COC UTILITY040209.pdf

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Equity Research
Taking A Closer Look At Utility Dividends
Risk Of Future Cuts Somewhat Overstated, In Our View

• Utility Dividends Raising Eyebrows. The combination of (1) substantial capital
expenditure plans, (2) calls on cash for pension funding, (3) pressured earnings on
lower sales growth forecasts, higher expenses, such as bad debt, and lower power
prices (which negatively affect the merchant generation business and/or off-system
sales margin), and (4) increased capital costs collectively question the safety of
utility dividends. Recent dividend cuts by Constellation Energy (CEG), Great
Plains Energy (GXP), and Ameren Corp. (AEE) have heightened these concerns.
• Taking A Closer Look. We have reviewed key financial metrics affecting
dividend security and growth and grouped our covered companies under a four-tier
rating system. In the majority of cases, we conclude that dividends are secure, even
if growth may slow.
• Wave Of Dividend Cuts Unlikely, In Our View. While the circumstances noted
above may result in future dividend cuts, we expect these will be isolated in nature,
given generally reasonable dividend payout ratios, capital expenditure flexibility,
and ongoing demonstrated ability to access the capital markets.
• That Said, It Could Make Sense. While we don’t believe many utilities are likely
to lower the dividend, we would point out that in the current market environment, it
might just make sense. With major industrial and financial companies having
moved proactively to preserve capital through dividend cuts, the sector might have
been given a “pass” to follow suit. Again, we think it’s unlikely, but if there was
ever a time….
• Equity Financing Our Biggest Concern. While our electric utility universe
trades above tangible book value as a whole (median of 1.2x), a number of
companies are currently trading at or below book. Issuing stock under book value
dilutes shareholder value. As a result, we think that these companies will employ a
discerning eye in evaluating their capital programs and dividend policies.
Ultimately, we believe most companies will strive to protect their dividend rates,
but we also point out that this decision is highly dependent on individual
managements’ viewpoints and the relative attractiveness of potential regulated
investment opportunities, such as FERC-regulated transmission.
• Company-Specific Dividend Ratings. Given the heightened scrutiny paid to
utility dividends, we have evaluated each of the companies we cover based on both
quantitative and qualitative factors, including payout ratio, planned capital
expenditures, dividend history, credit profile and our opinion on how management
views the importance of the dividend relative to potential growth opportunities.
Based on these factors, we have rated the dividend of each company according to
the following scale: 1--Secure with growth; 2--Secure with little or no growth; 3--
Secure intermediate term, might not be secure longer-term; and 4--Not secure.
These ratings can be found in the table on page four.

April 2, 2009

Utilities
Neil Kalton, CFA, Senior Analyst
[phone] / [e-mail]
Samuel Brothwell, Senior Analyst
[phone] / [e-mail]
Sarah Akers, Associate Analyst
[phone] / [e-mail]
Michael Bolte, Associate Analyst
[phone] / [e-mail]
Darin Conti, CFA, Associate Analyst
[phone] / [e-mail]
Jonathan Lefebvre, Associate Analyst
[phone] / [e-mail]
Jonathan Reeder, Associate Analyst
[phone] / [e-mail]

WACHOVIA CAPITAL MARKETS, LLC
Utilities EQUITY RESEARCH DEPARTMENT

2

Discussion

On the heels of a number of dividend cuts by utility companies, including Constellation Energy (CEG), Great
Plains Energy (GXP), and Ameren Corp. (AEE), dividend safety has risen to the surface as a top-of-mind
concern facing utility investors. We are taking this opportunity to (1) express our view that we do not expect
a wave of dividend cuts in the utility sector and (2) provide dividend opinions on companies under coverage
according to a four-tier rating system.

