Surviving Financial Contagent by Focusing on Company Results
Companies / Corporate Earnings Aug 04, 2007 - 08:00 AM GMTBy: Roger_Conrad
The subprime mortgage/high-yield meltdown continues to dominate the markets and financial media. There's a good reason for that: The world's financial markets are intimately connected in myriad ways, and none of us has a firm grip on all of them.
With luck, this situation won't develop into a full-scale financial meltdown along the lines of 1998. The economy, for example, is clearly healthy despite some weak spots, as this week's employment figures and the recent gross domestic product (GDP) growth and low inflation indicate. But until we see clear signs that it's winding down—and not spreading to other higher risk areas—investors are going to keep reacting, and strongly, to the various straws in the wind that appear.
This week, I saw one news item that made me a little nervous.
Namely, money center bank WELLS FARGO announced that it's stuck with substantial “bridge loans” made to private-capital firms to help finance the recent wave of multibillion-dollar takeovers. Wells had meant to repackage these loans for the issuing companies and resell them as high-yield “junk” bonds.
This was a much-easier strategy just a few weeks ago. Today, thanks to credit worries initially stirred by rising subprime mortgage defaults, the spreads between yields of lesser and higher-quality bonds are widening amid investor fears of a meltdown. As a result, it's going to be a lot more expensive to move this debt, and Wells is alerting investors to expect the worst.
Ironically, I'm really not worried about Wells now. Wells is traditionally the most conservative of the money center banks. In all the most-recent financial system crises—savings and loans in the 1980s, the Mexican peso in the early '90s and the Asia crisis of 1997-98—it was far less burned than the average big bank.
It's no surprise to me it's come clean already on this unfolding problem. Wells may not be out of the woods, but it seems as though management is on top of things, which could prove invaluable in coming weeks.
On the other hand, the news certainly makes me feel a little queasy about the other money center banks. For one thing, we haven't heard from them yet in a definitive way on these challenges. For another, they have a reputation for really stepping in problems up to their necks.
As the blowup at AMERICAN HOME FINANCIAL proved this week, the financial turmoil has definitely spread beyond just subprime mortgage defaults, which continue to rise. Where it leads now will depend on many things that are simply not knowable to us ordinary investors. Does anyone, for example, really know what happens to the stock market if several of those big private-capital buyouts collapse at once?
That kind of contagion was certainly the case in 1998. And only concerted action by the triumvirate of Federal Reserve Chairman Alan Greenspan, Treasury Secretary Bob Rubin and President Bill Clinton finally headed it off, largely by injecting huge amounts of capital into the financial system and bailing out the money center banks.
The euphoria following their move was in effect blamed for the 1999 mania that saw the Nasdaq Composite double, setting up its collapse the following year.
The current trio in those positions—the Fed's Ben Bernanke, the Treasury's Henry Paulson and President George W. Bush—are very mindful of the aftermath of the 1998 crisis, as well as the disaster that might have engulfed the global economy had no one acted aggressively back then. Which option would they deem as the lesser evil? And would they be up to the task of dealing with the consequences of whichever way they chose to go?
I for one certainly hope we don't have to find out the answers to these questions. But if we do, there's only one place in these markets that's guaranteed to weather whatever happens. That's high-quality stocks in secure industries and particularly those that throw off a rising stream of dividends.
Even high-quality stocks haven't been wholly spared the carnage of recent weeks in the financial markets. That's in part because many were considered potential takeover targets for private capital—utilities certainly were after the KOLHBERG KRAVIS ROBERTS bid for TXU CORP was announced—and had been bid up on that basis.
Their fall the past few weeks is in large part because of recognition that such buyouts are now less likely, though still possible.
The good news is there's still a lot of good news on high-quality stocks' fundamentals. And that's by far the most important factor concerning them.
Even as Wall Street has focused on the financial blowups, investors have virtually ignored the ongoing stream of second quarter earnings results during the past couple weeks. Those the public has paid attention to have invariably been the disasters, particularly in the housing and mortgage sectors. And media coverage of even the strongest reports has focused on the negative.
As a result, the market has reacted very little to high quality companies that have reported robust results. That's particularly true of those announcing on days when the overall market has taken a spill.
COMCAST CORP, for example, announced robust operating earnings and revenue growth of nearly 30 percent on a day the Dow Jones Industrial Average crashed more than 300 points last week. In the panic, its shares were down nearly 5 percent on that day.
Investors ignored the good news. And the media focused on a small drop in the company's basic cable customers, which were dwarfed by those it added from acquisitions during the year as well as customers it upsold to more services.
If this does turn into 1998 all over again, there are few stocks I'd want to own more than Comcast. To begin with, the stock is cheap after its recent abusing by the market. The company's basic business is pretty much recession proof, as people will demand phone and Internet service no matter how bad pressures get, even if they cut back on entertainment.
The company's bond rating is rising, as it continues to use abundant cash flow to pay off debt. Moreover, its business is benefiting from the accelerating and inexorable trend of increasing global connectivity.
