Utilities on the Block

	Roger Conrad Utility Forecaster.com
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It's not often a conservative stock group offers the potential for windfall gains. During the next two to three years, selected utilities will.

On August 8, President Bush wiped out the 1935 Public Utility Holding Company Act (PUHCA) with a stroke of his pen. For the first time since the Great Depression, anyone from a multi-state utility to a bank or private capital firm can buy a utility.

Before PUHCA, the utility industry was dominated by a handful of holding companies, which were consolidated by JP Morgan's United Corporation by the mid-1930s. PUHCA forced Morgan to divest and imposed tough controls on utility ownership, as well as minimum standards for financial strength.

Hundreds of power and gas utilities have merged in the past 70 years to create scale, and not one has broken apart. With PUHCA gone, this type of deal will continue, including the ongoing Cinergy/Duke Energy and Exelon/Public Service Enterprise Group mergers.

PUHCA's exit, however, means these deals will be competing with a different type of buyer: deep-pocketed investors with a goal of maximizing returns. Berkshire Hathaway's purchases of utility assets since the late '90s, for example, have already made Warren Buffett one of the biggest players in the sector.

Would-be acquirers will be attracted to the prospect of high, reliable returns in a business whose product is absolutely essential to modern life, and where surety of returns is rapidly improving.

Three years after the Enron fraud, the California crisis, high debt and overbuilding triggered a sector collapse—and a 60 percent crash in the Dow Utility Average—energy utes have dramatically slashed debt and operating risk and are refocused on their core business of delivering electricity and natural gas. Numbers have improved dramatically. Regulators are passing rate increases and stuffing once disruptive industry deregulation, and there are more credit upgrades than downgrades for the first time in a decade.

The only disincentive to buying utes is price. Some trade at higher valuations than at the 2000 peak. And there's been insider selling, creating the impression prices have peaked.

On average, however, the "return to buyer" for power and gas utilities—return on equity divided by the price-to-book value ratio—is still about 6.4 percent. That's well above fixed income.

Moreover, utility returns will rise on cost cutting, sales of excess energy and as regulators raise rates to reflect rising interest rates and other costs.

At this point, most prospective acquirers are only beginning to study their options. Consequently, it may be months or even years before the action really picks up.

Because it's going to take patience to cash in, our first rule for buying takeover candidates is to stick to companies worth holding on their own, no matter how long it takes to ink a deal. That means utilities gaining financial strength and paying a rising stream of dividends.

The three companies in the table "Takeover Trio" all fit the bill. EnergyEast is an electricity and natural gas distributor serving 3 million customers in upstate New York and New England. The company sold all of its power plants following deregulation in the Northeast, using the proceeds to cut debt and boost system reliability.

As a result, profits are now extremely steady, all the more so with long-term rate deals locked in. Returns are rising as management improves efficiencies and system throughput increases.

Despite solid performance the past couple years, EnergyEast still sells for just 1.4 times book value. That's a tempting level for a range of suitors, including Britain's National Grid, which already controls much of New England's power and gas transmission system. EnergyEast is a buy up to 28.

Since buying the Columbia Gas pipeline system in 2000, Income Portfolio denizen NiSource has been feverishly selling off its riskier assets and cutting debt. It's now purely a regulated utility, serving 3.7 million regulated electricity and natural gas customers and running a 16,000-mile interstate pipeline and storage system.

Management continues to focus on cost reduction, inking a multi-year outsourcing deal with IBM this spring. That should push up the company's return on equity, which is still under 10 percent, and boost its takeover appeal. The stock sells for just 1.3 times book value, one of the lowest ratios in the industry. Buy NiSource up to 25.

In the late '90s, Westar Energy was better known for its holdings in home security and other unregulated business than as the owner of a Kansas utility. But after several years of scandals and a near financial breakdown, the company is rapidly on the mend. Second quarter interest expense was slashed by 30 percent from year earlier levels, spurring a 9 percent boost in profits per share.

In addition to its improving financial picture, the company also owns half of the high-performance Wolf Creek nuclear plant, one of the lowest cost sources of energy in the region. The utility's territory is near to Berkshire Hathaway's Nebraska headquarters and its operations in Iowa. Trading at just 1.46 times book value, Westar is a buy up to 24.

Roger Conrad will be available to take your questions until Thursday, August 18. Please use the form below to submit your questions.