Tuesday, January 20, 2009

Volume 3, Issue #4

Also in Today's Issue...

It's also inconceivable that all of this money -- by far the single biggest fiscal stimulus plan in U.S. history -- will be spent efficiently. Two points, however, are crystal clear.

First, the potential economic and stock market consequences of not passing this package are severe. For one thing, the stock market would almost certainly revert to panic mode, hacking another huge chunk off global wealth. Rapidly falling share prices would again put pressure on the finances of less creditworthy companies and trigger covenant violations and possible defaults for others. We could also see another and potentially even more devastating freeze in the credit markets, as lenders worldwide gird themselves for a prolonged depression.

There are always opponents to every bill in Washington. But with the memory of the Panic of 2008 still fresh, you're just not going to see a whole lot of opposition other than a handful of votes on the political extremes. Even action to delay the bill's passage is dangerous to political futures.

Second, anytime this much money is spent, there is a tremendous impact on the real economy, and certain industries in particular. The key issue for stock markets worldwide now is whether coordinated and aggressive fiscal and monetary policy can avert a long and deep global recession.

The fact that such a huge bill is moving so quickly through Congress has been the single biggest positive for stocks in recent weeks. The biggest negatives are worries that it won't pass in a timely way, and that even it if does it won't be enough to offset the forces of deflation/recession that are now in motion.

In normal times, news that the economy is growing more slowly than expected can be a huge positive for the stock market. As my friend Stephen Leeb and I wrote in Market Timing for the 1990s, that's because it's an indication of "slack," i.e. additional room for the economy to grow without igniting inflation.

In the spring/summer of 2003, 2004, 2005 and 2006, stocks sold off on fears that growth was running too fast and inflation and interest rates were on the rise. Income-producing shares and bonds were particularly hit hard. Then came news a few months later that, indeed, growth was not running so fast, and stocks resumed their upward course.

That dynamic is now 180 degrees opposite. Rather, for the first time since the 1930s, the worry is about deflation. Every bit of evidence that points to a slowing economy triggers selling pressure for stocks. That which paints a more positive picture for growth brings back the buyers.

Last week, we once again saw this reversed relationship play out, with the market mood shifting on virtually a daily basis. The week opened on a positive note, with good feelings about the stimulus package and stabilizing commodity prices carried over from the past two weeks.

Those good feelings got a further boost from last Monday's announcement that U.S. construction spending dropped much less than expected in November. Tuesday was also a positive day, despite a larger-than-anticipated drop in November factory orders, in part due to an unexpected uptick in the Institute of Supply Management's Purchasing Manager's Index for the services industry.

Wednesday saw the bears come out in force, as U.S. inventories of crude oil rose much more than expected, raising fears once again that demand and therefore the economy were slowing faster than thought. The pressure was tempered somewhat on Thursday by a second straight week of far lower than anticipated initial unemployment insurance claims. But it resumed again on Friday as we've now entered "warning season" -- when companies will warn of shortfalls in fourth-quarter earnings.

To be sure, last week's market action was far less violent than what we saw in the autumn of 2008. But it's plain that the ups and downs of the economy remain paramount in investors' minds and will continue to be until the economy shows beyond a doubt that it's turned the corner.

Where's the Bar?

In a very real sense, an environment where inflation isn't a risk is a major plus for all income-type investments, from bonds and utilities to limited partnerships and Canadian income trusts.

Earlier in the decade, every time fears of too-rapid growth rose to the surface, income investments across the board sold off, no matter how solid the underlying businesses. Going back in time, that was also the case in 1999, 1993-94 and 1987-88, and particularly during the 1970s when inflation ranged into the double-digits.

Since mid-2007, credit risk has emerged as deadly as inflation was during the 1970s. And high, safe yields -- even those that have continued to grow steadily -- haven't provided a floor to share prices. The only exceptions have been investments in which the market perceived almost preternaturally low credit risk, such as U.S. Treasury bonds. Even the safest regulated utilities have taken some hits.

The lack of real inflation risk, however, is nonetheless a tremendous plus for high-yielding investments. And on the market's good days, we've seen buyers come back to stocks of companies that have demonstrated they can maintain their dividends through the ongoing economic stress tests.

Fourth-quarter earnings will make for some tough comparisons. That's going to become very clear over the next couple weeks, the traditional earnings warning season.

