National Champions as Key to Success for Utilities Companies
Companies / US Utilities Jul 21, 2007 - 11:57 AM GMTBy: Roger_Conrad
Regulatory support: That's the key to prosperity for energy, communications and water utilities all around the world.
If relations with the home country government are good, all will be well with the utility. Investment in infrastructure will be rewarded with competitive returns. Major challenges will be hurdled with minimal disruption or financial instability. And the company's investors will be rewarded with strong long-term total returns.
On the other hand, nothing is as potentially damaging to a utility than a hostile home country government. At this point, there's little risk of a return of the widespread nationalizations of utilities and other big corporations that occurred during the 1970s.
Even the Chavez government in Venezuela has paid investors for nationalized property, though arguably not completely at fair market value.
There are, however, plenty of very heavy-handed regulators in countries all over the world. And utilities there are constantly at risk that officials will second-guess past decisions and prohibit a fair return on investment in the name of keeping customer rates low.
Some countries tilt the playing field against industry incumbents, effectively subsidizing competitors.
As I've pointed out in Utility & Income—as well as my monthly advisory Utility Forecaster—attempts to manufacture utility industry competitions routinely end in failure. Rivals may flower for a while in the sunshine of generous subsidies and protection under the rules.
Sooner or later, however, they wilt for one reason: Utilities are a scale industry. Larger companies can more easily make the needed investment in infrastructure to meet demand.
Scale enables companies to spread out costs more easily. And all else equal, larger companies have a far easier time raising capital economically, which further enhances their cost advantage.
It's no accident that the history of the utility industry is one of consolidation. In the US, utility services were basically developed on a town-by-town basis.
As a result, market share has been far more dispersed in this country than in other places. That remains the case today, even after literally thousands of utility mergers.
In most other countries, however, ownership of utilities has been markedly different. Left-leaning governments nationalized operating companies progressively throughout the 20th century. As a result, by the late '70s, most of the world's power, water and telecom services were provided by government-run entities.
All that started to change in the '80s. British Prime Minister Margaret Thatcher and US President Ronald Reagan popularized the idea that investor-owned companies could provide services more efficiently and cheaply than government-run agencies.
At the same time, Wall Street interest in global utilities as a way to cash in on the growth of foreign countries began to take off. And governments themselves realized that successful privatizations could provide badly needed cash.
As a result, the '80s and '90s saw a massive reversal of the nationalizations of previous decades. Governments remain major players in utility ownership in many lands. But investors can now buy stakes in telecoms throughout Latin America, Europe and Asia, including many former communist countries.
In the early days of the privatizations, virtually all governments were supportive of their privatized utilities. Attracting foreign investment was seen as the key to upgrading and expanding infrastructure, as well as maintaining the value of the government ownership interest. Companies were able to win needed rate increases, and regulators in general didn't interfere with operations in most countries.
As the years passed, however, government motivation changed as well in many countries. Some looked at the fact that the original incumbents ruled the market and perceived a failure of capitalism.
In some cases, they imposed extremely harsh remedies to manufacture competition. And as governments sold down their interests in the privatized companies, they became progressively less motivated to be supportive.
Foreign utilities in general have been huge winners in the past several years. The US dollar's steep drop against the euro, Canadian dollar and other major currencies has pushed up the US dollar value of share prices and distributions. Also, to paraphrase my colleague Yiannis Mostrous in his excellent book The Silk Road: How You Can Profit by Investing in Asia's Newfound Prosperity, it's increasingly the foreign countries that are the world's growth engines.
Foreign utilities' sales and cash flow are directly tied to the health and growth of their home markets. A vibrant economy will suck down more electricity and water and use more telecom services. A weak economy means stagnant earnings and very likely little investment by the utility because regulators almost surely won't allow recovery.
With much of the world roaring ahead, it's no wonder foreign utilities have thrived as well. There are definitely pockets of worry.
One is the European Union, where some bureaucrats want to bust up power and gas utility giants. Another is New Zealand, where the chief telecom regulator is hell-bent on forcing TELECOM NEW ZEALAND to split up.
There is, however, a potential countertrend in the works: the increasing desire of governments to create national champions in key industries.
Dominant national utilities typically employ hundreds of thousands of workers. The quality of the service they provide is essential for commerce to run smoothly. Finally, there's a political yen to keep control of essential service within national borders.
The desire to create and nurture national champions is nothing new.
But its revival is very good news indeed for the companies lucky enough to operate in such countries.
