Electrical Stocks Gain From Diversification

Deregulation in Canada’s power industry has helped fuel strong growth at many electrical utilities in the past few years. However, some power providers prefer regulation, since it virtually guarantees that they will earn a profit without the risk that deregulated plants face. It’s now common to find power companies that operate both types of plants.

They’re also expanding to other parts of Canada and the world to cut their exposure to single region or regulatory board.

Here are four top buys in the electrical utility sector. However, more conservative investors should probably choose Canadian Utilities and Emera, over Fortis and TransAlta.

FORTIS INC. $23 (Toronto symbol FTS; SI Rating: Above average) operates regulated and non-regulated power systems in Canada, the United States, Belize and the Cayman Islands. It also owns hotels and commercial real estate properties, mainly in Atlantic Canada.

In 2004, the company paid $1.5 billion in cash and stock for regulated electrical utilities in Alberta and British Columbia. This helped cut Fortis’s income from its power operations in Atlantic Canada, from 50% of earnings to 30% in 2005.

However, Fortis’s earnings in the fourth quarter of 2005 only crept up to $22.3 million from $21.2 million a year earlier. That’s mainly because a settlement with Alberta regulators cut the Alberta subsidiary’s earnings in the latest quarter by $3 million. Per-share earnings remained unchanged at $0.21, while revenue grew 4.7%, to $353.1 million from $337.2 million.

Fortis’s cash flow is still growing strongly, up 15.8% in 2005 to $3.07 a share from $2.65 in 2004. Although the company spent roughly $5.00 a share on capital upgrades in 2005, partly due to the purchase of three hotels, the proceeds from the sale of common shares helped cover these costs. The new shares also cut Fortis’s long-term debt to 1.7 times equity from 1.9 times a year earlier.

In 2006, Fortis’s capital spending will likely drop to $4.40 a share. However, cash flow will probably slip to $2.85 a share, so Fortis will have to borrow the extra cash it needs. That should not hurt the company’s policy of annual dividend increases; the current rate of $0.64 yields 2.8%. But the extra interest costs will limit Fortis’s 2006 profits to $1.23 a share, and the stock now trades at 18.7 times that figure.

Fortis is a buy for long-term gains.

EMERA INC. $20 (Toronto symbol EMA; SI Rating: Average) supplies roughly 95% of Nova Scotia’s electricity needs. This business accounts for over 80% of its income. It also owns the main electrical utility in Bangor, Maine, and holds interests in other power-related projects.

In the three months ended December 31, 2005, Emera earned $0.34 a share from continuing operations, up 25.9% from $0.27 a year earlier. The savings from a new natural gas supply deal helped offset higher oil and coal costs. Revenue rose 3.7%, to $297.1 million from $286.5 million.

Nova Scotia regulators let the company raise its power rates by 5.3% in 2005. Emera is now asking for a 13% hike in 2006, to cover its higher fuel costs. However, regulators will probably reject this request and approve a smaller rate hike.

The company’s cash flow per share fell 6.6% in 2005, to $2.25 from $2.41 a year earlier, so it can easily afford its $0.89 dividend (4.5% yield). However, new investments in equipment to cut harmful emissions will increase Emera’s capital spending in 2006 to about $1.65 a share, up 57% from $1.05 in 2005. Emera will probably borrow some of the cash it needs for these projects, which would add to its long-term debt of 1.2 times equity.

Like Fortis, Emera now aims to cut its reliance on its home province with new investments in other parts of Canada and the United States. But unlike Fortis, the company will target single plants instead of entire systems.

The stock now trades at 19.2 times its forecast 2006 profits of $1.04 a share, and at 8.0 times cash flow of $2.49 a share.

Emera is a buy.

CANADIAN UTILITIES LTD. $39 (Toronto symbol CU.NV; SI Rating: Above average) supplies electricity and natural gas to over 1 million customers, primarily in Alberta. It also invests in overseas gas and electricity assets.

In the three months ended December 31, 2005, earnings fell to $0.69 a share from $0.71 a year earlier, mostly due to higher gas franchise fees paid to municipalities. Higher electricity rates helped push revenue up 6.8%, to $680.3 million from $637.0 million.

The company generated cash flow of $5.17 a share in 2005, up 22.2% from $4.23 in 2004. However, that failed to fully cover its capital costs of $4.13 a share, and its $1.10 dividend.

Consequently, Canadian Utilities’ long-term debt grew about 3% in 2005, and is a high 1.0 times equity. However, these new loans replaced older debt with higher interest rates. That should cut the company’s interest costs, and give it more cash for dividends. In fact, it just raised its annual dividend rate to $1.14 a share, for a yield of 2.9%.

Right now, Canadian Utilities’ regulated businesses supply roughly half of its revenue, but just a third of its income. That’s why the company will probably close its regulated power plants once their existing power supply contracts expire. It will hang on to its regulated gas operations, which helps cut its overall risk.

The stock hit $46 in January, but has moved down lately as warmer than usual winter weather in Alberta has hurt gas sales and prices. It now trades at 18.3 times the $2.13 a share it will probably earn in 2006.

Canadian Utilities is a buy.

TRANSALTA CORP. $23 (Toronto symbol TA; SI Rating: Average) operates 51 power plants in Canada, the U.S., Mexico and Australia. It also owns 50% of a major Canadian wind farm operator.

In the past few years, the company has sold its regulated operations to focus solely on its nonregulated plants.

However, it sells roughly 90% of its power under long-term, firm-price contracts or directly to specific customers such as carmakers and hospitals, which helps cut its exposure to sometimes volatile electricity prices. It also uses hedges to shield itself from rising fuel costs.

TransAlta earned $0.29 a share before unusual items in the fourth quarter of 2005, up 52.6% from $0.19 a year earlier, as higher power production and prices offset rising fuel and other costs. Revenue improved 22.7%, to $810.1 million from $660.1 million.

Most investors buy TransAlta for its $1.00 dividend, which now yields 4.3%. Concerns that rising maintenance costs combined with falling cash flow would force the company to cut the dividend have put pressure on the stock in the past few years.

However, TransAlta will probably generate $3.40 a share in cash flow in 2006, compared with $3.31 in 2005. The company plans to spend $1.40 a share on capital upgrades this year, so it can easily afford the current dividend. TransAlta will probably use any excess cash to pay down its long-term debt (0.7 times equity) before raising its dividend.

TransAlta now trades at 21.5 times its likely 2006 profit of $1.07 a share. That’s higher than other Canadian utility stocks, but still acceptable in light of TransAlta’s higher earnings potential and dividend yield.

TransAlta is a buy.