The worst may be over for the utility sector, with the value this year coming from investors identifying “improving” situations before their peers and credit ratings agencies “screw up the courage to follow,” according to a new report by CreditSights analysts.

Utility investments are still a high risk proposition, and more surprises are likely this year, especially for already “troubled” companies. “What can we say about a sector that included the four biggest losers in the S&P 500 (Dynegy, El Paso, Mirant and Williams) and six of the top 10 (add AES and Calpine)? We can say we fervently hope we never see a year like that again,” said analysts Dot Matthews and Andy DeVries.

A sector “traditionally seen as sleepy and low risk spent the year living through a nightmare, as the risks kept rising and the negative surprises kept coming.” The credit ratings agencies, they noted, downgraded companies “two and three notches at a pop, often without so much as a negative outlook for warning. Across the board, this was the worst year in utilities in our memory.”

By the fourth quarter of 2002, the analysts saw bonds begin to rally, and 2003 should be a “lot better for many of the companies in the sector as things get sorted out and people realize that many names were oversold.” Buoyed by President Bush’s dividend tax cut plan, utilities also should expect to see more merger and acquisition activity this year, said analysts. “These two developments should also largely benefit fixed income, although M&A can have its downside for bonds.” However, they noted that it will take a “fairly long period of relative calm, with no horrendous announcements, no accounting adjustments no one had ever heard of before, no earnings restatements…well, you get the picture…before people start acting pretty rationally again.”

With better days predicted ahead, CreditSights analysts said there are still companies that should be avoided because defaults are “very” possible. Investors, they said, should be selective and “watch management like a hawk.” A number of trends should surface this year, “some of which will be positive, and some very negative,” for investors.

Among the companies CreditSights analysts like were Alliant, CenterPoint and Nicor, partially because they are “good candidates to be bought by Warren Buffett.” Others on the positive list include Southern Co., Consolidated Edison, Duke Energy and Duke Power. DTE and Entergy, they said, also are likely buyers, making “sensible” purchases that would not jeopardize their ratings. Besides the “obvious” names, CreditSights said they would avoid Dominion, FPL and FirstEnergy “for now.” Dominion and FPL “have shown a tendency to buy at any price…FPL also has a lot of unregulated power in Texas, not the best place to be these days. FirstEnergy remains a concern…because of Davis-Besse.”

Said analysts, “we do not expect meaningful recovery in the sector this year or next.” Merchant generators without long-term contracts “are in for a rough 2003, and investors should be wary of rosy predictions for this year and next.” They said that some of the companies “have to survive two years of woe in their current conditions, and it isn’t all certain that they can do so.”

Merchant power plants also may have “wildly varying results,” depending on the type of plant, the location and the percent contracted or hedged. Natural gas prices are “likely to remain high,” with CreditSights forecast at $3.50/Mcf for 2003. “If demand remains relatively low due to mild weather in the summer, nuclear and coal will run ahead of gas and prices will remain low. If demand rises or spikes, gas will run, but spark spreads won’t necessarily improve enough to be meaningful for peaker earnings.”

Coal-fired generation, said analysts, “because of its base-load configuration, currently tends to have longer-term contracts with the utilities that previously owned it, but any marginal production could prove quite profitable this year. Those who are heavily invested in gas-fired facilities, like Calpine, could have another rough year if enough of their overall output isn’t contracted or hedged at favorable spreads.”

To repair balance sheets, CreditSights believes that issuing equity is about the “only way left,” because “the asset sale game is played out for now.” They believe assets will continue to be sold, but only at prices below what the sellers hope to receive. Another negative on asset sales, they said, was found out by Dynegy Inc. in 2002. “It sold assets, it did get cash and it did pay down debt.” However, because it took losses and other equity hits, the debt to capital ratio actually went up between the second and third quarters, even as its debt declined.

The analysts believe there will be at least one “real” bankruptcy this year, citing NRG and National Energy Group as two already there “for practical purposes,” and Allegheny Energy “would be there without the grace of its banks.” Also teetering are Aquila Inc. and Reliant Resources Inc., but analysts noted that “there are, unfortunately, so many potential candidates that picking one is like trying to pick the 2003 Miss America from among all the beauty contestants out there.”

CreditSights also believes that energy trading “gradually” will make a comeback, however, its place as a major source of “income” is over for now. “The capital required to be in trading and the fear it strikes in the hearts of investors and rating agencies will make it off limits to all but the biggest and strongest.”

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