The Vanishing Pure Play

Investors have a lot to worry about right now: the crash in energy commodities, the recent volatility in the stock market, and forecasts of a global growth slowdown reminiscent of 2008.

But there is at least one industry that should be able to weather this challenging environment, while offering excellent income to boot: regulated natural gas distributors, also known as local distribution companies (LDCs).

Cheap prices and regulatory momentum are boosting demand for cleaner-burning natural gas. Indeed, the U.S. Energy Information Administration reported that natural gas recently overtook King Coal as the leading fuel source for power generation for just the second month in history.

Burgeoning demand for natural gas will spur an infrastructure buildout to deliver this energy commodity to heavy users, such as power generators and industrial firms. And gas distributors stand to benefit as they start earning regulated returns on new pipes and other infrastructure.

The only problem is that publicly traded LDCs are quickly disappearing. Growth-starved power utilities are realizing that gas distributors own an increasingly valuable part of our nation’s energy infrastructure. And they’re not sitting idly by, waiting to see what happens next.

As Southern Company’s (NYSE: SO) $12 billion bid for LDC giant AGL Resources Inc. (NYSE: GAS) shows, electric utilities want a piece of this crucial infrastructure, and some would rather buy it than build it themselves.

In fact, we’ve previously alerted subscribers to the potential for electric utilities to buy up gas assets, such as in last year’s report, “The Great Natural Gas Grab.”

But as risk-averse income investors, we’re all about the dividend first–a company’s status as a potential takeover target should merely be the growth kicker on top of a fundamentally sound business that generates sufficient cash flows to support a steady stream of dividends.

And LDCs’ regulated rates of return help ensure that they’re reliable dividend payers.

Although there are more than 1,200 LDCs in the U.S., most are owned by municipalities, cooperatives, or integrated into the operations of large, diversified utilities.

Once Southern’s deal with AGL is consummated, there will be just 17 publicly traded natural gas distributors left. And nearly a quarter of them are micro-cap stocks.

As such, investors are effectively shut out from a significant portion of this market.

Know Your LDCs

LDCs are a structurally varied group, with operations that differ according to size, customer base, region, weather patterns and ownership structure.

Additionally, natural gas distributors each exhibit different market characteristics, operating parameters, rates and tariffs.

Some LDCs also own wholesale gas-storage facilities and high-pressure gas pipelines. These variations should be taken into consideration when evaluating individual companies for investment.

Mergers-and-acquisitions activity among LDCs over the past few years marks a second-wave of such deals that started in the late 1990s, called convergence deals.

At the time, deregulation incentivized electric utilities to combine electric and gas marketing activities to offer customers bundled energy services in one package.

However, the convergence trend was largely a failure, and many of these utilities later sold their gas assets, with the culmination of that era occurring in 2007 when Duke Energy Corp. (NYSE: DUK) spun off Spectra Energy Corp. (NYSE: SE).

In hindsight, the problem was that many utilities simply siloed their natural gas operations, rather than pursue synergistic opportunities.

What’s past is prologue: Standalone pure-play LDCs once again offer the best opportunities in this environment. And even if the top LDCs remain independent, they still pay safe and growing dividends.

For subscribers, we detail our favorite pure-play gas utilities, one of which yields 8.4%.

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