THE LUCKY
Spain has long been a supporter of building national champions in the utility business. Regulatory decisions have traditionally been very supportive of investment in the country, as well as foreign ventures. As a result, the country is home to three of the biggest essential service empires in the world.
TELEFONICA'S first move was to carve out an empire in Latin America during the '80s and '90s. In the past decade, it's extended its reach throughout Europe with some $130 billion in acquisitions and expansion. Today, it derives roughly a third of its business each from Spain, the rest of Europe and Latin America. And it's pursuing opportunities elsewhere, including China.
ENDESA followed Telefonica into Latin America, with the biggest move being the purchase of a 60 percent controlling interest in Chile's ENERSIS. Enersis had previously made major acquisitions throughout South America, particularly in Argentina and Brazil. Endesa has also since made expansion moves in the rest of Europe because the continent's power market has become increasingly integrated.
Here in mid-2007, Endesa itself is in the process of being acquired by a partnership between Spanish conglomerate ACCIONA and Italy's ENEL. The deal still has some hurdles to cross, not the least of which is Spain itself. But it looks likely to be completed later this year.
The most recent Spanish giant to emerge is IBERDROLA. Long a smaller cousin of Endesa, the company catapulted itself to multinational status by acquiring SCOTTISH POWER this year.
That made it the world's leading wind-power company, with a dominant share of the onshore market in Europe. This summer, management made its first foray into the US, reaching a deal to buy New York/New England power and gas distributor ENERGYEAST.
In the past few years, the European Union has become increasingly concerned with market power considerations in the utility business.
Some countries, such as Germany, have tied the hands of the privatized giants.
Whether it's been run by left- or right-leaning parties, Spain continues to resist any move to restrict the actions of its giants.
And that's very good news indeed for its giant utilities' prospects.
In the past year or two, Italy has begun to follow Spain's lead. The Prodi government has become a major supporter of dominant energy utility ENEL's bid to become a continentwide player.
The company became flush with cash two years ago when it exited the communications business by selling its WIND unit. Since then, it's been deploying its resources into fast-growing markets, primarily in Eastern Europe. This year, ENEL bought a Russian utility and gas system and it plans to spend some $5 billion more in the next few years.
The Prodi government has been an invaluable ally, pushing ENEL's case with the European Union, as well as the Spanish government. It was also a key supporter in the company's earlier unsuccessful bid to break up the merger between SUEZ and GAS DE FRANCE. That merger still seems likely to go through, though there could be opportunities for ENEL to pick up power assets once the deal is done.
France is a third country that looks set to take the national champion approach going forward. The country essentially bailed out its communications industry leader FRANCE TELECOM earlier this decade. Now under the leadership of the dynamic Nicolas Sarkozy, the country is making moves to boost the health of businesses that were once unthinkable, particularly on tax and labor issues.
That's a major plus for France Telecom, which has also been a major investor in other parts of Europe. It's also a positive for Suez and VEOLIA ENVIRONMENT, the world's two biggest water empires. The pair has long dominated its home country under charters that date back to the Napoleonic era. Now these two companies are pushing out all over the world, particularly China, where deteriorating water quality has enabled them to grab billions in contracts.
In the US, there hasn't been a true national utility champion since the court-ordered breakup of AT&T in 1984. Today, however, there are two prospective global empires in the making.
Today's “new AT&T” is essentially the union of the former AT&T's global BUSINESS division, four local phone spinoffs of the 1984 breakup or “Baby Bells,” the nation's largest wireless company and a handful of other network assets acquired along the way. The combination is both larger and more profitable than the old Ma Bell and continues to grow rapidly.
New AT&T's latest move is overseas, where it's expanding its global network capability for both businesses and consumers, as well as hunting for new assets. A floated proposal to buy out TELECOM ITALIA never materialized. But it's a clear sign the company is on the move.
VERIZON COMMUNICATIONS holds two former Baby Bells and the former GTE, as well as the old MCI business division and the nation's second-largest wireless company. Unlike AT&T, which owns 100 percent of its wireless division, Verizon owns only 55 percent of VERIZON WIRELESS. The rest is held by Britain's VODAFONE.
The partnership has been extremely successful; Verizon Wireless continues to grab customers and boost margins with new service offerings. It's been routinely attacked, however, by outsiders.
Certain major shareholders of Vodafone, for example, continue to argue the company should do one of three things: cash out of its 45 percent stake and deploy the money to control another US wireless company, monetize the 45 percent stake in Verizon Wireless by spinning it out directly to shareholders or buy out Verizon and grab the other 55 percent outright.