We've already seen several American icons issue warnings about their results, particularly in the sectors hardest hit by slowing growth, rising unemployment and tight credit like retail. Even Wal-Mart (NYSE: WMT) has now guided below prior Street estimates, and the news from others in its industry promises to be even more severe.

The key question for stocks, however, isn't the raw numbers that come out. It isn't even whether they beat Street expectations, or even if they cover the dividend. Rather, it's where the bar of market expectations has been set. Right now, it's very, very low. It won't take much to hurdle it comfortably, and actually see some upside.

Where the bar is set is likely to be most important in the energy sector. With oil prices dropping more than $100 a barrel over the past six months, much lower earnings in the energy patch shouldn't surprise anyone. Earlier this month, Super Oil Chevron (NYSE: CVX) cautioned that both upstream and downstream earnings would be "significantly lower" than in prior quarters. The shortfalls are certain to be even greater elsewhere in the sector, where the players lack the financial strength of the supers.

The silver lining: Last year's washout selling has set the bar of expectations at an extremely low level. Even with the economy weakening, it won't take much to meet or beat them, and that's all it will take to avoid significant downside from here for a particular stock.

Many energy stocks, for example, sell for less than they did the last time oil was at $20 a barrel. To be sure, that's a rough valuation indicator, as costs are higher and many individual companies are much larger than they were back in 2001-02. But with the market reacting less and less to bad news such as Chevron's warning, it's very clear a lot of bad news has been priced in that hasn't happened yet.

Here's what it boils down to. Even if the bad news now in share prices does pan out, downside from here is limited. There are always some sellers when the news is negative, for example when a company cuts a dividend. Others, however, will recognize value and the price will recover.

The only time when there's real downside risk in the market or a particular stock is when expectations/valuations aren't pricing in bad news as it occurs. That's what happened in fall 2008, as investors reacted to the sudden meltdown of the U.S. financial system. But with sentiment so negative and valuations so low, we're a world away from that now.

Second, if the bad news now priced in doesn't occur, we're in for potentially the mother of all rallies. Moreover, the action is likely to be as sudden and dramatic as the rally of the past couple weeks. And it will catch a lot of the people now on the sidelines flat-footed.

With the economic challenges this severe, I'm not looking for a rising tide to raise all boats. Individual companies have certainly been stress tested over the past 18 months-plus, and those that have made it thus far have proven their mettle. But the nature of shakeouts is they always last longer than anyone expects, and there's always that last victim to fall.

At this juncture, I'm expecting to see many companies report favorable comparisons between fourth-quarter 2008 earnings those from the year before. Even comparisons with the third quarter, which included the collapse of Lehman Brothers and the freezing of the credit markets in September, will be difficult.

For income oriented investments, however, we have a rather simple bar here. Mainly, the key questions are do the earnings still cover the current distribution and are they on track to do so in 2009, and if they don't are the shares pricing in the likely reduction?

As Chevron's earnings guidance makes clear, companies that produce raw commodities are going to post much lower earnings than they have in prior quarters. Producers that pay out a large portion of cash flow in earnings, therefore, are likely to have to cut distributions. But with many of these entities now offering dividend yields 15 to 20 percent and even higher, their shares are already pricing in cuts of some magnitude. Fourth-quarter earnings will tell us if the bar has been set low enough.

A dozen Canadian energy producer trusts, for example, have trimmed distributions during this cycle. That's because realized selling prices for oil and gas in the third quarter were more than twice current market prices, and cash flow has therefore dropped. On the other hand, many trusts are now selling below levels they held in 2001, when oil was under $20 a barrel and natural gas was well under $2 per million British thermal units. And some are yielding as much as 30 percent and trading under book value.

The bar, therefore, is extremely low. In fact, as long as oil stays over $20 and gas over $2, it's likely to be exceeded by a wide margin. That's why energy producer trusts were able to rally into the new year by as much as 30 percent, and it's why they still have significant upside even if energy prices slump for some time.

Further, as I've pointed out in prior weeks, my view is the catastrophic drop in oil and gas prices guarantees another price spike, and potentially one of even greater magnitude than what we saw in mid-2008. As my friend and colleague Elliott Gue has noted, investors have been focused exclusively on the drop in demand of recent months. Little or no attention has been paid to what amounts to wanton supply destruction, i.e. the cancellation and postponement of dozens of projects to increase output of fossil fuels and/or use of alternatives.

Coupled with the winding down of many of the world's biggest fields, this means much less energy supply on the market over the next three to five years. That may not matter so much if the world sinks into a multiyear depression. Anything short of that, however, will eventually see a return in demand to normal levels. And supply will only meet it if there's a renewed wave of investment. That won't happen unless we see sharply higher prices.

