A Skeptical Eye On The Promised Demise of Big Utilities
Companies / US Utilities Oct 15, 2007 - 02:37 PM GMTBy: Roger_Conrad
I've never been impressed by hype surrounding supposedly “disruptive” new technologies—developments billed to change the balance of power in an industry. And my skepticism meter goes positively off the chart when the claims pertain to communications and other utility-like industries.
Sometimes new technologies do create revolutions. For example, railroads and automobiles in the last century put buggy whip companies out of business. Telegraphs and tele-type machines are now found only in museums, as are the companies like Western Union that once dominated the market. And IBM's obsession with the mainframe kept it from buying Intel and Microsoft in their infancy, dooming it to also-ran status in the burgeoning PC and later laptop market.
More than 99 percent of the time, however, industry leaders absorb the new technology in plenty of time to stay dominant. They may or may not have developed it originally. But they wind up using it to become more profitable. Meanwhile, the upstart developers are either bought out or eventually buried by the competition.
But that simple fact hasn't stopped the financial media from routinely writing premature epithets for the leaders of scores of industries. And regulated utilities and telecoms have been top targets.
In its May 21, 1984, issue, Business Week's cover asked the question “Are Utilities Obsolete?” The accompanying article asserted that power monopolies in particular were outmoded dinosaurs, financially strapped and unable culturally to adapt to the needs of American society.
Nearly three decades later, electric utility companies are doing a lot better than Business Week . But that hasn't stopped the pundits from repeatedly proclaiming their inevitable demise at the hands of everything from fuel cells to natural gas power plants built by the likes of “independents” like Calpine Corp .
It's been the same story in telecom. Back in the 1980s, it was supposed to be wireless technology that toppled Big Telecom. Instead, it was the giants who developed the winning cellular phone franchises, namely AT&T and Verizon Communications , and are now more profitable than ever.
In the late '90s, the competitive local exchange carriers (CLECs) were the upstarts that were supposed to doom the big boys to extinction. Wall Street threw hundreds of billions of dollars at CLECs to construct direct fiber-optic links to businesses that would compete directly with the copper wires of Big Telecom.
Today, the only surviving CLECs are those that have entered other businesses, like Level 3 Communications . All the rest—including the biggest of them all, WorldCom —went completely bust. Not only were stockholders wiped out but most bondholders got back only pennies on the dollar, if they made back anything at all.
Instead, it's Verizon, one of the so-called dinosaurs, that's constructing the country's first fiber-optic-based broadband network. Initially derided by industry wags for its cost, FiOS has instead come in ahead of schedule and budget, and sales are topping expectations handily as well.
Moreover, we're seeing cost benefits as the company replaces its aging copper network. And after initially resisting such a move, AT&T is putting its capital to work as well building out its infrastructure.
It's hard to believe now that anyone was gullible enough to believe that Vonage was going to dethrone the telecom industry's giants. But just a couple years ago, the financial media was choked with stories singing the praises of that company and its supposedly disruptive technology, Voice over Internet Protocol (VoIP).
Note that VoIP—which basically involves using an e-mail-like delivery of communications signals—has changed the way the telecom industry does business. It's not only become standard fare throughout the industry, but it's set to become the way American communications works.
Vonage, however, is headed toward oblivion as a cautionary tale for the dangers of investor exuberance. Even if it manages to cheat the hangman by prolonging its legal battle with Verizon over patents, the company continues to bleed red ink. The end is only a matter of time.
Of course, anyone unfortunate enough to buy Vonage at the initial public offering (IPO) has already been cleaned out. That is, everyone except CEO and founder Jeffrey Citron, whose day-trading brokerage Datek also washed out ordinary investors while making him wealthy enough to pay a $20 million-plus fine to the Securities and Exchange Commission (SEC) without batting an eye.
SprintNextel's WiMax is the latest supposedly disruptive telecom technology to hit the news wires. This week, however, the company's dynamic CEO Gary Forsee announced his resignation. That followed a growing shareholder and board rebellion against his plan to build a national WiMax network at a cost of billions of dollars in coming years.