We Do Not Expect A Wave of Utility Dividend Cuts

The combination of (1) substantial capital expenditure plans, (2) calls on cash for pension funding, (3)
pressured earnings on lower sales growth forecasts, higher expenses, such as bad debt, and lower power
prices (which negatively affect the merchant generation business and/or off-system sales margin), and (4)
increased capital costs have called into question the safety of utility dividends. While these circumstances
may result in future dividend cuts, we expect these will be isolated incidents and do not anticipate a wave of
cuts throughout the utility sector. Our thesis is largely based on the following factors:

(1) Dividend Payout Ratios Appear Reasonable--While there is a wide distribution across our
covered names, the median dividend payout ratio for our electric utility universe is 58% (67%
for the regulated group and 48% for the IPP/regulated group). We consider this to be a
reasonable level given payout ratios have risen in excess of 75% in the past. The low payout
ratios relative to historical levels are largely the result of earnings growth outpacing dividend
growth over the past several years as regulated utilities have had attractive investment
opportunities related to regulated transmission, distribution and generation, and the merchant
fleets at integrated utilities have benefited from rising power prices. The below-average payout
ratios provide utility companies with a cushion to protect their existing dividends. If the
industry payout ratio was substantially higher, we would obviously have greater concerns about
dividend stability. The figure below displays payout ratios on the S&P Utility Index over the
past 20 years.

Figure 1: S&P Utilities Historical Payout Ratio
40%
50%
60%
70%
80%
90%
100%
Mar-
8
9
Mar-90
Mar-
91
Mar-
92
Mar-93
Mar-94
Mar-
95
Mar-96
Mar-97
Mar-
98
Mar-
9
9
Mar-00
Mar-
01
Mar-
0
2
Mar-03
Mar-04
Mar-
05
Mar-06
Mar-07
Mar-
08
Mar-09
20-Year Median
Source: FactSet

(2) Capital Spending Flexibility--One of the longer-term attractive features of the utility group is
the strong regulated rate base growth opportunities as the industry is in the midst of a major
capital build-out to replace aging infrastructure and meet growing environmental demands (coal
emission restrictions, renewable portfolio standards, etc.). With that being said, many of our
companies are not necessarily “locked” into major capital projects. We believe there is a
healthy degree of discretion and, therefore, flexibility to delay certain initiatives. We point out
that a major component of utility capex relates to distribution spending to connect new
WACHOVIA CAPITAL MARKETS, LLC
Taking A Closer Look At Utility Dividends EQUITY RESEARCH DEPARTMENT

3

customers, and another portion is dedicated to new generation and transmission projects aimed
at meeting system demand growth. The lower level of new housing starts and a reduced
demand outlook affords utility companies additional flexibility to scale back near-term plans.
Not surprisingly, many of our companies have already reduced 2009 capex by 10-20%, and we
think there is room to scale back 2010 as well, greatly reducing external financing needs.

On the other hand, there are a number of very attractive regulated opportunities available, such
as FERC-regulated transmission (electric as well as gas pipeline), which can provide attractive
ROEs and incentives with limited regulatory lag. Ultimately, we think that some companies
might opt to pursue these types of projects and possibly reconsider the dividend policy in the
event that equity financing is unattractive. By and large, however, utility management teams
tend view the dividend as sacrosanct, and we think many would choose to maintain the dividend
and push back capital spending.

(3) Utility Companies Have Had Access to Capital Markets--Regulated utilities generally do not
produce significant free cash flow, particularly during capex-heavy building cycles, such as the
present, resulting in an ongoing dependence on external financing to fund capital spending
plans. While external financing has admittedly become more cumbersome over the past 12-18
months, the debt market has remained reasonably open to utilities. We have been particularly
encouraged by recent senior debt issuances by high-investment-grade-rated utilities with interest
costs in the 5.5-6.5% range.

Given (1) regulated utilities are allowed to recover their debt costs, although often subject to
regulatory lag, and (2) the aforementioned access to debt markets at reasonable prices, we
consider equity financing to be the greater concern. While our electric utility universe trades
above tangible book value as a whole (median of 1.2x), a number of companies are currently
trading at or below book. Issuing stock under book value dilutes shareholder value. As a result,
we think that these companies will evaluate capital programs and dividend policies with a
cautious eye. As mentioned previously, we believe most companies will strive to protect their
dividend rates, but we also point out that this is highly dependent on individual managements’
viewpoints and the relative attractiveness of potential regulated investment opportunities.

