^{MIZUHO SECURITIES USA INC.  |  US EQUITY RESEARCH}

Summary

The major utility-centric indices (Philadelphia UTY, Spider ETF XLU, and S&P

Electrics) are up about 19.0% year to date. Meanwhile, the median stock in our universe is off 3.5% from its 52-week highs and is nearly 35.7% above its 52-week lows. Can it last? Perhaps, but likely not. This "Swinging Pendulum" note is an effort to preempt the natural question(s) regarding the potential downside when the sector falls out of favor and/or rates at the long of the curve begin to rise in earnest.

Key Points 

We analyzed two-year rolling forward P/E multiples over 5-, 10-, and 15- year periods in an effort to translate potential downside from current levels by comparing the current P/E against the historical P/E over these three observation periods. Our conclusions:

1) We expect to see up to a 3.2x decline in the average P/E multiple which equates to a potential price drop of about 17%, or $10 per share.

The Winners: EXC, OGE, and FE each would fall by less than 10% in this scenario. Not surprisingly, these companies have the lowest differential between average and historical P/Es;

The Challenged Ones: WR, NI, and AVA and could fall by more than 24%. That may be unrealistic given that WR is in a transaction, and NI has transformed itself considerably in recent years.

2) However, it is important to note that this analysis is based on an historical review and in a given situation, a particular Company's current risk and outlook profile may be materially different implying the price differential may no longer be as steep in a reversion towards the mean scenario. That said, investors should remain mindful that pendulums swing two ways.

3) Importantly, the empirical evidence indicates that the strong correlation between utility share prices and Treasuries began delinking in earnest in November 2007 when the 10-year Treasury note broke through the 4.0% yield threshold and when the Baa Corporate bond crossed below 6.0% in July 2010. Historical correlations have weakened since then. 

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