash flow
deficiencies, such that it is plausible that the electric power reserve
margins will not achieve previously assumed targets. In addition, the "spark
spread" has improved of late.
In this context, we see no particular reason to adjust our positive view of
Utilities and think that names such as Duke Power, Dominion Resources, Exelon
and Public Services Enterprise Group are interesting as is American Electric
Power, which remains on the Salomon Smith Barney Recommended List.
Figure 3 (Figures can be seen in PDF format)
Source: FactSet and Salomon Smith Barney
Companies Mentioned
American Electric Power Co.# (AEP-$45.30; 2M)
Calpine Corporation# (CPN-$13.04; 3H)
DUKE ENERGY# (DUK-$36.46; 1M)
Dominion Resources Inc.# (D-$62.40; 2M)
Dynegy Inc.# (DYN-$32.00; 1H)
Exelon Corporation# (EXC-$51.80; 2H)
Public Service Enterprise Group Inc.# (PEG-$44.86; 2H)
The AES Corporation# (AES-$9.10; 3H) |