It's pretty hard to infer any weakness from the second quarter earnings, subprime crisis or no. After all, even people who lose their homes can still buy cable service when they rent. In fact, they're in greater need of diversion than ever.
In other words, Comcast will be a pretty good stock to hang onto if this thing really starts to get out of hand, and that's despite not paying a dividend. The same goes for other high-quality companies generating growing streams of cash flow in secure businesses.
Those are the companies that have always interested me in my 21 years in the investment advisory business. It's times like these where they really prove their worth.
Of course, even the great ones stumble from time to time. But this earnings season—coming as it does after several months of subprime weakness—gives us a golden opportunity to assess the quality of what we hold and whether it measures up. We can literally look at things now and make a judgment whether they'll stand up to what might happen in the markets, in a worst case.
Trying to figure out how far the subprime/high-yield troubles will spread is speculative. It's unknowable and completely beyond our control as investors. Basing an investment strategy on forecasting potential damage is pretty much a formula for disaster, no matter which way things go.
In contrast, what we own in our portfolios is entirely within our control. And it's also in our control to unload what may be vulnerable and load up on what looks best able to handle what may come down in pike. Earnings season gives us the information to do the job right.
QUALITY COUNTS
What's the mark of a safe haven in stormy waters? Actually, there are many, and no one number really tells the whole tale.
On the day a company announces earnings—and maybe a couple days after—whether it meets, beats or lags Wall Street estimates is paramount. Often, it's not the headline earnings-per-share number that counts but earnings adjusted for the one-time items and events that the company has made known in advance.
If a company beats estimates, the result is usually a jump in its stock. If a company meets projections, the stock will sometimes move up in a market like this because, before the release, the fear level will be high and a decent showing will help relieve that fear. If a company lags expectations, the result is generally a selloff, with the magnitude of the drop depending on how bad the miss is and whether explanations for the miss are acceptable.
Misses have been punished especially hard in this earnings season.
In the utilities sector, even companies that have held their full-year guidance have taken a spill in the market on a bad number, even if the misses were relatively minor. In a market where the fear level is rising, few are willing to ask questions before jettisoning for fear of being left holding the bag in a deteriorating stock.
When a stock falls on bad earnings, it's because investors aren't willing to take a chance on its prospects at the moment. They want to see signs that things are turning around or at least stabilizing.
And if they're not, they're going to stay on the sidelines until they are.
I wholeheartedly agree that deteriorating fundamentals are a clear reason to sell any stock. It's all too easy to cut a long-time holding slack when things seem to be coming apart.
But as the utility bear market of 2001-02—and, in fact, the broad bear market of 2000-02—proved beyond the shadow of a doubt, sliding prospects were the best possible reason to get out. Holding and hoping was a formula for disaster as companies came unraveled.
Where I take issue with some of today's sellers is there's a real difference between missing a Wall Street earnings estimate and having a deteriorating business. Obviously, if a company is coming in under projections over and over again, something is wrong.
Basically, it's either providing lousy guidance, which isn't exactly a vote of confidence for their accounting department or chief financial officer. Or it's a sign that the business itself has become too volatile to forecast. Either way, it's not a good sign for the company in the long haul or its suitability as an investment for reliable long-term wealth building.
Making or missing a headline number, however, is only a part of the story. And many times, the rest of it is far more important and, in fact, may actually contradict the headlines.
To get a real look at the big picture, there are several other numbers worth looking at. There are also many qualitative measures that don't show up in the numbers, such as management's strategic actions, the health of a particular market and the basic focus a company has on its business. In other words, you've got to spend more than one minute scanning headlines to get a real read on what's happening at a company.
There's obviously a lot we don't and can't possibly know as observers, rather than company insiders. We're not going to know in advance what acquisitions are going to be made. We're not going to know for certain whether or not a particular operation is working or not, at least not before results are announced.
Most important, we're hopefully not going to come to the conclusion we know how to run a company's business better than its own management. At least, I don't want to own any company where I can reliably second-guess what they're doing.
It's their business. And if they can't do the job, I certainly don't have the answers for them, other than I want out.
When it comes to analyzing utility stocks, I use eight criteria to rate relative risk, and I size up all of the 215 companies in the Utility Forecaster universe on that basis. The criteria fall into three basic groups: financial, operating and regulatory.
Regulation is more critical to a utility's earnings than to companies in any other industry. If officials won't grant an adequate return on investment, the company is doomed to mediocre earnings and possible failure. If it does, the utility will enjoy success, no matter the economic environment.
Utilities gain points for having constructive relations with regulators and lose for having hostile relations. The tenor of relations literally has the potential to change with every decision, and it's as impossible to forecast regulators' moves in advance with 100 percent accuracy as it is to predict the outcome of court cases.
But it's true that good climates tend to stay that way, while the bad ones only change if something dramatic happens, like an election. Meantime, there are few factors as important to gauging whether a utility's business is getting healthier or not. And every development must be monitored and considered.
Financial criteria are based on the balance sheet, income statement and statement of cash flows. As income-paying stocks' prices basically follow the health of their dividends, the payout ratio is one very handy metric.
