Finding Value in the Energy Sector

 | Aug 03, 2011 | 8:40 AM EDT
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To research a book that RealMoney contributors Roger Arnold, Glenn Williams and I are writing together, I've spent a lot of time thinking about and reviewing energy and utility stocks. In particular, I've spent a fair amount of time catching up on gas and electric-utility companies.

Utilities have been one of my favorite sectors for years. A wave of cost overruns, bankruptcies and near bankruptcies at nuclear power plants in the 1980s introduced me to distressed investing, so I have a certain fondness for this sector. Whenever I've been able to buy this group below tangible book value, I've made money.

This sector will present many investment opportunities over the next decade. Regulations and costs will increase. Coal-burning plants will be taxed in some form or another. Mandated "renewable" energy quotas will increase the sector's costs. A large-scale transition towards nuclear power in the U.S. will likely be delayed. Anti-utility sentiment in both government and the markets will grow. As a result, when these stocks fall to the bargain levels that I prefer, there will be a chance to make money buying them.

I foresee small utilities ceasing to exist as standalone companies. Small gas companies, as well as electric utilities, will be snapped up. Economies of scale will be necessary to deal with increasing costs and a worsening regulatory environment. The need for capital to meet the cost of mandated green projects over the next 10 years will be high. It's going to make financial sense for these smaller companies to merge with their larger neighbors. We saw this when Central Vermont Public Service (CV) was acquired by a neighboring electric company, Green Mountain Power, this year.

When I look at utility companies by market capitalization, a few acquisition candidates stand out. Otter Tail Power (OTTR) provides electricity to 130,000 customers in North and South Dakota, and Minnesota. Why wouldn't Alliant Energy (LNT) or some other large neighboring power company acquire it? As a bonus attraction, Otter Tail has a division that constructs windmill towers and has several noncore operations that could be sold to offset the cost of acquisition. The stock is not horribly cheap, but it is safe to assume that it soon will be.

The other utility company in South Dakota is a likely merger candidate as well. At some point, it will make sense for a larger company to acquire the electric and gas utility operations of Black Hills Corporation (BKH). The company has more than 200,000 electricity customers in South Dakota, Wyoming and Colorado. In Wyoming, the gas utility serves almost 35,000 customers. Black Hills also has an oil-and-gas exploration division, as well as a coal-mining operation. It would make sense for several large gas and electric companies in neighboring states to acquire Black Hills when this sector comes under pressure.

I keep lists of banks and infrastructure companies on my desk because I believe powerful economic trends will push these stocks far higher than what seems possible. I'm adding a list of smaller gas and electric companies as trends in this industry could see most of them acquired over the next decade. When these stocks trade below tangible book value, I will buy them and hold on until their eventual sale at a premium to my purchase price.

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