The utility sector was the top performer in the first quarter of this year and for many companies, the worst may be over, according to a report by CreditSights analysts. Although there are “a lot” of risky names, the analysts believe the sector as a whole is becoming more stable — but there still is substantial work ahead for some.

“The first quarter was a blockbuster for spreads, aided partly by some more normal weather,” said analysts Dot Matthews and Andy DeVries. “Utility spreads tightened dramatically, outperforming all other sectors. Of course, having outperformed a lot of sectors on the downside, it was only fair that utilities outperformed on the upside for a change.”

Part of the reason for the upswing was the more normal weather patterns this past winter, said the analysts. Heating degree days were lower than normal in all regions of the United States except the Northeast and the Mid-Atlantic, but they were up over the prior winter in almost all regions, “substantially so” in the East. The more normal patterns boosted power production, and the distribution utilities, both gas and electric benefited from higher usage in the first quarter.

There was a word of caution, however, on the better winter. “High gas prices likely meant higher delinquencies, and, with no ability to shut off nonpaying customers during the winter, bad debt expense will climb, in some cases, from 2-2.5% from the more customary 1.5-2%.”

Spreads improved, they noted, as the perception of many names “brightened” and the “fatigue factor” also helped. “After two years of unremitting bad news, with spreads gapping on every negative headline and rating agencies dropping companies multiple notches, a lot of names seemed to settle down and not look as bad as they were perceived.” Also, investors “simply got tired of all the bad news and decided that spreads for some names were too wide for their newly perceived lower risk.”

In the second quarter, the CreditSights analysts believe improvement should continue. However, regulated utilities will do better than the more “troubled” names, except for what they called “repair” trades. Fairly normal weather is predicted, so “no weather-driven demand growth” will likely occur. “This will primarily benefit the distribution utilities, which may not have quite as much output over this quarter and next as last year, but won’t have a big drop in demand.” However, for the smaller power and gas distribution companies, the analysts warned that the ratings agencies “may be focusing in on them as they finish up with the bigger, more volatile names.”

For merchant generators, Matthews and DeVries expect problems with gas-fired plants. Although the first quarter’s spark spreads were better for most than those for the same period a year ago, “that may not have translated into major earnings improvements, as coal and nuclear probably met most of the demand.” For example, they noted that the Tennessee Valley Authority hit its all time peak this winter, but most of the demand was met by its own coal and nuclear plants.

“We think that merchants with excess coal and/or nuclear capacity to sell could have a very good year, and a pretty good first and second quarter supplying power.” If gas-fired output falls, “this is very bad news for some merchants, especially those that are still bringing plants on line. Balancing this view are the implied spark spreads, which are higher. Only the summer will tell whether the futures and the reality will collide.”

Overall, the sector remains “very unsettled,” with downgrades and negative watch listings still dominant. “However, there are likely to be short- and long-term improvements that can provide selective opportunities for outperformance during the quarter and the rest of the year,” they said. There likely will be “repair trades” among the more troubled names, like Dynegy Inc., Reliant Resources Inc. and AES, which have renegotiated bank lines for two or three years.

However, many other merchants still have key refinancings of debt this year, including Mirant, various and July; Aquila, April and May; El Paso, August; Calpine, May and November; Williams, various dates including July; and Edison Mission, December. “We expect the banks to continue to roll their lines, exacting collateral and higher interest rates and further subordinating public bondholders. When the new lines are announced, there may be repair trades that tighten spreads.”

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