The critics' beef: Forsee has focused on grandiose plans to challenge AT&T and Verizon through WiMax technology, rather than running the company's conventional wireless business effectively. As a result, Sprint continues to lose customers to its rivals at an alarming rate.
To be sure, WiMax has promise. The technology is extremely flexible, allowing wireless data to be transmitted quickly over long distances in a wide variety of ways with a focus on the “last mile.” It could come in handy for use in more remote areas, where there's little or no wired infrastructure.
Unfortunately for Sprint, the cost of deploying WiMax has been on a consistent upward trajectory. Meanwhile, wireless data networks of rivals such as Verizon have become ubiquitous. WiMax still advertises higher speeds than these networks, but the others are rapidly catching up.
Moreover, the latest generation of wireless network technology—4-G—is now in rapid development and may be ready to go as soon as 2010. That includes a venture to link Verizon Wireless' US network with that of 45-percent-owner Vodafone's global network with higher speeds and more bandwidth than ever.
Even if WiMax manages to solve its technical glitches, to be a real alternative, it's hard to conceive how it will be able to compete with this type of network, particularly in the lucrative and rapidly growing global business market.
Ultimately, the biggest hurdle WiMax faces may be the Forsee resignation. The former CEO was relentless in his promotion of WiMax and his determination to commit whatever resources were needed for its development. Given the circumstances of his demise, it's highly unlikely his successor will be nearly as aggressive.
Earlier this year, Sprint entered a partnership with Clearwire to jointly construct their WiMax networks and ultimately sell services under one brand. That strategy was designed to take some of the heat off management for the rising cost of developing WiMax. But it could also provide a neat exit strategy for Sprint in a possible spinoff.
Another option would be to simply secure more financing and divide the potential pie. Intel and Motorola have committed a lot of time and resources to WiMax and presumably will continue to provide support. Sprint is the only realistic partner for the scale they operate on. Moreover, Sprint itself has to roll out more advanced spectrum to meet Federal Communications Commission (FCC) rules.
There's still no shortage of WiMax optimists. The Yankee Group , for example, is still forecasting 7 million to 8 million WiMax users in the US by 2011 and 27 million worldwide.
Even that, however, would be only a sliver of the overall US market and would still leave Sprint a distant No. 3 to AT&T and Verizon. That's hardly the kind of disruptive technology that ended the era of the buggy whip.
Articles about new transforming technologies are often fun to read. And they can be extremely profitable as well, as is the case with the development of nanotechnology. My colleague Gregg Early writes extensively about nano is his complimentary e-zine Nanotech Investor News , which can be subscribed to by going to www.kciinvesting.com .
Nanotechnology is being adopted by leading players in literally every industry. That's precisely what has made it successful thus far and what will keep it booming going forward. Existing industry leaders can take it to a higher level.
It may be fun to talk about the demise of major players in a sector, particularly big regulated companies. But history has shown time and again that it rarely happens. Those who get caught up in the hype invariably pay the price, as they did with the Vonage IPO and countless other examples.
Love to Hate
Since the origin of electricity, natural gas, telecom and water service at the end of the 19th century, not one regulated utility has ever gone out of business. There have been bankruptcies and occasionally shareholders have been completely wiped out. For example, Northwestern Corp's unregulated operations dragged its share price to zero in 2002.
Even Northwestern, however, continued to function as a business throughout its troubles. The company eventually unloaded its unregulated arm and emerged from Chapter 11 as a purely regulated company. Bondholders were made whole.
In fact, the only time a regulated power or gas utility has vanished from the corporate rolls has been from an acquisition, which invariably has created a larger, stronger and more dominant company. Not one has vanished because a rival managed to develop a better technology.
The action in the telecom industry has been somewhat wilder, particularly since the breakup of AT&T in 1984. And we've seen plenty of bankruptcies and total wipeouts in the sector.
