20% Returns in Utility Sector as Coal is Replaced by Abundant Supply of Natural Gas: High Current Income and Long Term Returns Predicted by Award Winning Research Analyst

Wall Street Transcript

67 WALL STREET, New York - September 11, 2012 - The Wall Street Transcript has just published its Utilities, Alternative Energy and Water Services Report. This special feature contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. The full issue is also available by calling (212) 952-7433.

Topics covered: Grid Parity Timelines for Alternative Energy - Water Infrastructure Development - Water Industry Consolidation

Companies include: PG & E Corp. (PCG), SCANA Corp. (SCG), Dominion Resources, Inc. (D), Duke Energy Corp. (DUK), Southern Company (SO), Northeast Utilities (NU), Exelon Corp. (EXC), NRG Energy, Inc. (NRG), CH Energy Group Inc. (CHG) and many others.

In the following excerpt from the Utilities, Alternative Energy and Water Services Report, an experienced utility industry analyst discusses the economic impact of lower U.S. natural gas prices for investors:

TWST: Why are those your preferences at the moment?

Mr. Winter: Assuming our six- to 18-month time horizon, the nonregulated energy businesses remain challenged by low gas prices and oversupply of natural gas. Regulated utilities are less sensitive to low gas prices, and actually are positively exposed to low gas prices. The United States energy industry is rapidly evolving or undergoing a significant revision to its landscape driven by a sudden abundance of natural gas. As a result, natural gas prices have fallen from over $10 per MMMBtu to as low as $2. So it's become cheap at the same time that EPA regulations are making many older coal plants uneconomical. The biggest beneficiaries are regulated utilities and U.S. consumer.

On the other hand, low gas prices result in lower margins and earnings for utilities that have nonregulated exposure to gas prices or power prices. Because gas prices set the price of power in most deregulated states or regions, the price of power has also fallen and resulted in lower nonregulated power margins. Given the dynamics associated with the abundance of gas, we believe it will take at least six months, if not 18 months, to economically work our way back into a more normal supply/demand equilibrium. Now, economics tends to work out over time so we think we will get there.

At the same time, we are observing the rapid pace at which suddenly low-cost gas-fired generation is overtaking coal-fired generation as a source of power, which means we see a significant growing demand for natural gas and upward pressure on prices. But again, it will take some time to play out. So that is why we don't favor commodity-sensitive utilities.

Why do we favor distribution utilities? Distribution utilities, which again are the electric, gas and water wires and pipes companies and the traditional electric utilities - regulated utilities don't directly benefit from the lower cost of fuel, because they pass it on the lower costs to the customers and the customer gets a lower bill. But lower bills create a very favorable environment for the utility to operate because when customers get lower bills they tend to be a little more satisfied with the utility service. They tend to not complain to the regulators or the public utilities commission, and without the pressure, commissioners will tend to treat utilities more constructively.

Not to forget, there is some price elasticity associated with the utility bill, meaning if you know your gas utility bill is going to be low during the winter or summer, customers will likely consume more heat or air-conditioning service.

So that being said, we have a more favorable environment for electric and gas regulated utilities to invest in the business, in infrastructure because regulators and customers are a little more satisfied than they have been in the past, because there is no upward pressure on bills related to fuel.

And this is occurring during a time that utilities are forced to invest heavily in infrastructure to address global warming. Utilities must invest a tremendous amount of capital investment to retrofit older plants, put pollution-control equipment on coal generation, retire coal generation, build transmission lines, build wind farms, build solar farms. And that is a good thing for regulated utilities because that investment can earn. The PUC can award rate increases to allow a return on the investment. This is known as growing rate base. While higher rates are awarded for the capital investment, the fuel portion of the bill is declining, which minimizes the pain to the customer. Under a less favorable gas-cost environment, utilities would have to request even larger rate increases than we're seeing now.

Regulated utilities have ample ability to invest in the business and earn a return. They are allowed to earn 10% to 11% returns on the 50% equity portion of their investment. I think most investors consider a 10% to 11% return to be quite attractive in today's interest rate environment.

In addition, the regulated utility business remains a low-risk monopoly business, so it's appropriate for even the most conservative of investors. Unfortunately, gas utilities experienced a very mild winter, but over time we expect normal weather, and they too have significant opportunity to invest in pipe integrity.

Recall the unfortunate pipeline explosion in San Bruno, Calif., owned by Pacific Gas & Electric (PCG); another in Allentown, Pa. The disasters have really led to a considerable refocus on gas pipeline integrity. There is a tremendous focus on replacing distribution pipe, so that we don't have any more incidents. Because state commissions don't want to be responsible for not allowing pipeline investment and don't want an explosion in their jurisdiction, they encourage the replacement of older pipe as rapidly as possible through timely and frequent rate increases to recognize the investment. So bottom line, gas utilities have a growing rate base, and thus, earnings growth.

That all being said, utility stocks have done well in 2011 and then through the first half or so of 2012 - 20% return in 2011. We had a small performance hiccup to start the year, but now, the group is back up 5% or 6% year to date. Investor expectation, our expectation going into 2011, going into 2012, is that utility stocks would earn an 8% to 10% total return. And so we got 20% last year. We're three-fourths of the way to that already this year. Importantly, those returns are achieved at relatively low risk. The 4% to 4.5% current return or dividend yields compares to U.S. Treasuries coupons of less than 1.5%. And finally, and most importantly, utilities generally will raise dividends on an annual basis.

TWST: You mentioned we're in a time when the utility industry is addressing global warming. Which companies from your group are doing the most effective or most interesting or innovative approaches to address this phenomenon?

For more from this interview and many others visit the Wall Street Transcript - a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs, portfolio managers, and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

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