Strategic Investing in Telecommunications, Utilities From 30,000 Feet Up
Companies / US Utilities May 12, 2007 - 01:21 AM GMTBy: Roger_Conrad
Earlier this week, I got a call from a reporter at a major newspaper, asking for my “view from 30,000 feet up” on the power industry. Big picture perspectives are most useful when they help us to see the forest as a whole, rather than just tree-by-tree. They're downright dangerous, however, when analysts fall in love with their prognostications.
In 2002, after 14 years of picking utility stocks, I wrote my first “30,000 feet up” book on the sector, “Power Hungry: Strategic Investing in Telecommunications, Utilities & Other Essential Services”. My timing could have been a lot better, as utilities were in the middle of their worst bear market since the early 1970s. And several of the executives I interviewed for the book have moved on to other lines of work.
I'm rather proud of how the book's main themes hang together. For one thing, the power utility industry--as well as water and communications--have continued to consolidate in pursuit of ever-improving economies of scale. Many of the transactions we've seen have been across borders.
My forecast for the ultimate dominance of the former Baby Bells has come true. Sector technologies that '90s analysts prophesied would turn things upside down have been co-opted and increased big company profits. I continue to follow the investment strategy rules, as I have for the past 20 plus years. And only one of the 41 “Model Portfolio” investments highlighted at the end of “Power Hungry” has proved to be a loser; it was a whopper, WORLDCOM.
I missed the boat on WorldCom largely because I thought it was building dominance, rather than cooking the books. But the book's biggest error was that I was too optimistic on the prospects for the deregulation of electricity. Retail competition, for example, has never caught on in most states, and several, like Virginia, have actually rolled back laws implementing it.
I particularly cringe when I read my sunny forecast for energy trading companies in the aftermath of the ENRON bankruptcy. As it turned out, this group was in for a meltdown of its own in 2002, and there was bad accounting as well that sealed their doom though not on the scale of Ken Lay's outfit.
By early 2003, only a tiny handful of energy trading firms were still standing. Most were being shut down at huge losses by their owners. The primary reason was rapidly collapsing wholesale power prices.
I had thought that rising natural gas prices would push up the price of electricity. Gas now has two seasons of peak demand: winter, when heaters are fired up, and now summer, as air conditioners force power companies to produce as much juice as they can. Gas prices have graduated to a current trading range of $7 to $8 per million British thermal units (MMBTU) and are more volatile than ever.
I anticipated that the new plants would create a tidal wave of demand for natural gas that would drive up prices into a whole new range from the $1 to $2 per MMBTU they held throughout the '90s. But I had thought that power prices would keep pace and that the gas plants would remain economic to keep running.
As it turned out, that's what's happened in much of the country, but only in the past few years. Power prices in Texas, for example, have surged the past few years, rewarding market participants like NRG ENERGY (NYSE: NRG) and TXU (NYSE: TXU). The immediate impact of the new capacity, however, was to drive down power prices sharply by early 2003. That in turn set the stage for the real meltdown in the sector as billions of dollars in debt suddenly appeared to be at great risk.
Many of the new plants, despite being state-of-the-art for efficiency, are simply too expensive to run most of the year. Only during seasons of peak demand will the spark spreads (or gross margins) be high enough to run them profitably. That's what ultimately drove the biggest builder of gas plants into Chapter 11, CALPINE CORP (OTC: CPNLQ), as cash flow from its power plants could no longer cover the cost of the massive debt load needed to build them.
Only after some massive asset sales has Calpine been able to approach exiting bankruptcy. And I doubt very much whether it will last long as an independent company. There's simply too much risk in operating a power producer that's basically dependent on a single type of plant, particularly when the price of the key fuel is so volatile. The good news is Calpine's exit from the business will almost surely be from a merger after it comes out of bankruptcy.
Greed in the '90s drove even the most conservative industry executives to make irrational and ultimately extremely destructive decisions. Even the likes of DUKE ENERGY (NYSE: DUK) fell prey to the siren call of “build now, ask questions later.” And only now, after paying a very steep price, has the sector been able to recover.
