Conrad Charges Up Utilities

02/28/2003 12:00 am EST

Focus:

Roger Conrad

Founder and Chief Editor, Capitalist Times

Financial advisors have many different reasons for attending a Money Show. For Roger Conrad, it is simply because he loves to meet with investors, answer their questions, and help make them better long-term investors. There is also no one else I know of within the industry that has his knowledge regarding utilities. Here, the editor of the Utility Forecaster, and contributing editor to Personal Finance, offers his favorites in four different utility sectors.

"As far as the general market goes, we’re still in a bear market until we see clear evidence otherwise. We may get a relief rally in the next month or so if there is a resolution to what’s going on in Iraq. The market looks like it wants to rally. But four things are going to remain problems for the market. One is overcapacity. There is overcapacity in a wide range of industries right now. Some of that has to do with China becoming a major manufacturing force. But a lot also has to do with the 1990s being a period of such strong growth and building and investment, and it will a while for demand to catch up with that.

"High debt also remains a problem. A lot of companies took on high debt, and that’s restricting growth because they are focusing on maintaining credit ratings, bringing down capital costs, etc. Another problem is a shortage of natural resources. I think we’ve passed a turning point for oil and gas. Demand for oil by China has tripled since 1998. So we have more demand. At the same time, the North Sea and areas outside of OPEC are sort of peaking. The evidence seems to be showing that the world is going to be more and more dependent on the Middle East for oil. What that means is that the producers now have the upper hand on the supply side, whereas the consumers had it in the 1980s and 1990s. We’ve seen the price of natural gas take off, but we haven’t seen production pick up. Partly, that’s because it’s getting harder to find cheap supplies of gas. Partly, it’s because companies don’t want to invest in gas now, because they feel prices will decline. There’s really a unanimous opinion on Wall Street right now that oil and gas prices are going to drop off a cliff soon. And that’s definitely affected production decisions. Also, gas companies - just like all other companies today - are focused on credit ratings, and if they make major investments, their credit rating would be in danger. So rather than doing that, a lot of them are actually cutting back on capital spending. So we are seeing production drop, despite rising prices.

"It looks like we will see pressure on gas prices throughout the year. Oil prices may come down, if the ‘war premium’ is taken away, but I still expect that any big decline will be temporary and that oil and gas prices will continue to act as a check on growth. I think we’re also seeing the return of big government, with more regulation. The new FCC decision should be called the ‘full lawyers employment act’. We will now see litigation in all 50 states. I think this will be another constraint on growth that we didn’t have in the 1990s. I don’t think we’re heading for any big catastrophe, because I think the powers that be - Fed and government - will keep stepping on the accelerator and try to pump things up. I think we can we can expect, ‘no doom and no boom’. That’s not good for highly leveraged investments, or companies with a lot of debt, which are counting on a big boom of growth to bail them out. But it is a good time for companies that are high quality, and that live within their means. This may sound boring, but I believe these will be the winning themes going forward.

"How does that impact the utilities industry? Well the parts of the utility industry that are still regulated are very steady. Returns are set by regulators and they are pretty much impervious to economic ups and downs. The last thing people are going to do is to cut off their water supply, or cut off their electricity. They didn’t tear up the track in the 1990s, but they also haven’t crashed since then. They just continue to be very, very steady. The parts of the industry that are still operating under that premise are doing extremely well and have proven to be bear market champions. The part that’s unregulated, did well in the late 1990s, but has since really been struggling. These areas include energy trading, unregulated power production, and telecom operations. These are all business that expand or contact based on economic growth.

"For investment purposes, I break the stocks I follow into four distinct groups. Number one is regulated utilities. The second block is what I’d call diversified companies. These companies have the regulated businesses, but couple that with unregulated operations. These are the companies I believe will ultimately offer the highest total long-term returns. But for now, may have potential risk. The third group is the merchants. These are at the unregulated extreme. Almost all of them are now sitting on the brink of bankruptcy. The fourth group is the transitionals. These are companies that were at one time diversified, with unregulated operations, but have made the decision they don’t want to be in those businesses and want to get back to being a regulated company. History shows that when utilities make that decision, they almost always recover. But it takes a lot of patience. I think we will see a turn for the better long before most others expect, but it still won’t happen overnight.