Importantly, while external equity has become more costly, equity markets have not been closed
to utilities. Northeast Utilities, for example, issued $383MM of equity in front of major
transmission capital spending plans. The offering was announced March 16 and shares were
issued above book value. Portland General Electric also issued equity in March amounting to
$175MM. Despite the fact that shares were trading below book value, POR management
elected to move forward with the equity offering to fund sizeable capex plans related to wind,
environmental compliance spending, and other initiatives. POR’s situation is similar to a
number of other utilities in that the elimination of the dividend would have mitigated, but not
completely eliminated future equity needs.

One factor management teams are likely considering is the balance between cutting the dividend
as a source of equity capital and the potential negative impact of such a cut on the share price in
the near term. This is a very dynamic decision, and in our opinion, one that is largely subject to
management discretion. We would add the decision is likely affected by market expectations.
While an unexpected dividend cut is likely to be greeted with a negative reaction by investors,
we have seen several cases in the past where an announced dividend cut that was largely
anticipated by investors had little to no (or even a positive) impact on a company’s stock.

A Contrarian Point Of View

While the foregoing factors lead us to believe that wholesale dividend cuts in the utility sector are unlikely,
we’d be remiss if we didn’t visit an argument we’ve heard from some investors lately. While utilities have
generally fared pretty well and have maintained their ability to raise capital in this difficult market, might it
WACHOVIA CAPITAL MARKETS, LLC
Utilities EQUITY RESEARCH DEPARTMENT

4

be prudent to proactively reduce the dividend, preserve capital, and mitigate the need to borrow or issue at
higher costs? Recent proactive dividend reductions by companies such as JP Morgan or General Electric
were not followed by a collapse in market valuation but were generally viewed as prudent financial
management.

For a utility, lowering the dividend in a tough market might be viewed in a similar light, although we would
hasten to add that a key reason to own a utility stock is the dividend. That said, in addition to preserving
capital, a temporal reduction in the dividend payout maintains and augments book value, which is an
important consideration in the rate-setting process. A proactive dividend cut could also send a prudency
message to regulators. As for stock reaction, a utility that cuts its dividend typically does see its stock drop,
but if the move is viewed as temporal with an expectation that the payout will grow from the new baseline or
be restored, shares likely would recover relatively quickly. In the long term, the market would likely reward
financial prudence over dilution of shareholder value through an unsustainable payout.

Company-Specific Dividend Ratings

Given the heightened scrutiny paid to utility dividends, we have evaluated each of the companies we cover
based on both quantitative and qualitative factors, including payout ratio, planned capital expenditures,
dividend history, credit profile, and our opinion on how management views the importance of the dividend
relative to potential growth opportunities. Based on these factors, we have rated the dividend of each
company according to the following scale:

1--Secure with growth
2--Secure with little or no growth
3--Secure intermediate term, might not be secure longer-term
4--Not secure

The table below provides our dividend rating of each company under coverage, along with selected dividend
information.

WACHOVIA CAPITAL MARKETS, LLC
Taking A Closer Look At Utility Dividends EQUITY RESEARCH DEPARTMENT

