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FOOL PLATE SPECIAL: An Investment Opinion
Utilities Are Hot, But Does Anybody Notice?

Most investors would be surprised to know that the best-performing stock sector this year has been utilities, up by 27%. The electric utility industry was sent kicking and screaming into a competitive environment in the mid-'90s as state after state removed the decades-old local monopoly status many held. Low inflation has helped them control costs, the booming economy has raised the top line, and the more open environment has led to some real innovation.

By Bill Mann (TMF Otter)
August 21, 2000

Lost in the blathering about all of the hot topics of old economy/new economy cyclicality, a major component of the U.S. economy has been skyrocketing lately amid powerful earnings, a rapidly changing regulatory environment, and technological change.

Unfortunately, this industry -- electric utilities -- has for so long been thought of as grandma's stipend that the amount of mindshare given to this industry has been minuscule relative to its economic impact as a combined $218 billion revenue generator. Let's draw ourselves up from the slagheap of conformity and take a look at the high-tech industry everybody likes to forget.

No more guaranteed slow growth
The government-mandated monopoly utility is a thing of the past, as state after state has opened up its grids to price competition among varying power producers. Where electric utility prices were formerly set by state utility commissions to allow the companies and their investors to earn a set profit margin, today the market itself is the great arbiter.

Just like the telecommunications markets, the lowering of barriers has led to some significant innovation among some companies, and some marginalization of others. But in spite of a summer that has been the mildest on record in many of the U.S. population centers, a large number of utilities are doing well, showing record profit margins and share price appreciation (as evidenced by a chart of the S&P Utilities Index).

So while the investing community is out scouring the technology trade rags for a hint about the next big thing, the fastest-appreciating group in 2000 has been electric and combined utilities, up 27% on the year. Utilities are big, stable, and profitable, though that doesn't necessarily thrill hypergrowth-hungry investors. Also, the continuing strength of the economy coupled with low inflation make for an ideal environment for utilities as electricity demand serves as an excellent proxy for the overall health of the economy.

Big, stable, profitable
Those factors, plus the perception of utilities as being safe and undervalued, have conspired to send them much higher this year. The catalyst may have been Berkshire Hathaway's (NYSE: BRK.A) recent decision to acquire Iowa-based Mid-American Energy, coupled with a spate of mergers and the continued roiling of the more volatile portions of the public markets.

But as the utilities turned in their second-quarter results over the last month, it seems that those who adopted early and saw some undervalued companies have seen significant appreciation. For example, AES Corp. (NYSE: AES) is up 54% on the year, Duke Energy (NYSE: DUK) is up 40%, and Dynegy (NYSE: DYN) is up 148% -- all excluding the often substantial dividend utilities pay.

The state-by-state approach to deregulation has created some opportunities and has opened up some problems. High temperatures in California this year have forced utilities there to operate "rolling brownouts," or selective cutting off of supply, due to a lack of capacity. California and other states have instituted price caps, and as such many competitive providers have chosen to invest their facilities in less-oppressive regulatory environments.

Certainly the uneven rate and end product of deregulation has caused inefficiencies, and non-incumbent utilities have little incentive to lower their return on investment by serving as peak-only power sources. But improving trading practices and better transmission should help, as should energy trading floors erected by the likes of Williams Companies (NYSE: WMB) and Enron (NYSE: ENE).

But the industry itself has changed dramatically and now includes telecommunications and broadband on a wholesale and retail basis. Montana Power (NYSE: MTP) has an expansive fiber-optic network, as does Duke Energy. TXU Corp. (NYSE: TXU), Southern Companies (NYSE: SO), and Carolina Power & Light (NYSE: CPL), among others, are providing retail services targeted to individuals or small to medium-sized businesses, providing local loops along the utilities' existing right-of-ways.

This growth and heightened stock appreciation may continue as the utility industry moves from the dinosaur monopoly age and into the world of commodity competition. Investors wishing to find an industry undergoing rapid change in a relatively safe environment should take a look at utility stocks. Seriously. Hey, quit laughing!

Your Turn:
Betcha didn't know the Fool had a Utilities discussion board! There are some bright people there discussing all things electric, including their returns this year. One could do worse. In fact, most people have.

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