Low-risk Utilities for Income-seekers

Bonds provide investors with steady income, and preservation of capital. While there’s not as much room for interest rates to fall, higher rates could lead to major losses on fixed-income investments.

In our opinion, most income-seeking investors are better off in high-quality, well-managed utility stocks, such as these four.

In taxable accounts, these stocks provide roughly as much income as most long-term bonds, after the dividend tax credit. They also give investors the possibility of a capital gain.

TRANSALTA CORP. $24 (Toronto symbol TA; Conservative Growth Portfolio, Utilities sector; SI Rating: Average) operates 51 electric power plants in Canada, the United States, Mexico and Australia.

The company currently pays a quarterly dividend of $0.25 a share, for an annual yield of 4.2%.

TransAlta’s stock has stayed in a narrow range in the past three years. Investors feared that rising coal and natural gas prices, which account for 85% of TransAlta’s fuel needs, would force it to cut the dividend. Concerns over future maintenance costs at some of TransAlta’s older plants have also weighed on the stock.

However, TransAlta gets most of its coal from mines it owns in Alberta, which cuts its risk. These reserves should last 50 years. They also have less sulphur than other coal deposits, which helps cut down on harmful emissions.

That should help TransAlta comply with tougher new environmental laws. Increasing use of cleaner burning fuels such as natural gas will also cut the need to spend more on environmental controls, and free up enough cash for the current dividend.

Recent plant shutdowns for maintenance cut TransAlta’s revenue in the three months ended June 30, 2006 by 3.6%, to $599.0 million from $621.2 million a year earlier. But this work should improve the reliability of these plants.

Despite the lower revenues, profits in the quarter grew 23.1%, to $0.16 a share (total $31.1 million) from $0.13 a share ($25.8 million). These figures exclude unusual items. Cash flow per share rose 22.6%, to $0.76 from $0.62.

The strong cash flow has let TransAlta cut its long-term debt, from 1.0 times equity at the end of 2005 to 0.9 times at June 30, 2006. The lower debt cut TransAlta’s interest costs in the latest quarter by $13.8 million.

The stock now trades at 18.2 times the $1.32 a share it will probably earn this year. Profits should reach $1.44 in 2007, and the stock trades at 16.7 times that estimate.

TransAlta is a buy.

TRANSCANADA CORP. $35 (Toronto symbol TRP; Conservative Growth Portfolio, Utilities sector; SI Rating: Above average) operates a 41,000-km pipeline network that transports natural gas from Alberta to central Canada and the United States. This business supplies 60% of its profit. The remaining 40% comes from its energy division, which owns or operates 23 electrical power plants.

The company has increased its dividend every year since 2000. The current annual rate of $1.28 yields 3.7%.

In the second quarter ended June 30, 2006, TransCanada’s earnings from continuing operations grew 22.0%, to $0.50 a share (total $244 million) from $0.41 a share ($200 million) a year earlier.

The latest quarterly earnings included a $13 million gain on the sale of an investment. Cash flow per share rose 7.9%, to $1.10 from $1.02, while revenue grew 17.2%, to $1.7 billion from $1.45 billion.

Much of TransCanada’s recent growth has come from its power business. Thanks mainly to acquisitions and rising power rates, second quarter profits at the power division rose 137% from the year-earlier quarter. That helped offset an 11% drop in profits at the pipeline unit.

TransCanada now hopes to spur long-term growth in its pipeline businesses with several new projects, including the $2.1 billion U.S. Keystone pipeline. This project will transport crude oil from Alberta’s oil sands region to refineries in the U.S. Midwest.

Other big projects include a liquefied natural gas terminal in Quebec, and a new $181 million U.S. gas pipeline in Mexico.

Consequently, capital spending in 2006 will probably rise to $1.70 a share, up 9.7% from $1.55 in 2005.

The company should generate cash flow of around $4.10 a share in 2006, so it can easily afford these outlays. Long-term debt is 1.6 times equity, up from 1.5 times in 2005. That’s high, but still manageable.

The stock rose to $38 in December 2005, but moved down as warmer-than-usual winter weather cut demand for gas. It now trades at 18.5 times its projected 2006 profit of $1.89 a share.

TransCanada is a buy.

EMERA INC. $20 (Toronto symbol EMA; Income Portfolio, Utilities sector; SI Rating: Average) is the main supplier of electrical power in Nova Scotia, and Bangor, Maine.

Emera’s high market share and largely regulated operations give it plenty of steady cash flow to increase dividends (its current dividend of $0.89 a share yields 4.5%) and fund new projects.

For example, Emera recently agreed to build a $350 million pipeline that would transport natural gas from a proposed liquefied natural gas (LNG) terminal near Saint John, N.B. to the U.S. portion of the Maritimes & Northeast Pipeline in Maine. (Emera owns 12.9% of the Maritimes & Northeast pipeline.)

Natural gas prices have moved down in the past few months. But the long-term potential for LNG is strong, particularly as production at many of North America’s conventional gas fields begins to fall. Emera has signed a 25-year contract with the LNG terminal’s owners, which helps cut the project’s risk.

This a major commitment for Emera, which earned $0.26 a share (total $29.2 million) in the three months ended June 30, 2006. That’s a 44.4% gain over the $0.18 a share ($19.3 million) it earned in the year-earlier quarter.

Most of the higher profit came from lower fuel costs, and gains on the sale of excess natural gas. Revenue fell 1.5%, to $275.9 million from $280.1 million, due to the temporary shutdown of a large industrial customer.

Emera has just $26.4 million ($0.24 a share) in cash, so it will have to borrow the money it needs to build the new pipeline. It also plans to issue more stock. This combination will likely keep Emera’s debt-to-equity ratio near its current level of 1.2.

The stock now trades at 17.2 times its estimated 2006 earnings of $1.16 a share, and at just 7.5 times its cash flow forecast of $2.65 a share.

Emera is a buy.

FORTIS INC. $24 (Toronto symbol FTS; Conservative Growth Portfolio, Utilities sector; SI Rating: Above average) supplies electrical power to around 915,000 customers in five Canadian provinces. It also owns or invests in electrical utilities in New York State, Belize and the Cayman Islands. Its real estate division owns hotels and other commercial properties, mainly in Atlantic Canada.

The company has increased its dividend in each of the past 32 years. The current rate of $0.64 a share yields 2.7%. That’s lower than TransAlta, TransCanada and Emera, but we feel that Fortis’s focus on expanding its operations outside of Atlantic Canada should enhance its earnings growth, and let it continue its policy of annual dividend increases.

In the second quarter of 2006, Fortis earned $37.9 million, down slightly from $38.2 million a year earlier; per-share earnings remained unchanged at $0.37.

Excluding unusual items, income in the most recent quarter would have grown by $7.8 million, or 20.4%. Revenue fell 5.0%, to $343.8 million from $361.9 million, mainly due to an accounting change at its Newfoundland Power subsidiary.

Regulated utilities provide over 80% of Fortis’s revenue, and 75% of its profit. While that hinders its growth, it provides Fortis with predictable cash flows that it can use for new projects.

For example, it recently spent roughly $30 million U.S. on a new hydroelectric dam in Belize. The new dam will help Fortis’s Belize subsidiary take advantage of growing demand for power as prosperity spreads. The dam can also earn cash by selling excess power to utilities in nearby Mexico.

Fortis’s stock has stayed in a narrow band for the past two years. But it is still attractive at 19.5 times the $1.23 a share it will probably earn in 2006, and at 8.5 times its projected cash flow of $2.82.

Fortis is a buy.