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Regulated utility stocks as a group had a solid 2009. They were hardly among the market’s biggest winners, however, with the Dow Jones Utility Average (DJUA) returning just 12.5 percent.

Here in early 2010, the DJUA is still roughly a third off its high of late 2007, before investors decided to lump them in with everything else in an almost unprecedented late 2008 selling wave. That’s despite the fact that the industry has largely sailed through the recession with dividends and balance sheets intact.

In fact, utilities today are borrowing at some of the lowest interest rates seen in more than a generation. That’s the result of still-low benchmark rates, coupled with a dramatic shrinkage of yield spreads investors require between bonds issued by utilities of all stripes and Treasuries. And companies are taking full advantage to deleverage their balance sheets, stretch out maturities, cut interest expense and even lay the ground work for financing needed infrastructure.

Utilities sailed through the recession in part because they provide essential services, demand for which is rarely affected much by recessions. Equally important, however, is the massive reduction of debt and operating risk since the fall of Enron in 2001 nearly brought the entire industry to its knees.

At one point in early 2003, some two dozen utilities were either in bankruptcy or one bad decision from it. That lesson hasn’t been lost on management, which has been determined to avoid a repeat ever since. Basically, at the same time the financial system led by big banks was levering up in the past decade, utilities were levering down. And the demise of the banks over the past 18 months has only stiffened management’s resolve to avoid another debacle.

Amazingly, however, utilities have gotten relatively little credit in the market place for this achievement. Rather than focus on still low share prices and what have been continually strengthening balance sheets, analysts and credit raters have focused relentlessly on what can go wrong.

This week, for example, a prominent analyst downgraded several companies on the basis that a weak economy would impede their ability to win needed rate increases for capital spending. That’s a meaningful long-term concern for the sector, particularly for companies that operate in tough regulatory climates. And as the sellout of Governor Charlie Crist in Florida illustrates, danger can strike almost anywhere.

To review, the governor, who’s running for a US Senate seat in a state hard hit by recession, politicized a series of rate increases filed by electric utilities, sacking one of the most seasoned public service commissions in the country. In the former commissioners’ place he’s appointed people with no experience in utility matters, other than they hate rate increases.

The result is a real threat to the quality of regulation in a state where utilities have historically been able to do effective long-term planning to meet service challenges that include devastating hurricanes at the most efficient cost. The real losers in the long run will be the state’s residents, who will face higher rates and declining service quality if regulator/utility relations deteriorate.

But investors, too, will lose as returns fall, a reason I advise steering clear of companies like Progress Energy (NYSE: PGN) though not FPL Group (NYSE: FPL). FPL is the largest producer of solar and wind power in the US and derives well over half its income from out of state.

On the other hand, as I’ve pointed out in Utility Forecaster, regulators in the vast majority of states appear more determined than ever to work with utilities to meet the public’s needs at low cost in tough times. Companies have had to accept lower rate increases than they would like. But the money is still flowing, and, when the economy does recover, the door’s open for more utility recovery as well.

Deterioration of regulatory relations is certainly a concern, and I’m constantly on the alert for signs of it. But it’s hardly of the magnitude to derail utilities’ solid performance of recent years in the worst possible environment.

Neither is the drop in industrial demand for power that we’ve seen since this recession began. Not only have we seen the worst of this. But utilities have weathered it with minimal impact to balance sheet strength and dividends. Moreover, the sharp recovery in US industrial output in late 2009 suggests the recovery that’s been evident for some months may be ready to accelerate. That will not only push up demand from industry for electricity but power prices in wholesale markets as well.

In short, things are getting better, not worse. The only real question is how fast they’ll improve and restore demand to pre-crash levels. And utilities are well prepared to keep paying big dividends and maintaining strong balance sheets until that happens.

To be sure, every quarter’s earnings will be important to watch for signs of deterioration. And even companies that have done well so far can still stumble as long as conditions remain weak. Utilities are also always potential targets in an election year.

At this juncture, however, the worry quotient is far out of proportion to what’s happening on the ground. And that means reasonable risk along with massive potential for companies to beat expectations for earnings and dividends, earning higher stock prices along the way.

My favorites remain utilities based in the Southeast. The region has been hit by the collapse in housing prices and home construction, and that in turn has weakened several banks. But it remains the prime destination in the US for investment in industrial production, thanks to superior infrastructure and the most pro-business regulatory climate in the nation. That also applies to utilities, which have the ability to do long-term planning their counterparts in other states can only dream of.

Of the states to avoid, New York and West Virginia rank at the top of the list. Things could change in the Empire State this year because it elects a new governor. For now, however, it’s potentially rough sledding for power companies operating in the state, and we’re better off generally out.

How high can utility stocks go? The primary reason the Dow Jones Utility Average is so far off its high is the steep drop over the past year in large producers like Exelon Corp (NYSE: EXC) and Entergy Corp (NYSE: ETR), the No. 1 and No. 2 producers of nuclear energy in the US, respectively.

Enthusiasm for both stocks ran high in late 2007, part and parcel of the rush to renewable energy. That cooled markedly over the next two years, first with the recession and later on the mistaken impression that renewable energy in the US has suffered some kind of setback, due to slower growth and the possibility that a CO2 regulation bill will not pass Congress.

In reality, however, both are purely ephemeral factors. And although this country may not build many more nuclear plants, the need to cut CO2 will continue to make nuclear power a popular resource.

Both stocks have become a bit more cyclical because of investors’ perceptions that nuclear energy sold on wholesale markets is set to be less profitable. But that will change with a vengeance as the economy bounces back.

Entergy, meanwhile, has potential upside from the partial spinout of its unregulated nuclear plants as Enexus. That deal is still being hung up by New York, a consequence of the state’s poor quality of utility regulation. But management is obviously patient and success will unlock value.

In short, there’s nothing to prevent both Entergy and Exelon from reclaiming their old highs and taking the Dow Jones Utility Average back up with them. And that adds up to some pretty substantial returns for utility shareholders. The bottom line: I’m sticking with my picks and you should too.

Disclosure: no positions

Source: What's Happening with Utility Stocks?