In fact, the violence of last year's energy price decline will keep billions of dollars on the sidelines, until would-be investors are reasonably certain it will be economic. Total (NYSE: TOT), for example, has stated it needs at least $80 to $90 a barrel oil long-term to make a planned new investment in the oil sands work. And it's unlikely to put down the money the first time oil crosses that threshold again.

Again, I'm not a mind reader. But it makes sense to me that this psychology will linger the next time energy prices start to rise, just as it did earlier this decade. And the longer it does, the less supply will be on the market and the higher energy prices can go.

The potential upside from the next energy price spike is even greater than what we saw in mid-2008. That's the main reason investors should keep energy in their portfolio, despite what could be some horrendous earnings comparisons over the next few quarters and dividend cuts at yield-bearing energy plays.

And the bar has been set very low, which will limit real downside though not volatility.

Where the Buys Are

Turning to sectors outside the energy patch, I do continue to expect solid earnings for essential service utilities that will more than cover dividends and hold credit ratings steady. Stocks of weaker players are still going to be subject to some violent ups and downs on a daily basis. And even the stronger players are going to see some earnings erosion from stagnant customer growth, unpaid bills and slightly higher borrowing rates.

Companies that are active in the wholesale power market will also take a hit to profits. I don't agree with the "sell" recommendation earlier this month by a Deutsche Bank analyst for mid-south power utility Entergy (NYSE: ETR), particularly his forecast for "muted" long-term growth. But there's no doubt lower natural gas prices will negatively affect the price of wholesale electricity -- which follows gas prices closely in most areas -- as well as demand from industry.

Like most giant utilities, Entergy's dividend is insulated from economic weakness by large and profitable regulated operations. Operations at the New Orleans unit, for example, are likely to keep showing improvement as that city continues to rebuild from the ravages of the 2005 hurricanes. The company has delayed the spinoff of its unregulated nuclear power units due to the difficulty of raising enough credit economically to finance it. But the plants are all apparently running very well and the markets they serve, recession or no, remain very tight.

The same can't be said, however, for every power wholesaler in the country. Companies such as Dynegy (NYSE: DYN) and Reliant Energy (NYSE: RRI) for example, face the prospect of sharply falling earnings in 2009 in the context of still very high debt. Lower coal and natural gas input costs for their plants will help. But if the U.S. economy fails to revive, the possibility of bankruptcy will grow.

Industry weakness, incidentally, is a major reason I advise shareholders of NRG Energy (NYSE: NRG) to throw in their lot with Exelon (NYSE: EXC) by tendering their shares. The deal is in stock and therefore offers significant upside and, if NRG management is forced to come to the table, is likely to be sweetened. Meanwhile, this is a scale business and big, efficient companies have a much better chance of weathering current market and economic storms than smaller ones.

As for strong regulated utilities like Southern Company (NYSE: SO), investors have little to fear from fourth-quarter or 2009 earnings. Neither should anyone worry about big, safe water utilities like Aqua America (NYSE: WTR) or American Water Works (NYSE: AWK). And although energy prices have fallen, infrastructure owners and operators like Enterprise Products Partners (NYSE: EPD) are still increasing dividends, pursuing long-term expansion projects and enjoying steady throughput.

As has been the case every quarter since this recession began over a year ago, this earnings season is bringing out the skeptics on the communications industry. We've already seen several dire projections for the industry's strongest companies AT&T (NYSE: T) and Verizon (NYSE: VZ), and predictably it's driven some selling.

The latest bear case is that wireless sales will slow enough to allow wireline losses to take down these companies' earnings below expectations. These are already dismal as evidenced by yields of around 6 percent for both stocks and historically low price-to-sales and price-to-book value ratios.

This is, of course, possible. Certainly, the weakness continues elsewhere in the industry. Earlier this month, the CEO of the pair's chief rival Sprint (NYSE: S), Don Hesse, stated at a Citigroup conference that his company planned to close as many as 20 call centers in 2009 and cited other "headcount" cuts as well. His statement that the key for Sprint "is not to panic" is also cause for pause. So are the billions in writeoffs his company and its partners in the Clearwater WiMax venture will be taking.