It's worth noting, however, that not one has involved a traditional phone company. That includes those that diversified disastrously—like Cincinnati Bell , formerly Broadwing Communications —and Qwest Communications , which purchased former Baby Bell US West .
Rather, the only companies to ever go bust in these sectors have been the upstarts. In fact, they've routinely failed. That's despite state and federal governments' best efforts to tilt the playing field in their favor, generous Wall Street support, and often innovative and flexible management.
Regulated utilities have repeatedly been accused of stodgy management, inflexible corporate cultures, vested interests in old technology and a thousand other faults that supposedly would make them unable to adapt to technological developments. In every case, these liabilities have proven irrelevant. As a result, the technologies have changed, but the players are still the same.
Why do utilities continue to attract so many death-wishers? I suspect the root is that all of us use their services. We take for granted that our power is always on or that the data network or telephone we use always works. But we definitely notice when there's an interruption in service. Most of us also notice when our utility bill rises, and we don't like it.
Growing concern over global warming has provided a new reason to hate utilities. In fact, there are quite a few people going around the country claiming power companies are intentionally holding back technological advances in solar and other renewable energies for the purpose of keeping market share. Others claim the big phone companies are blocking better broadband service for the same reason.
Unfortunately, the level of anti-utility bile is more likely to rise than fall in coming years. That's because all of these industries are in dire need of a major capital spending boom. From water mains to bridges to power lines, America's infrastructure is aging fast. At the same time, demand for communications services and electricity are burgeoning.
Meeting these needs means a lot more money will have to be spent. Utility companies have no choice but to ask customers to pitch in. And getting a reasonable return on their investment depends on convincing the public to pay its fair share—always a difficult task given the lack of sophistication about infrastructure and the general belief that you can get something for nothing.
As I've pointed out in previous editions of Utility & Income , navigating this challenge is the key to successful utility investing for the next decade. The companies that can get compensated fairly will enjoy robust, stable growth in earnings, dividends and share prices. Those that can't will suffer stagnant profits at best, and at worst dividend cuts and bankruptcies.
That's incidentally what happened during the last capital spending wave in the utility industry, which wound up by the early '80s. The new generation of nuclear power plants dramatically reduced America's dependence on imported oil as predicted. But the cost of building them came in far above estimates.
Some states—notably in the Southeast—allowed their utilities to stay whole by passing on enough of the cost into rates at a decent rate of return. Other states, however, dramatically weakened the companies serving them, resulting in dividend cuts, occasional bankruptcies and sharply lower share prices. Worst of all, it's resulted in long-term deficiencies of capital spending that's led to the network aging crisis we're seeing today.
Will the same thing happen this time around? The answer depends in large part on how much money utilities actually spend during this capital boom.
In most states, companies are working hard to keep their future burdens as low as possible with a variety of means. These include buying power and promoting conservation, rather than building plants.
The trick here is getting regulators to grant enough incentives to customers to conserve and for utilities to promote policies that hold down sales. And the kinks are still being worked out.
A good bit of the capital spending, however, will be unavoidable. That includes remaining cleanup efforts related to the Clean Air Act of 1990, as well as prospective expenditures on the control of carbon dioxide (CO2).
In the former, AEP reached an agreement with the US Environmental Protection Agency this week to spend some $4.6 billion over the next 10 years to finally bring emissions of acid-rain-causing gases into compliance. That's on top of $2.4 billion spent since 2004, and recovery will depend heavily on regulators.
No one knows what the cost of CO2 regulation will ultimately be. But with the odds now favoring a wider Democratic majority in Congress after the November 2008 elections—and even Republican presidential candidates talking about the issue—legislation is a certainty thereafter. The only question is whether what's passed will lean more heavily on the carrot or the stick.
Surprising, the leading Democratic candidates for president have stated policies that rely more heavily on the carrot. But Congress is full of people who'd like to turn the issue into one where they can scapegoat the utility industry for their own political gain. So until something is actually passed, we won't know for certain what companies' burdens will be.
