Utility Mania: Xcel Energy's Shockingly High Valuation

In 2006 utility M&A activity started in February with Keyspan Corp (KSE) being acquired by National Grid (NGG) @$41.50 cash. We anticipated this move and expected final regulatory approval to be slow in coming to fruition. What ensued for the remainder of the year was more in line with wishful thinking than reality. A number of acquisitions were announced only to be terminated in the beginning of 2007. Nonetheless, Utilities have continued to trade at above normal multiples.

What we dub Utility Mania actually started overseas in the U.K. eventually powering a surge in U.S. utility equities. Xcel Energy (XEL) went along for the ride. 99% of revenue is regulated and increases were granted in 2006. Electricity rate increases in Texas are on the table for 2007. Electricity growth is limited to about 2% so profits can only grow substantially from margins. This is where Xcel has some obstacles to overcome.

The effective tax rate for 2006 was 24.2% due to one time tax credits. The anticipated effective tax rate for 2007 is 29.5%. This should offset any improvement in rates and efficiencies.

Earned credits from pollution reduction are somewhat a double edge sword. On the one hand, converting the coal-fired Riverside and High Bridge units in Minnesota to natural gas should result in cost savings. On the other hand, Xcel has already added three natural gas-burning units in 2006, increasing reliance on natural gas pricing.

An interesting point was made during an office discussion regarding the contrasting effect from possible higher natural gas prices. Regulated electricity would suffer from higher prices yet at the same time distributed natural gas might benefit from a linkage mechanism that might be employed in Colorado and Minnesota. Using 2005 verified figures, revenue from electricity and gas distribution was at a 3 to 1 ratio. We couldn't find the cost and margin breakdown. Without this information it is impossible to calculate the exact trigger point for negative returns.

We estimate 2007 earnings to be flat for the year at $1.36. Xcel may increase the dividend which always gives a good impression yet doesn't really affect the fundamentals. Dividend distribution rates have vacillated between 61% and 101% over the past ten years.

Currently, ttm P/E is hovering over 18. We expect Utility Mania to fizzle out in 2007 and a return to normal P/E range of 14 to 17.

P/E ratio source: Standard & Poor's

Disclosure: no conflicts.