5

Figure 2: Dividend Ratings Table
4/02/2009 Symbol
Dividend
Rating
4/1/09
Price ($)
2009 EPS
Estimate
Indicated
Dividend
Dividend
Payout
2009E
Dividend
Yield
Price/
Tangible
Book Analyst
Regulated Electric
CMS Energy CMS 2 $11.95 $1.25 $0.50 40% 4.2% 1.09 SB
Cleco Corporation CNL 1 22.11 1.95 0.90 46% 4.1% 1.24 NK
Duke Energy DUK 2 14.26 1.21 0.92 76% 6.5% 1.17 SB
IDACORP, Inc. IDA 2 23.22 2.45 1.20 49% 5.2% 0.85 NK
NV Energy NVE 2 9.43 0.90 0.40 44% 4.2% 0.70 SB
PG&E Corporation PCG 1 38.15 3.15 1.68 53% 4.4% 1.47 SB
Portland General Electric POR 1 17.83 1.85 0.98 53% 5.5% 0.82 NK
Progress Energy PGN 2 35.96 3.05 2.48 81% 6.9% 1.88 NK
PNM Resources PNM 2 8.01 0.39 0.50 128% 6.2% 0.64 SB
SCANA SCG 2 30.76 2.80 1.88 67% 6.1% 1.19 NK
Southern Company SO 1 30.81 2.40 1.68 70% 5.5% 1.79 NK
Westar Energy WR 1 17.53 1.75 1.20 69% 6.8% 0.86 NK
Xcel Energy XEL 1 18.38 1.50 0.95 63% 5.2% 1.19 NK
Consolidated Edison ED 2 39.39 3.20 2.36 74% 6.0% 1.17 NK
ITC Holdings ITC 1 43.04 2.40 1.22 51% 2.8% 8.54 NK
Northeast Utilities NU 1 21.40 1.90 0.95 50% 4.4% 1.22 NK
NSTAR NST 1 31.96 2.38 1.50 63% 4.7% 1.89 NK
Regulated Electric Group Median 63% 5.2% 1.19
Integrated Natural Gas
El Paso Corporation EP 2 $6.52 $0.92 $0.20 22% 3.1% N/A SB
Equitable Resources EQT 1 31.38 1.60 0.88 55% 2.8% 2.14 SB
NiSource Inc. NI 3 9.99 1.05 0.92 88% 9.2% 4.17 SB
Oneok Inc. OKE 1 23.07 2.57 1.60 62% 6.9% 2.06 SB
Questar Corp. STR 1 30.12 2.70 0.50 19% 1.7% 1.70 SB
Sempra Energy SRE 1 46.72 4.25 1.56 37% 3.3% 1.39 SB
Spectra Energy SE 3 14.47 1.07 1.00 93% 6.9% 4.45 SB
Southern Union SUG 2 15.25 1.76 0.60 34% 3.9% 0.74 SB
Williams Cos. WMB 1 11.53 0.80 0.44 55% 3.8% 1.13 SB
Integrated Natural Gas Group Median 55% 3.8% 1.88
Natural Gas Distribution
Atmos Energy Corp. ATO 1 $22.95 $2.06 $1.32 64% 5.8% 1.84 SB
South Jersey Industries SJI 1 35.38 2.40 1.19 50% 3.4% 2.30 SB
Natural Gas Distribution Group Median 57% 4.6% 2.07
IPP / Regulated Electric:
Allegheny Energy AYE 1 $23.34 $2.55 $0.60 24% 2.6% 1.59 NK
Dominion Resources D 1 30.77 3.19 1.75 55% 5.7% 3.07 SB
Edison International EIX 2 28.90 3.05 1.24 41% 4.3% 0.99 SB
Entergy ETR 1 68.70 7.10 3.00 42% 4.4% 1.71 NK
Exelon Corporation EXC 1 45.28 4.15 2.10 51% 4.6% 3.55 NK
FPL Group FPL 1 51.17 4.10 1.89 46% 3.7% 1.79 NK
Pepco Holdings POM 3 12.53 1.45 1.08 74% 8.6% 0.99 NK
PPL Corporation PPL 1 28.79 1.75 1.38 79% 4.8% 2.88 NK
PS Enterprise Group PEG 1 29.65 3.10 1.33 43% 4.5% 2.05 NK
IPP / Regulated Electric Group Median 46% 4.5% 1.79
Water Utilities:
Aqua America WTR 1 $19.91 $0.83 $0.54 65% 2.7% 2.65 NK
American Water Works AWK 2 18.27 1.40 0.80 57% 4.4% 1.22 NK
American States Water AWR 1 35.36 1.75 1.00 57% 2.8% 2.00 NK
California Water CWT 2 40.87 2.10 1.18 56% 2.9% 2.12 NK
Water Utility Group Median 57% 2.9% 2.06
Analyst: NK = Neil Kalton, SB = Sam Brothwell
Source: Wachovia Capital Markets, LLC Estimates and FactSet
WACHOVIA CAPITAL MARKETS, LLC
Utilities EQUITY RESEARCH DEPARTMENT

6

Within our coverage, we have three companies with a dividend rating of “3”--secure intermediate term, might
not be secure long term. We discuss our thoughts on these companies’ dividends, along with PNM, which
has a “2” dividend rating, below:

• NiSource Inc. (NI)--NI’s recent debt issuance with an 11% coupon is curiously contrasted against
the stock’s current 9.5% yield, begging the question; why not own the bonds? It seems to us that
cutting the dividend would have been perhaps cheaper.