THE LOOK AHEAD
Such are the perils of long-term forecasting and big picture analysis. That's one reason I prefer to be a bottom-up analyst. By that, I mean that I build my overall perspectives on what individual power companies are actually doing, rather than the other way around.
Nonetheless, now's as good a time as any for another round of big picture forecasting on the power sector: Where we are now, where we're likely to go in the next few years and what will carry us there the most profitably.
The first thing to point out is electric utility stocks have recovered all the ground they lost in the meltdown earlier in the decade, and then some. The Dow Jones Utilities Average is up threefold from its lows of late 2002, and is some 25 percent to 30 percent above the peak it reached in late 2000.
Since the low point of early 2003, three things have happened. First, utilities have gotten back to basics, paring back to their core businesses of providing essential services, improving reliability, repairing relations with regulators and slashing debt. That effort continues today.
Second, for the first time since the 1960s, there appears to be a new compact between state and federal regulators and utilities, even in what have been some of the toughest and most restrictive jurisdictions for companies. WESTAR ENERGY'S (NYSE: WR) amicable settlement of a rate case in Kansas this month, for example, would have been almost unthinkable a few years ago.
Rather than bashing utilities to bring down near-term rates as low as possible, officials are again cooperating with companies to make needed investments to improve reliability, meet ever-rising demand and clean up the environment. Utilities for their part are making investments, earning a return on them and thereby boosting profits.
The third thing that's happened since early 2003 is utilities' access to capital has gone from chronically challenged to robust. Banks first began loosening up when private capital started taking an interest in power plants. That prevented a wave of industry bankruptcies that some feared, as only the worst off were forced to take that route. The last stage is currently underway, as vastly improved financials have at last induced major credit raters to begin boosting power utility ratings once again.
This week, S&P restored CMS ENERGY (NYSE: CMS) to investment grade, following the company's unloading of some $1.8 billion in non-core, under-performing assets thus far this year. Others are close behind, including SIERRA PACIFIC RESOURCES (NYSE: SRP), which has overcome a huge debt problem largely by forging a new compact with the state's historically cantankerous regulators.
The big picture conclusion: The recovery stage for the industry that began in early 2003 is rapidly coming to a close. The big gains from the back to basics movement are behind us. The bright side is the industry is now at its best health in decades and odds are finances and operations will continue to strengthen for the next few years, particularly for the industry's weakest players. The negative side is valuations are at their highest levels in years, whether you're looking at average yields of 3 percent to 4 percent, price-to-book value ratios of 2.0 to 3.0 and even and higher or price-to-earnings ratios of 15 to 20 for companies with very little potential growth.
In short, it's time to look at the next stage for the power sector, and who's positioned to profit most from the transition. In my view, capital spending is the key both to the upside and downside.
Up until the early '70s, when utilities spent money on new power plants, transmission lines and distribution systems, their
investment routinely flowed through to the rate base. And because companies were allowed to earn a fair return capital spending boosted earnings and dividends as well.
That regulatory compact started to come apart in the '70s. And since then, the flow of capital spending to the power sector has been erratic to non-existent. As inflation, rising interest rates and environmental concerns lifted construction costs for new plants, companies learned very quickly that regulators were not going to allow full recovery of their investment, much less anything that could be conceived of as a fair return.
At that point, heavy capital spending needs became an albatross for utilities, rather than the fuel for earnings growth as had been the case during the '60s and earlier. Regulators disallowed billions of dollars in costs--particularly for new nuclear power plants--driving the builders to slash dividends and, in some cases, to the brink of bankruptcy. PUBLIC SERVICE OF NEW HAMPSHIRE was ultimately forced into Chapter 11 due to cost overruns and rate disallowances relating to the construction of the Seabrook nuclear power plant.
