Analysis: Diversification a big draw to El Paso, PPL

NEW YORK (Reuters) - Attracted by diversifying earnings opportunities in the energy sector, hedge funds piled into El Paso Corp EP.N and PPL Corp (PPL.N) in the second quarter, betting on two players that are finding ways to succeed amid difficult market conditions.

The moves come as energy investment is at a crossroads, with the desire to focus more on alternative energy -- despite its uncertain ability to deliver large power loads -- grinding against the need for the stable energy supplied by old fossil-fuel technology.

El Paso and PPL, both heavily tied to the natural gas markets, were among the top 10 new equity positions taken by 30 of the largest fundamentally-oriented hedge funds during the April-to-June period, according to Thomson Reuters data.

The "Smart Money" bet on El Paso, which operates pipelines and explores for new energy reserves, comes at a time of low natural gas prices. In effect, the investment by managers like Christopher Shumway of Shumway Capital Partners and Dinakar Singh of TPG Axon Capital is a long-term assumption that the company can generate strong profits in the over-supplied North American gas market.

PPL, which produces power and supplies it to millions of customers, mostly on the U.S. East Coast, plans to buy two large Kentucky utilities to diversify its earnings portfolio early next year.

That plan attracted investors including Singh and Domenic Ferrante of Brookside Capital Investors who see the move as a way to reduce the company's reliance on sometimes volatile commodity power prices and stabilize earnings.

"It's great to hear I'm not alone anymore" on why PPL is a good investment, said Dudack Research Group analyst Daniele Seitz. "It was scary for a while."

EL PASO'S 'HEALTHIER SITUATION'

El Paso has been selling parts of its natural gas pipeline network to a wholly owned master limited partnership and using the proceeds to build new pipelines and cut debt. That's a strategy Wall Street likes, especially after Enron collapsed in part due to massive debt.

"It's a way to very efficiently raise capital to meet new-build programs," BMO Capital Markets analyst Carl Kirst said. "This is a sector that really got stuck being in a very over-levered situation. We think by the end of next year (El Paso) will be back to investment-grade metrics."

Going further, the company has a five-year historical growth model -- a rate that corresponds to its average annual per-share earnings growth -- of 19.6 percent, according to Thomson Reuters StarMine data.

That steady growth, despite a sluggish economy and a glut of natural gas in North America, has impressed many investors.

And while El Paso shares, currently trading around $11.30, are up 16 percent so far this year, they are down nearly 80 percent from their all-time high of $54.07, hit in early 2008.

At the Eagle Ford and Haynesville shale areas in Texas and Pennsylvania, El Paso has proved it can make a profit even with natural gas prices hovering just under $4 per 1,000 cubic feet, compared with a median price of $6.23 during the past five years and an all-time high above $11 in June 2008.

The Houston-based company has hedged about 55 percent of its 2011 production with a $6 floor.

"It may not be the best-hedged position in the industry for 2011, but it's pretty close," El Paso spokesman Bruce Connery said.

The company also recently received approval to build its Ruby Pipeline in the western United States.

"While low gas prices are a challenge for the industry, El Paso is in a much different, healthier situation than where they were two years ago, and that is allowing them to get through this without anyone being overly fearful," Kirst said.

DIVERSITY AT PPL

Earlier this year, PPL said it would buy two major Kentucky utilities from German energy giant E.ON (EONGn.DE) for about $6.7 billion.

"The transaction provides PPL with an increase in regulated earnings and cash flow, which in these volatile markets is attractive to many investors," PPL spokesman George Biechler said.

Currently, about 75 percent of Allentown, Pennsylvania-based PPL's business is tied to commodity wholesale power markets, where prices are volatile. The Kentucky assets will expand PPL's revenue stream to include more distribution, which tends to be stable.

"The diversity will help the company to manage a more consistent earnings growth, and that's really what was the point," Dudack's Seitz said.

The stock has dropped about 16 percent this year to its current level around $26.50, but its expected SmartEstimate earnings growth rate over the next 12 months is 13.1 percent, according to Thomson Reuters StarMine.

"The stock is trading at least at a 20 percent discount to the group," Seitz said. "In a way, it offers a lot of upside potential."

(Reporting by Ernest Scheyder; editing by Aaron Pressman and John Wallace)