By Andrew Leckey

The utility stock has been a "no-brainer" investment, an obvious choice of those foraging around to find greater income. In 2010, the prospects of this traditional vehicle may improve somewhat.

Exciting, utilities stocks are not. The average utility mutual fund has been a relatively flat performer this year, despite a gain of 30 percent over the past 12 months and a five-year annualized return of 5 percent, according to Lipper Inc.

Yet conservative and retired investors usually covet utilities not for any flash, but for steady dividends and the hope that dependable payouts will continue far into the future. Regulation by state commissions plays a crucial role in that.

"Utilities regulation has been more balanced and constructive over the past five years than it has been the past 20 years," said Michael Worms, utilities analyst for BMO Capital Markets in New York.

Utilities are now actively building environmentally clean infrastructure, he said, whether it involves wind, solar or smart meters. State commissions are approving these initiatives, which are generating added earnings for the companies.

"One positive going forward is that the utilities are now back in the rate case game, filing with regulators after several years in which they hadn't been seeking any increases," observed Christopher Muir, equity research analyst for Standard and Poor's Corp. in New York.

Regulated utilities are guaranteed by the regulators that they will have the ability to recover their investments plus a fair rate of return, said Muir. That provides assurance to investors dependent upon their income.

"Utilities offer leverage to their local or regional economy and a fairly steady cash flow, which is a combination many investors would find attractive," said Travis Miller, senior stock analyst with Morningstar Inc. in Chicago. "They tend to follow the general economic cycle in terms of profitability."

The regulated utility CMS Energy Corp. (CMS), a provider of natural gas and electric service to about 6.5 million Michigan customers, is recommended by Worms. It also supplies power generation in various other U.S. locations.

While CMS has had to cope with Michigan's difficult economy, new rates did go into effect last year after regulators streamlined the rate procedure. The company has divested non-core assets to become a "pure" regulated utility and it is gradually reducing its debt level.

Less attractive but nonetheless featuring "good stories" are regulated utilities Consolidated Edison (ED), Northeast Utilities (NU), PG&E Corp. (PCG), Progress Energy Inc. (PGN) and Southern Co. (SO), Worms believes. Their average dividend yield is 4.7 percent, with their dividends in no danger of cuts or elimination.

In mutual funds, the Franklin Utilities Fund (FKUTX) has a 12-month annualized return of 24 percent and a five-year annualized return of 5 percent.

Emphasizing electric utilities, its largest holdings are Southern Co. (SO), Entergy Corp. (ETR) and Sempra Energy (SRE). Franklin Utilities has a 4.25 percent "load" (initial sales charge), $1,000 minimum initial purchase and a low 0.80 percent annual expense ratio.

There are also utilities for higher-risk investors.

"If you look at electric utilities, they are essentially what they are, but the independent power producers are totally unregulated companies with earnings that swing wildly," explained Muir. "When power prices go up, such as when the economy picks up speed, their stocks will follow."

Muir recommends stock of natural gas utilities with exploration and production assets such as Energen Corp. (EGN), National Fuel Gas Co. (NFG) and Questar Corp. (STR). They have more modest dividends than their electric utility brethren but offer greater chance of price appreciation.

"We're starting to see slightly improving utilities earnings, though there is still uncertainty as to how strongly the economy will recover and what that means for energy demand," said Miller. "As we get an uptick in economic activity and industrial production with more confidence among consumers of energy, we would expect an uplift in earnings."

Fully regulated utilities have better cash flow. Independent power producers, meanwhile, are tied to the volatility of commodity markets and, with prices low since mid-2008, they've "gotten killed," Miller said. But there is opportunity in their current low prices.

NRG Energy (NRG) is a power generation company recommended by Miller. With power plants of 24,000 megawatts of generation in five countries, it has most of its assets in the U.S. Northeast, Texas and California.

The company exited Chapter 11 bankruptcy in 2003, purchased 10,900-megawatt power generator Texas Genco in 2006 and acquired Reliant's marketing and trading operation last year. It has been entering into long-term supply agreements and replacing high-cost Appalachian coal with low-cost Western coal as the fuel source for its coal-fired plants.

The NRG board has rejected two takeover attempts since 2006.

Among other "pure play" independent power producers, Miller recommends Mirant Corp. (MIR) and RRI Energy (RRI). None of those companies pay dividends.

Doing your homework before buying utilities stocks is crucial because their business mix can vary considerably:

"Integrated companies have regulated and unregulated parts of their businesses," explained Miller. "For instance, Constellation Energy Group Inc. derives 50 percent of its earnings from regulated business and 50 percent from unregulated business."

 

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© Andrew Leckey

 

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