As the '70s became the '80s and then the '90s, these negative rate case outcomes mounted. In fact, consumer advocates became ever-more aggressive, pressuring regulators to launch prudency reviews that often led to the writeoff of billions of dollars of costs deemed unnecessary with 20/20 hindsight. The process hit a crescendo in the '90s, as regulators and politicians alike pushed plans for deregulation on the theory that breaking up utility monopolies and bringing in new competitors would bring down rates. “Greedy” utilities and their investors were given short shrift.
The result of all this is that rates have been kept generally low in the industry for the past 20-plus years. At the same time, however, companies have largely stopped making the kind of investments needed to keep the overall system healthy, opting instead for short-term fixes such as outsourcing and relying on easy-to-build natural gas fired power plants rather than building real baseload capacity. The nation's transmission system has been almost completely defunded, except for maintenance and repairs, such as following storms.
At the same time, America's reliance on electricity continues to grow. And despite continued advances in efficiency, the trend shows no sign of abating. In fact, we could see a quantum surge in demand in coming years, if the new breed of electric vehicles begins to catch on as battery technology continues to develop. Electric vehicles and battery technology are frequent subjects for my colleague Gregg Early and his Nanotech Investor News. (Visit http://www.kcifinance.com for a complimentary subscription.)
Meanwhile, power companies are also in the middle of a major round of spending on environmental controls, particularly for the coal plants that generate about half of our electricity. SOUTHERN COMPANY'S (NYSE: SO) bill over the next five years for reducing emissions is projected at around $6 billion. And that's not including the spending that will be required to deal with carbon dioxide emissions blamed for global warming.
It doesn't matter whether any of us agree with the science or not. Even the companies involved have conceded to political reality that carbon emissions are going to be controlled one way or another. Their efforts now are focused instead on helping the shape the debate and the ultimate rules they have to follow. Southern Company, for example, has become an advocate for the current US Congress to take action, in hopes of heading off more draconian regulation in a future Congress with bigger Democratic majorities. That's despite the huge capital spending bill it will likely face to deal with its
emissions.
Climate change regulation is currently advancing in the House of Representatives and will apparently take the form of two bills. An early summer bill will focus on additional incentives for conservation, efficiency and carbon-neutral energy development, wind power, for example. These enjoy widespread support in both parties, as well as the White House, and will likely proceed to law rather rapidly. That will benefit the likes of AES CORP (NYSE: AES) and FPL GROUP (NYSE: FPL), the leading developers of wind plants. AES is also a leader in transmission technology.
The second climate change bill is slated by House leaders to hit the floor sometime in the fall. This one will contain tough restrictions on carbon emissions, very likely through a cap-and-trade system. This system has proven success in reducing acid rain emissions since passing into law in 1990. Cap-and-trade has been adopted by California and other states, and is the system enshrined by the Kyoto Protocol. It's favored by industry because it allows companies flexibility in meeting regulations.
Cap-and-trade for carbon will be more complicated than has been the case for acid rain, mainly because power plants are only one of many carbon emitters. Industry wants to negotiate a deal in a Congress that's only narrowly controlled by Democrats and with a Republican in the White House. Whether or not it succeeds will determine how much of a burden reducing carbon is for ratepayers and shareholders alike.
The second bill faces highly uncertain prospects, to say the least. Were President Bush in a stronger political position, he could put his stamp in the final legislation the way is father did with acid rain in 1990. As it stands now, however, his only say is likely to be through a veto threat. Success is likely to boil down to whether the Democratic leadership can hammer out a deal with sympathetic Republicans in the Senate. If it can't, the Democrats will have a powerful club to bash the GOP with as 2008 elections approach.
At this point, there are too many variables to forecast the impact of carbon regulation on utility capital spending. What is certain, however, is that capital spending is going to rise industry wide. And it will either be beneficial by going to rate base and adding to earnings, or disastrous by forcing big writeoffs, dividend cuts and possible bankruptcies.
The key is regulation. As long as the new regulatory compact lasts, capital spending will be a boon rather than a liability for utilities. Southern Company has already been granted approval of its current environmental expenditures budget by regulators in the Southeast. As a result, its upgrades will be a plus for earnings. That's even likely to be the case if it has to begin spending to cut carbon emissions.