• Pepco Holdings (POM)--POM’s dividend has been a topic of increased discussion as (1) shares
now yield 8.6%, well above the electric universe median of 5.3%, (2) shares trade near book value
and (3) the company is embarking on a substantial capital expenditure plan. Responding to the
uncertainty, POM management expressed a commitment to the common dividend at the March 27
analyst day. Management’s comments, along with near-term capital spending flexibility and no new
external financing needs in 2009, lead us to consider the dividend as secure over the next 12-18
months. However, in addition to its commitment to the dividend, the company also stated that it was
committed to its regulated rate base growth strategy, which we consider to be potentially competing
notions longer term. We understand management’s desire to maintain the dividend and
acknowledge that prefunding and capex flexibility buys the company time. However, given
attractive returns for FERC-regulated transmission investment and the company’s longer-term
commitment to smart-grid investments, we would not rule out an eventual change in dividend policy
should equity financing continue to be unattractive looking out 18-24 months.

• Spectra Energy (SE)--We rate SE’s dividend “3” because of its near-100% payout ratio this year.
Spectra recently affirmed its dividend, and indicated that it expects earnings to grow beyond 2010 to
bring the payout ratio down. We agree, but caution that since some of SE’s earnings growth is
commodity-price driven, that does pose some risk, which could potentially make the current
dividend payout unsustainable.

• PNM Resources (PNM)--Although a “2” dividend rating, we expect a 2009 dividend payout ratio
of roughly 125%, significantly above average. This reflects many issues over the last few years that
have eroded earnings. That said, we believe the dividend is secure for now as (1) the board cut the
dividend by 46% in August 2008 primarily to improve PNM’s liquidity, (2) it is our understanding
that the board is taking a longer-term view with regard to the dividend, and thus, will look beyond
the 2009 payout ratio, and (3) PNM recently reached a settlement in its pending electric rate case in
New Mexico. While still subject to regulatory approval, we view the settlement as constructive and
supportive of future earnings growth and financial stability. Based on our current $0.80 EPS
estimate for 2010 and assuming no growth in the dividend, PNM’s dividend payout ratio would be
roughly 62%, which is in line with the sector average.

Required Disclosures

Additional Information Available Upon Request

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Taking A Closer Look At Utility Dividends EQUITY RESEARCH DEPARTMENT

7

I certify that:
1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed;
and
2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this
research report.

Wachovia Capital Markets, LLC does not compensate its research analysts based on specific investment banking transactions. WCM’s research
analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm, which includes, but is not
limited to investment banking revenue.

STOCK RATING
1 = Outperform: The stock appears attractively valued, and we believe the stock's total return will exceed that of the market over the next 12
months. BUY
2 = Market Perform: The stock appears appropriately valued, and we believe the stock's total return will be in line with the market over the next
12 months. HOLD
3 = Underperform: The stock appears overvalued, and we believe the stock's total return will be below the market over the next 12 months.
SELL
SECTOR RATING
O = Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months.
M = Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months.
U = Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months.
VOLATILITY RATING
V = A stock is defined as volatile if the stock price has fluctuated by +/-20% or greater in at least 8 of the past 24 months or if the analyst expects
significant volatility. All IPO stocks are automatically rated volatile within the first 24 months of trading.

As of: April 2, 2009
39% of companies covered by Wachovia Capital Markets, LLC
Equity Research are rated Outperform.
Wachovia Capital Markets, LLC has provided investment banking services
for 40% of its Equity Research Outperform-rated companies.
56% of companies covered by Wachovia Capital Markets, LLC
Equity Research are rated Market Perform.
Wachovia Capital Markets, LLC has provided investment banking services
for 30% of its Equity Research Market Perform-rated companies.
5% of companies covered by Wachovia Capital Markets, LLC
Equity Research are rated Underperform.
Wachovia Capital Markets, LLC has provided investment banking services
for 33% of its Equity Research Underperform-rated companies.

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Utilities EQUITY RESEARCH DEPARTMENT

8

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