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Stock rally continues as Wall Street debates value of utilities

Assome utility stocks continue to trade high, Wall Street has heated up debate onwhether the sector is overvalued or underappreciated at the midpoint of 2016.

In aJuly 12 report, Morgan Stanley Research indicated that investors believe therecent rally has run its course, but the firm said it is "not so sure."

"Giventhe significant macro movements globally, most notably from the Brexit vote, wehave noticed both unusual stockmovements and a very high level of uncertainty among investorsregarding how much opportunity for alpha exists in the utility sector, giventhe large macro fund flows," Morgan Stanley analyst Stephen Byrd wrote. "Webelieve that the significant movements in equities and fixed income provide anunusually good opportunity for value creation, given that we often see marketsover- and under-correct during such periods."

Byrd,in a July 14 interview, said the impact of Britain's decision to the European Union on thefixed income market, coupled with risk aversion, factors into the for utility stocks.

"Ifit had gone the other way … I think the valuations would probably not be quitewhere we are," Byrd said.

UBSSecurities LLC noted in a July 11 research report that utilities have "pulled-backslightly" with an almost equal amount of gains and declines following aperiod when only HawaiianElectric Industries Inc. declined as far as utilities the brokeragecovers.

"Thismight indicate that the rally is running out of steam," UBS analystJulien-Dumoulin Smith wrote in the report. "[W]e continue to believe thatas long as interest rates remain near these multi-year lows that there is stillupward pressure given historical trends."

Risks

Whileutilities in general look attractive, Byrd said there is potential forovervaluation and significant risk.

"Asall of this money comes into the utility sector, it tends to come in, in kindof a crude manner, sort of like a rising tide," Byrd said. "It justlifts all boats. And some have really underappreciated downsides, some haverelatively poor growth. Then they trade at elevated multiples right along withreally high quality, high growth utilities out there. "

is anexample of a utility that may be overvalued in the current market with risks "moresignificant than appreciated," according to Morgan Stanley.

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"Notonly is their EPS growth a bit below average, but also we do think it's fairlylikely that shareholders are going to have significant liability for this explosion in Harlem that killed eight people," Byrdsaid. "And yet, ConEd trades at or above its peers right now on a P/Emultiple basis and we don't think that makes sense."

EvercoreISI recently downgradedCon Edison, along with EdisonInternational and NiSourceInc., on concerns that post-Brexit premiums on some utility stocksmay be out of line with otherwise modest earnings growth expectations. Thefirm, however, raised price targets on all three utilities based on theexpectation they will "retain a significant defensive premium" for along period of time.

MorganStanley identified SCANA Corp.as another stock facing "significanttail risk" based on the current budget for the nuclear expansionproject, coupled with the risk of more construction delays and concerns aboutthe financial strength of vendor ToshibaCorp.

The 'long view'

MorganStanley believes investors will be rewarded in the current environment bytaking the "long view" and purchasing stocks with strong growthpotential at a reasonable price.

MorganStanley points to Sempra Energyand NextEra Energy Inc.as recommended targets based on incremental growth opportunities, noting thatit expects a compound annual growth rate of 13% from 2016-18 for Sempra.In addition, Morgan Stanley expects EPS growth of 15% in 2019 for Sempra.

Sempraalso has been a mainstay in the gas business and recent moves by companies suchas Southern Co. intothe sector have been rewarded.

BarclaysCapital Inc. on July 14 upgraded Southern to "overweight" from "equalweight," while raising the price target to $62 from $59, while GoldmanSachs reinstated the company at "neutral."

Themoves come on the heels of Southern closingits acquisition of gas utility AGL Resources Inc. and for a 50%stake in Kinder Morgan Inc.'s7,600-mile Southern Natural GasCo. LLC's pipeline.

"Overall,I think utilities should be rewarded for moving more into gas investments,"Byrd said. "The returns tend to be good. The absolute amount of capitalthat they can deploy tends to be quite high. So, it's a real area of growth andit's not just a short-term transformation. It's a long-term transformation."

InSempra's case, the analyst said the company also has a strong presence inMexico, which also is "undergoing a tremendous shift" toward gas.

Outsideof these companies, Morgan Stanley on July 13 upgraded PublicService Enterprise Group Inc. to "equal weight" from "underweight"and raised its price target to $47 from $43 partly based on the stock's recentunderperformance versus peers. PSEG shares underperformed the broader utilitiesgroup by 7.5% in the past three months, according to Morgan Stanley, which seesa "more balanced risk-reward for the stock."