"Companies that will benefit the most from this expected environment are the regulated utilities. Compared to other sectors of the market, based on earnings, sales, and dividends, the regulated utility industry is steadier than pretty much anything else out there. That’s a strong feature for safety. The main vulnerability is probably rising interest rates, but any such problems look to be a long way off. If the market takes another leg down, this may be one of the few areas that hold up. I’m convinced of that, mainly because they’ve held up so far.

"I think the number one group would be the water companies. Philadelphia Suburban (PS NYSE) remains my favorite water company and one of my favorite utilities. Over the last ten years, they embarked on a strategy where they basically took over small water companies and added them to their mix. There are about 50,000 water systems out there, and as clean water requirements have grown, these little systems just can’t afford to build treatment plants to upgrade their water. PS has a strategy called, ‘4-7-10-5’. They try to increase their customer base 4% each year, revenues by 7%, and earnings by 10%, and from that they raise their dividend 5% a year. They will soon be in about a dozen states. There is very little business risk, because this is an essential service. If you’re looking for growth and safety, this is one of the better candidates.

"Consolidated Water (CWCO NASDQ) is a much different story. Its growth is based on the reverse osmosis process. This basically converts salt water into fresh water. One of the areas of the world that is in dire need of water is the Caribbean. You get these huge cruise ships sailing in, and sucking up all the water resources. Consolidated has gone to a number of resorts, set up franchises with various governments, and install these systems to convert salt water to drinking water. They happen to be based in the Cayman Islands; I wouldn’t be concerned, as the company is very straight-forward and submit their documents to the SEC.

"Southwest Water (SWWC NASDAQ) has a regulated franchise business. But they also have a business where they contract manage other systems that are owned by municipalities. That business has been growing fairly rapidly. They focus primarily on fast-growing cities with populations of 10,000 or less. They collect a fee for running the system. They have a very strong record and a very diversified base. None of their customers make up more than 2% of total sales. The yield is not very high, but they do pay a stock dividend.

"I also like transmission and distribution companies. In many states, the transmission system – the wires and pipe – are still regulated. But the rest of the business, the wholesale power generation side, is unregulated, so there is risk. These companies operate transmission networks, get a fee for their use, they generate steady cash flows, and generate high dividends. They’ve done very well over the last two to three years, and I think they will continue going forward.

"Atmos Energy (ATO NYSE) is a gas company that basically focuses on the rural part of the country. They look at small towns, where more and more people are now moving. There is less competition in these markets and the regulatory relationships tend to be better. Most of their rates are weather-normalized, so even if it is an exceptionally hot winter, they still make the same amount of money. They just operate the network, which leads to steady earnings with steady cash flow.

"Piedmont Natural Gas (PNY NYSE) is focused on the North Carolina market. Customer growth has been around 5% for a long time, which means that they basically add customers, add sales, and add earnings. This is a very solid, steady franchise. They are on credit watch now mainly because they are in the process of acquiring a similar company, also based in North Carolina. The yield is about 5%.

"The wires business in some states is in an identical situation. A lot of companies chose to sell their power plants and just operate wire and pipe systems. Their earnings are no longer volatile, they’ve been bear market champions, and they yield about 5%, and increase their dividends. They are very steady earners. One is Nstar (NST NYSE), which serves the Boston and Cambridge areas with its electric and gas system. If you’re running a network, Massachusetts is one of the best states to operate in. Nstar just operates the network, generates new customers, and shows steady growth with a high-credit rating, and a good dividend..

"Another one would be Energy East (EAS NYSE). This company is a little more aggressive than Nstar in that it’s been acquiring other transmission and distribution utilities in the Northeast. The flipside to this added risk is that the company generates above average growth. This is a very well managed outfit. It offers a 5% dividend. Overall, this is a very solid outfit.

"The final area is utilities that fought tooth and nail to stop deregulation in their states. They succeeded and now that basically means they are operating as vertical monopolies. The poster child of the group is Southern Co. (SO NYSE). They made a lot of money diversifying in the 1990s, and then spun these operations off as Mirant, which has fallen on hard times. Meanwhile Southern has had the exact opposite experience. The company has long been the monopoly in Georgia, Alabama, a big chunk of Mississippi, and the panhandle of Florida. This is a very steady and conservative region, with very constructive regulation. The company pretty much has everything contracted out through 2009. This company has definitely benefited from remaining a vertical monopoly. Finally, I like Great Plains Energy (GXP NYSE), which used to be known as Kansas City P&L. They now have a new plant built, capital costs are falling, cash flows are rising, and they remain a regulated monopoly."

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