On the other hand, however, Mr. Hesse is no longer talking about the possibility of a price war to prevent Sprint customers from defecting, calling it an "unnatural" step. That seems to suggest some pricing power for company. If true, that's not just good news for the U.S.' number three wireless services provider's turnaround. It's proof positive that the U.S. wireless industry is still on very strong footing, even with economy this weak.

As is the case with every industry, we're going to have to look at the numbers carefully. But again, the expectation in communications company share prices -- including cable giant Comcast (Nasdaq: CMCSA) -- is that earnings are going to be poor. The bar is low and if companies exceed it, it will be positive for share prices, particularly if there are signs by then that the economy is perking up.

One other area on which I'm unabashedly bullish for 2009 is environmentally-focused infrastructure. My two reasons: Funding for major projects is recession proof and likely to be massive, and stocks of major players are selling at washed out prices.

On the first point, the key is that major sources of funding are governments, or else regulated utilities operating with strong government support. As long as projects remain on track and within budget guidelines, the cash will flow and so will the profits for investors.

The so-called environmental market grew by double-digits in 2008. Fueled by government mandates and spending, it's expected to keep going at a 7 to 10 percent rate over the next several years. Some 47 percent of this investment is expected to go into water, 39 percent into waste and 9 percent into the air, with 5 percent for miscellaneous uses.
Given the state of the U.S. economy and President-elect Obama's call for "shovel-ready" projects, I'm expecting much of the green investment to go into more mundane area, such as improving water quality with pipe repairs and more efficient cleaning processes. But there will be plenty left over for more revolutionary uses, including energy projects which aren't counted in the above numbers.

Chief among these are projects focused on improving the efficiency of energy distribution, such as the so-called smart grid infrastructure. By cutting down on waste and the lost voltage from plant to plug, electric utilities can literally save billions of dollars in future expenses to build new power plants. And equally important, they can put the investment into rate base right away, as opposed to recovering the cost of power plants which typically only happens after a unit is built.

Energy efficiency alone, however, won't meet all of America's future energy needs, even if the economy does stay in the doldrums for a very long time. For one thing, many of the power plants that have met the country's needs for years are wearing out and replacing a part here and there isn't going to cut it for much longer.

Environmental mandates such as carbon dioxide reduction will also require new investment, either in alternative energy or in cleaning up emissions. And -- even assuming very aggressive projections for conservation and very modest economic growth -- the Energy Information Administration still projects a 20 percent increase in electricity demand by 2030.

Companies will demand a higher return to compensate for the uncertainty or returns on investment. But projects that can secure regulatory approval and funding before startup will be a potential goldmine for their owners and operators.

One of the more promising is Duke Energy's (NYSE: DUK) planned state-of-the-art coal-fired plant in Indiana. The Edwardsport project is a 630 megawatt capacity coal-fired plant running on integrated gasification combined cycle technology (IGCC). IGCC basically converts coal into a gas to synthesis gas, from which sulfur, mercury and ash are removed before being sent to a combined cycle plant, where it takes maximum advantage of increased energy by powering two combustion turbines and a steam turbine at once.

Like all coal-fired plants, Edwardsport will release carbon dioxide (CO2) into the atmosphere. But unlike the conventional coal plants it will replace at its site, it's far more efficient, producing 10 times a much power as the older units which will be shuttered. As a result, it will also produce 45 percent less CO2 per megawatt hour of power.

That's already comparable with natural gas combined cycle plants and should ensure Edwardsport remains competitive with gas once CO2 restrictions kick in and start to push up costs. Duke, however, has also stated its intention to apply carbon capture and sequestration technology to the plant as it's developed, potentially as a template for the rest of its coal-fired plants.

This technology, of course, is not yet commercially available. But there is a lot of money now going into its development and the winner of the race stands to gain billions upon billions of dollars in orders. France-based Alstom (Paris: ALO, OTC: AOMFF) is one candidate, but so are engineering giants like Shaw Group (NYSE: SGR).

Carbon sequestration and smart grid technology are just two of the areas I'm now tracking in my new service New World 3.0. Other editors of the service include Elliott Gue, David Dittman, Gregg Early and Yiannis Mostrous.

Where to Start: The Best Utilities to Buy Today

For over twenty years, Utility Forecaster has provided my subscribers with in-depth coverage and expert analysis of investment opportunities in electric, water, natural gas and telecommunication utilities.

Each issue examines key macroeconomic and regulatory developments that drive utilities' performance and share prices, while closely scrutinizing the growth potential of every publicly traded utility company.

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Sincerely,
Roger Conrad
Editor, Utility Forecaster

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