Pennsylvania-based electric utility PPL (NYSE: PPL ) found itself in the path of one of the most devastating storms in history last year, as Hurricane Sandy barreled into the mid-Atlantic and left billions of dollars in damage in its wake. Although PPL stock didn't suffer a long-term hit from the storm, the utility now faces a much different threat from rising interest rates that could eventually have a major impact on its financing costs. Let's take a look at what's been happening with PPL in the recent past and how it's responding to this new threat.
Understanding PPL's business
Investors often treat utilities like boring businesses, but each one has different types of exposure to the various markets within the broader sector. For its part, PPL has an interesting combination of businesses, with both regulated customer-focused transmission and distribution units and unregulated electricity generation. Moreover, it does business not only in the U.S. but also in the U.K., where it has a relatively place in the market through its WPD subsidiary.
The prospects for PPL's respective businesses differ greatly. On one hand, the regulated utility business has been doing very well, with new base rates in its Pennsylvania and Kentucky markets helping drive profits higher in its most recent quarter. U.K.-based results were also strong, as the environment across the Atlantic has been relatively benign lately. U.K. rival National Grid (NYSE: NGG ) has also seen exceptional results in its own British operations as it leverages the competitive moat that being a major regulated utility gives it in the market there. For PPL, more than half its earnings come from the U.K. division.
Unfortunately, what hasn't done as well for PPL is its unregulated competitive electricity generation business. Cheap natural gas prices last year led PPL, nuclear giant Exelon (NYSE: EXC ) , and other major utility players to hedge against the possibility that gas would stay low, as cheap gas makes their respective nuclear operations less competitive. Yet those hedges came back to bite PPL and Exelon, as rising nat-gas prices during the most recent quarter caused substantial losses from their hedge positions.
None of those things has really hit PPL stock, but the bond-market collapse over the past month has done a number on its share price. Utility stocks are often seen as bond substitutes, so when bond prices are weak, utilities often follow suit. Moreover, given the huge amounts of debt that PPL and its peers have in order to finance their capital-intensive operations, rising rates translate to rising financing costs in the long run, sapping future profits to the extent that PPL can't pass on those higher costs to regulated customers.
What's PPL doing to boost profits?
PPL hasn't been standing still in the face of these threats, though. In April, PPL opened a new clean-coal facility that will help it recover gypsum as a byproduct that can then go toward fertilizer use. The company also completed a hydroelectric expansion project in Montana, raising its generation capacity by about 70% as part of PPL's overall push toward renewable energy.
PPL also got a victory last month when the U.S. Supreme Court allowed it to claim a foreign tax credit for a "windfall tax" imposed on the company's U.K. operations by the British government. The one-time $40 million impact is less than 10% of its total income-tax bill for 2012, but avoiding double taxation is a key element for the success of PPL's multinational operations.
Facing the Fed storm
In the end, though, the biggest challenge for PPL stock will come from the Federal Reserve and its interest rate policies. PPL has done the best it can to boost its fundamental performance, but investors nevertheless are likely to bid utility stocks up or down as a group based on their expectations of what the Fed will do with rates. Moreover, the future direction of natural gas prices will go a long way toward determining whether PPL becomes more competitive in its unregulated market or continues to face the pressures that have held that division back in the recent past.
PPL has posted impressive results, but Exelon is perfectly positioned to capitalize on the clean-energy trend with the largest nuclear fleet in North America. This strength, combined with an increased focus on balance sheet health and its recent merger with Constellation, places Exelon and its resized dividend on a short list of the top utilities. To determine if Exelon is a good long-term fit for your portfolio, you're invited to check out The Motley Fool's premium research report on the company. Simply click here now for instant access.
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