Whatever it is, the key for regulated utilities will be to gain and hold the support of the officials who set their rates. That's why I'll be focusing on companies operating in states that have historically cooperated with utilities and shunning those in areas of less certainty.
Here then is a brief listing of some of the best and worst regulatory climates now. I'll have more in the November issue of Utility Forecaster , which will be available online the first week of November.
Best States
Alabama
Georgia
Florida
Indiana
North Carolina
Uncertain States
Arizona
Connecticut
Missouri
Montana
New York
Market Watch
Signs of US economic weakness linger on, particularly in the still-imploding mortgage market. Wall Street, however, appears to be losing its fear of credit.
During the past few weeks, money has flowed into the “safe havens” like utilities. But it's also started to trickle back into sectors that could be considered more at risk to further economic weakness, including high-yield bonds and selected real estate investment trusts.
In my view, the risk of a serious recession has been falling ever since the Federal Reserve made its big rate cut. That was basically a statement by the central bank that it wouldn't allow a market panic to create a credit crunch and thereby throw the US economy into a major slowdown. And its actions were mirrored by central banks throughout the world.
We're still likely to experience some shocks. Thornburg Mortgage , for example, announced this week that its losses from selling securities early in the crisis were larger than expected. That triggered a sharp reaction in the shares of the dealer in high-end mortgages.
But it's important that management stated the move wouldn't impact the amount of taxable income available for distribution in 2007. That seems to indicate the worst may be behind the company, though it will likely remain range-bound for a while.
For the most part, good quality investments appear to be headed higher over the next few months. Utilities have had a positive fourth quarter in 35 of the last 40 years.
For one thing, big money likes to play it safe coming into the home stretch, particularly if it's been a good year, as this one has. For another, interest rates and inflation are benign for the moment, and falling credit risk has reduced the appeal of holing up in cash or Treasury paper.
As I pointed out last week, however, growth is likely to become more important as we move into 2008. Growing businesses produce rising dividends, which in turn keep pace with at least moderate inflation. That's also the best way to ensure against credit risk because a growing business is the best insurance against dividend cuts.
I also think it's a good idea to limit duration—a measure of how vulnerable a fund's portfolio is to interest rate swings—to five years or less. That will limit most inflation risk, while providing for a decent yield.
As for individual securities, look for maturities of five years or less for bonds. I also like adjustable-rate securities and utility bonds with low credit ratings, given that sector's noted ability to rebound from any disaster.
Finally, it's a good idea for income investors to add holdings in sectors that tend to perform well when growth, interest rates and inflation are rising. I prefer stocks of companies that produce natural resources that are essential for economic growth.
These companies are already cashing in on one trend: synchronized demand growth from Asia, Eastern Europe, Latin America and the Middle East. Benefiting from a revival of inflation would just be icing on the cake.
One area is energy. We've seen a big run in prices, and some investors are getting nervous even about the likes of Super Oil Chevron Corp . But there's still incredible value in the Canadian trust universe, where investors have overly focused on a taxation event that's more than three years away and virtually ignored thriving businesses selling for a song.
You don't have to take a major chance to cash in. Just buy the biggest and strongest, such as Enerplus Resources . Another added benefit is the US dollar value of Enerplus' share price and dividend rise along with the Canadian dollar—also a beneficiary of rising energy prices.
Metals are another prime area. These “hard assets” also rise with inflation, and they're in record demand from growing nations around the world. And with the economies of China, emerging Asia, Eastern and Central Europe, the Middle East and even Latin America becoming engines of growth in their own rights, demand is only going to increase.
In addition, consolidation is eliminating competition and helping control costs. Freeport-McMoRan Copper & Gold is now the world's third-largest copper producer and ironically a takeover bet as well. It pays a modest yield, but management has proven itself willing to ramp up the payout when it has the cash. It's now focusing on paying off the bulk of company debt by early 2008 but has already announced plans for shareholder-focused moves later in the year
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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