John Kohli, CFA¹, CPA
Portfolio Manager and Research Analyst
Franklin Global Advisers

Fundamentally, we believe the utilities sector is in solid shape. This is a sector that went through its own credit crisis at the beginning of this decade with Enron's failure, so when the recent credit crisis hit last year, the average utility company appeared to be already well prepared. Because of the capital-intensive nature of utilities, there was some concern about companies overextending themselves and having to raise new capital at high rates. But as we have observed, most of the industry has moved through the latest crisis in a relatively solid manner.

We find dividends to be a good measurement tool when analyzing the health of the utilities industry, as dividends have historically been a vital component of the overall return from investing in this sector. With only a few exceptions, companies in the utilities industry have maintained or increased their level of dividends since the start of the financial crisis last year. The industry as a whole is expected to grow its income distributions over time at a measured pace while maintaining a payout ratio that has been historically about two-thirds of the level of industry average net income.

The broad equity market has recovered strongly this year since its March lows. The utilities sector, on the other hand, underperformed during this time due to a decline in demand resulting from the economic downturn, which has had an impact on profitability. Historically, utility usage has been fairly inelastic, which results in the predictability of industry earnings, cash flow and dividends. We believe if the economy continues to recover, demand should return fairly quickly for utility services.

If the economy remains relatively weak, 2010 could be a challenge for electric utilities. High unemployment and difficult credit situations may continue to pressure consumers, leading to low utility usage, as well as subsidized or unpaid bills. Although commodity prices have declined, spending at the utility company level is increasing. That may increase the price of power that consumers will have to pay going forward. Utilities could also face challenges if they go to regulators more often to try to recover dollars they are spending on their infrastructure.

Our focus has been on the potential impact of the passage of several energy bills that address climate legislation in the U.S. These bills could possibly provide capital opportunities for the utilities industry over the next few years, as policymakers encourage smart-grid technology investments and other renewable projects.

An example of a company that may benefit from this type of legislation is Xcel Energy, an electric utility that operates throughout the Midwest. Two of its largest service territories are the Denver region of Colorado and the Minneapolis region of Minnesota. Xcel has the potential to benefit from wind development in the Midwest by building the infrastructure to ship wind energy into, say, the Minneapolis region. Likewise, with wind development and solar projects in the Colorado vicinity, Xcel has already developed a significant amount of growth opportunity from building the infrastructure around these developing renewable projects.

Footnote
¹CFA^® and Chartered Financial Analyst^® are registered trademarks owned by the CFA Institute.