This is basically the annual rate of distributions as a percentage of earnings. I refine it further to include only recurring earnings from a utility's core operations. One-time writeoffs or gains are excluded, as are operations slated for termination or sale.
As regulated companies that dominate essential services, utility cash flows tend to be steadier than those of companies in any other sector. As a result, utes can tolerate higher payout ratios than, for example, companies that produce commodities or natural resources, whose prices are notoriously volatile.
In this environment, a payout ratio of 70 percent or lower is best.
Low payout companies tend to increase dividends, and higher dividends tend to lead share prices higher as well.
A utility with a payout ratio of more than 80 percent may be OK, provided 90 to 95 percent of its operations are regulated. Utilities with payout ratios of 90 percent or more—and especially those with payout ratios of more than 100 percent—should be considered at risk to dividend cuts until those numbers come down.
At the bottom of the 2001-02 utility sector meltdown, many companies' dividends were at risk. Underlying earnings were shaky, and payout ratios were very high.
As a result, it was hardly surprising that there were so many dividend cuts. In contrast, today only about a dozen companies face a serious threat to their dividends, at least in the next 12 to 18 months. And several of them are on the verge of coming out of the danger zone in the second half of 2007.
Nonetheless, the payout ratio is the first number I calculate when I analyze a utility's quarterly earnings. And if the coverage is slipping, there had better be a very good reason for me not to pull the plug immediately.
Debt is another critical financial ratio I examine. Snapshot figures such as bond ratings and the debt-to-equity ratio are important gauges. But I'm even more interested in dynamic measures, such as the rate of increase or decrease in interest expense, relative to the growth of the company.
Finally, operating criteria vary with the type of utility, from power utilities to communications companies. There are some that transcend sectors, such as growth in the number of customers or “revenue-generating units” in the case of companies like Comcast, and whose success depends on upselling customers to multiple services.
Companies that buy natural resources in order to provide services—such as electricity generation companies that buy fuel for power plants—are vulnerable to swings in energy prices. Therefore, how a company controls its exposure is a very crucial component of its success as a business. Water companies that control their own water supplies, for example, score more highly than those that have to buy it from others at market prices.
Efficiency measures vary widely from sector to sector but are vital to all. Power generators' capacity factors—the percentage of time they're able to run their plants—is important mainly for the trend.
American nuclear plant operators have increased their average capacity factor from 65 to more than 90 percent in the past 17 years. But during some quarters, plants will be shut down for scheduled maintenance.
As a result, a drop from one quarter to another may not be a bad thing, provided there's an outage involved for maintenance. The key is knowing what happened behind the number.
Other commonly used measures of efficiency such as customers per employee are really only relevant when comparing the same company's performance and only then when offset against the impact on business growth. Plenty of rotten companies have posted strong “efficiency” results simply by cutting away their productive centers.
Wall Street may be happy for a while. But in the end, the whole thing falls apart and fades away--not a good thing for long-term investors.
Ultimately, the most important number I know of to judge a utility—or any other dividend-paying company—is dividend growth.
Here, consistency and reliability are as important as magnitude.
Thus far this earnings season, I've seen two outstanding examples of both: US utility ENTERGY CORP and Canadian income trust PEMBINA PIPELINE INCOME FUND. Both are long-time, profitable Utility Forecaster recommendations, and both almost surely have their best years ahead of them.
Entergy's dividend increase was the largest, a giant 39 percent boost. The company had been holding back hikes since Hurricane Katrina basically wiped out its biggest city and headquarters, New Orleans.
Now, after two years of hard work restoring service and attempting to win financial relief for the Herculean task from government and insurance, the company is tasting the fruits of its success at last.
And it's sharing them with its owners with this dividend increase.
On Halloween night 2011, the Canadian government announced it would start taxing income trusts as corporations beginning in 2011. Since then, we've heard a lot of garbage about how even the best trusts would be gutting their dividends imminently and taking investors down with them. The doomsayers, however, don't talk a whole lot about Pembina and for good reason: It would make their case a laughingstock.
This week, the owner and operator of pipelines and gas midstream assets increased its distribution for the third time since Halloween by a full 9 percent. The boost is in recognition that the trust's myriad projects in oil sands infrastructure and other areas are rapidly coming to fruition, generating more reliable fee revenue than ever before. And management is ramping up capital spending for more projects as well, holding the door open for even more dividend increases going forward.
Not every trust has Pembina's advantages. And some are likely to wind up just where their critics forecast: as literal graveyards of capital. The same, however, can be said of every other asset class, particularly when Wall Street rhetoric is the most convincing that they can't fail.
That's why a successful income investing strategy doesn't focus on just one group of stocks or even one asset class but a diversified mix of high-quality companies drawn from a full spectrum of industries. Never fall in love with a single sector, no matter how good it looks. But never shun one entirely either, no matter how many know-it-alls are badmouthing it.
Just be selective and discriminating and above all look at the business that's underlying the whole thing. In the long run, that's your only guarantor that you'll come out ahead. And in a market with so many uncertainties and potential dangers, it's your best insurance and the best way to keep your head while everyone else may be losing theirs.
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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