One of the original cornerstones of the Verizon/Vodafone partnership was the granting of a “put option” for Vodafone, giving the company the right to sell its stake to Verizon at any time for $20 billion.
That put option expires next month. As a result, some Vodafone shareholders have upped the pressure on management to make a move soon.
This week, a rumor made the rounds that Vodafone was planning to buy Verizon at a premium of more than 30 percent to the latter's current market price. The rumor was fervently denied by Vodafone management, and the impact on share prices was short-lived.
Nonetheless, it's certainly not out of the realm of possibility. And in the meantime, Verizon is a very solid franchise and cheap stock.
And like AT&T, it enjoys solid regulatory support as it continues to grow.
In the Far East, SINGAPORE TELECOM has used a very strong position in the rapidly growing island nation to expand its reach throughout southern Asia. Growth is particularly strong in India and Vietnam.
The government continues to hold a major stake in the company and maintains one of the most pro-business regulatory environments in the world.
THE UNLUCKY
Under chief regulatory bureaucrat Vivianne Redding, the official European Union has taken a dim view of national champions.
Individual countries, however, have paid little attention. As a result, utilities in France, Italy and Spain should continue to thrive.
Utilities in other countries may be less fortunate. Germany, for example, continues to make things tough for D eutsche Telekom , which is battling to cut costs to keep up with declining market share. Britain, under the Labour government, has been another unpredictable and often dangerous environment for utilities.
The chief regulator holds a tight leash on BRITISH TELECOM'S ability to profit from its broadband network. Energy grid owner NATIONAL GRID'S allowed returns are always under attack. Even the country's water utilities are becoming the object of increasing scrutiny, just a few years after the government committed to a long-term plan to enable them to invest billions in new infrastructure.
Shifting westward, TELMEX was long viewed as a national champion for Mexico, as has been its wireless spinoff, AMERICAS MOVIL. Run by Carlos Slim, both companies have expanded rapidly throughout Latin America, using a solid base in their home country.
That may be changing, however. The new government has apparently decided that the country needs competition in communications and is willing to tilt the playing field to get new entrants.
Moreover, it's launched an investigation of Carlos Slim's interests.
All is still well, but there's enough here that bears watching.
Australia and New Zealand are two other iffy regulatory environments for utilities. Kiwi regulators will apparently break up Telecom New Zealand in the name of boosting competition, despite the likely consequence of lower infrastructure investment and higher overall costs. Australia, meanwhile, has continued to punish utility investors with poor returns on equity, both foreign and domestic.
This, of course, isn't an all-inclusive list of countries good and bad. And politics are always changing.
Good climates can become bad ones literally in the course of a single election and vice versa. And there are plenty of benign regulatory climates where companies are thriving, without being promoted as national champions.
Nonetheless, the forty-fold gain in Telefonica shares in the past 20 years is pretty clear evidence that successful national champions are among the best long-term investments money can buy.
MARKET WATCH
The benchmark 10-year Treasury note yield plunged back below 5 percent today. Unfortunately, the catalyst appears to be fears of a slowdown in the economy, which has triggered a flight to quality and in fact selling of almost everything else.
Federal Reserve Chairman Ben Bernanke likely fanned the flames this week when he stated a rather dour forecast for inflation. The chairman said there would have to be more evidence of falling inflation before the central bank would make any changes to policy.
That means the interest rates the Fed controls are going to stay at current levels for a while, which in turn dashed hopes of some stimulus in the face of recent economic weakness.
I'm not completely convinced market rates won't spike again in the next few months, and that the 10-year Treasury note yield won't take out the 5.5 percent mark by fall. Nonetheless, it's starting to look more and more like we've seen the worst for now, and that market interest rates are now going to move lower into the fall as they have the past four years.
I suggest we continue to play things exactly as we have been. That means continuing to hold very high-quality positions in a wide range of sectors, which are capable of outperforming in varied conditions.
As long as this kind of stock market volatility continues, we're going to get a lot of false signals. The good news is earnings season is about to get underway in earnest, and that's the perfect time to gauge the quality level of your holdings.
We're still off this year's highs in the utility sector, as well as in other income stocks. But we're still well up from levels we saw a few years ago. If something has gone wrong with a recommended position, this is still a very good time to get out.
More likely, however, this earnings season will provide needed confirmation of the quality of our holdings. That may not shield them from all volatility or even sizeable losses if the overall market should really stumble.
But it does ensure the damage—however nasty and brutish—will be relatively short and followed by a strong recovery. And really the assurance we need.
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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