In contrast, the prospects for earning a return on investment in states like Illinois are considerably more iffy. The Illinois Commerce Commission has now filed with the Federal Energy Regulatory Commission (FERC) to challenge EXELON'S (NYSE: EXC) transmission rate case. FERC has been trying to incentivize spending on high voltage power lines by increasing allowed returns on investment. Illinois needs this spending, but the rate increases have become politically hard to bear given the recent jump in the state's wholesale power prices after a 10-year freeze.
How FERC reacts will be extremely important in determining how much the industry will spend on transmission. I expect a supportive decision. But in any case, it also illustrates that not every state is on board with the new regulatory compact.
It's clear that utility share returns will come to depend more and more in coming years on how much capital spending companies do, and whether regulators allow a fair return on investment. On the plus side, the industry is starting from a strong place. As first quarter earnings attest, the trend toward improving financial health continues.
On the minus side, the more money that's spent and the higher rates go, the greater the pressure will become on regulators to disallow investment, or at least cut down on the allowed returns. Utility rates are not an issue in most states at present. In fact, power rates have risen over the past few decades at a rate far lower than prevailing inflation. In many areas, power is as cheap as it's ever been in real terms.
As the example of the '70s attests, however, there is a limit to rate recovery. Some states reach it more quickly than others. But even Southern Company faced disallowances in Georgia when it built its Vogtle nuclear plant at a cost that was considerably over original estimates. In short, keeping an eye on rates and costs is going to become progressively more important going forward.
The power sector is fundamentally a scale business. Whether you're talking about producing from nuclear plants or distributing and servicing solar panels, bigger companies are better able to spread out costs, reach markets, offer new products and above all access capital.
As I discuss in the May issue of Utility Forecaster, the quest for scale through mergers has been a part of the utility industry since its foundation in the late 19th century. There are currently 10 takeovers underway, most of which will create greater scale for their owners.
We may have seen the last really big deal in this industry for a while. But there's still a process of consolidation underway particularly in power production, where a handful of companies are gobbling up the nation's nuclear power plants and the remaining independent power producers are putting themselves up for sale. For example, MIRANT (NYSE: MIR) has been looking at prospective buyers for much of this spring and should reach a deal sometime in the next couple of months. Calpine too is likely to be bought, once it officially emerges from Chapter 11.
This type of acquisition is likely to continue and will fuel earnings for the purchasers as well. Other companies will benefit from the rising demand for power and higher wholesale prices for electricity, particularly in the deregulated markets of the Northeast and Midwest.
Fuel and purchased power costs are another challenge to utilities. Besides getting regulatory approval to earn a return on capital spending, companies must gain and keep officials' blessing to recover changes in fuel and purchase power costs. Many companies enjoy automatic recovery of these costs in rates. But some states require companies to file for each change in rates, raising the risk of disallowances each time.
As with capital spending recovery, the key to fuel cost recovery is regulation. As long as a utility's accord with regulators holds, its earnings will grow and it will remain in strong condition. Those are the companies to buy and hold for the long haul. In contrast, utilities in states with historically weaker climates should be watched carefully for signs of regulatory backsliding.
Interest rate swings will also have an effect on utilities' performance, owing to the fact that they're prolific borrowers and
investors still treat them as rate sensitive. Rising rates will present buying opportunities by pushing down prices temporarily. Falling rates will push prices higher--as they're doing now--providing a time for caution and possibly taking some money off the table in anything that's become disproportionately large as a percentage of one's portfolio.
The long-term key to which utilities will be winners and which will be losers is capital spending and regulation. That's where investors need to keep their focus.
Here's a brief look at some positive climates and negative ones here in spring of 2007. Note as with the politics it's based on, regulation can change and there's no substitute for watching the cases unfold on the ground.
SOME GOOD CLIMATES
Alabama, Georgia, Florida, Indiana, North Carolina, South Carolina.
SOME TESTY CLIMATES
Illinois, Kansas, Maryland, New York.
GOOD CLIMATES TO WATCH
California, Michigan, Nevada.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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