Energy Utilities Reforming Their Ways

- The midlife crisis of American utilities appears to be nearing its end, which, along with the recent dividend tax cut by Congress, couldn't come at a better time for utility investors.

During the 1990s energy utility executives looked enviously at the high-flying share prices of telecommunications and technology companies. Encouraged by Wall Street to yield to their temptations, the executives supported the deregulation and restructuring of their businesses and embarked on business ventures, such as speculative commodity trading, that were alien to their regulated-monopoly backgrounds.

We all pay for our sins.

Led by the well-publicized collapse of Enron, balance-sheet problems began to surface throughout the utility industry and credit ratings and share prices fell.

Energy companies have done the only sensible thing. They have begun to reform their ways, taking steps to reduce debt and return their emphasis to their core regulated utility businesses while touting that fact to investors.

"Today, electric utilities are selling noncore assets, downsizing, issuing new equity, canceling acquisitions, reducing significant levels of capital expenditures, realigning trading around their own generation assets and customer obligations and accelerating debt repayment," a representative of the Edison Electric Institute, an industry trade group, told Congress earlier this year.

Utilities have taken such steps to rebuild investor confidence, whose erosion has hurt the ability of utilities to raise capital for much-needed infrastructure projects. For example, the Dow Jones utilities average index, which tracks the stock of 15 utilities, including Richmond's Dominion Resources, fell from a high of more than 400 in December 2000 to around 170 last October. Shares in the FBR American Gas Index Fund fell from roughly $22 to around $8 over the same period.

Since October, however, the utilities index, now roughly 245, and the gas index fund, currently around $12 per share, have recovered. The return to a more conservative management approach has helped boost utilities' shares. Also helping in recent weeks, has been a growing realization that a dividend tax cut was going to happen.

People bought stocks expecting their price to go up when the tax law passed. "As passage of the [tax] bill became obvious .*.*. we saw a significant move upward across the board for dividend paying utilities," noted Tom Hamlin of Wachovia Securities.

But students of the stock market, like Hamlin, say that passage of the tax-cut law, which was signed by President Bush last week, has now had most of the direct impact on share prices that it is going to have.

The tax cut's impact on the long-term behavior of individual investors and consequently on utility share prices remains an open question. "Does it sustain a permanently higher value in stocks? Probably by not a great degree," Hamlin said.

Regardless of whether share prices benefit further from the tax- law's passage, utility companies expect a lower tax on dividends to make their ability to raise money by selling equity easier.

A boost in the dividend cash stream for investors would provide an additional incentive for people to invest, the American Gas Association told Congress. Selling stock is viewed as a superior and less risky way of raising money than borrowing.

The return of utilities to more conservative business approaches and the dividend tax cut should give new wind to utility stocks.

More than two-thirds of individual utility investors are over 65 and, for the most part, live on modest middle-class incomes, according to utility industry studies.

Individuals, particularly older Americans, have been attracted to utility stocks because they have historically paid dividends and been relatively secure. Shareholder-owned electric utilities paid out $12.7 billion in dividends in 2001.

The tax bill reduces the tax on dividends for those in the highest income bracket from 38.6 percent to 15 percent. Consequently, individual investors in that bracket will see their after-tax yield from utility dividend income increase from 2.8 percent to 3.8 percent. A tax cut that produces a full percentage- point increase in return could obviously encourage some new investment in utility stocks.

But roughly half of utility stocks are held by institutions and pension funds that already don't pay taxes directly. And many of the individual investors are, by the utilities' own calculations, past retirement and not in the highest income brackets.

A dividend tax cut is less likely to have a big impact on their behavior.