Essential Service Companies to Weather Economic Downturn

By: Roger_Conrad

Aren't you glad you own essential service stocks? Despite one of the most volatile, fear-driven markets in memory, shares of top-quality power, gas, water and communications companies are decidedly holding their own. In fact, even as the big cap averages have slid in recent weeks, the utility averages are again near all-time highs.

Essential service companies' advantage is simply that what they provide is critical to a functioning America. Anxiety-ridden consumers will cut back on gift-giving, postpone the purchase of an appliance or car or cancel a vacation. But they'll still pay their power, water and heating bills, and just try to take away their cell phones and laptops!

In other words, no matter how bad things get in the general economy, utilities always make it. For investors, they keep paying their dividends, and their stocks hold value better than almost anything else.

The flipside of operating an essential service business is regulation. Usually, the relationship works cooperatively. In the case of rate base-oriented businesses—such as water, gas and electricity distribution—that means investment in infrastructure is rewarded with a fair return. That's basically to keep from adjusting monopoly customer rates.

In the case of nonrate-based, nonmonopoly businesses such as communications, energy production and increasingly, power generation, regulators don't set rates. Rather, they set the rules of the road under which these industries operate.

Regulation tends to go through cycles. In the early days of essential services, power, communications and water had the best of all worlds. Not only were they iron-clad monopolies, but they were allowed to operate pretty much however they wished.

This was in large part because of their need for growth and expansion. AT&T, for example, was granted a monopoly in 1908 largely because that was perceived by trust-busting President Theodore Roosevelt as the only way the country would be completely wired.

For the power industry, the era of monopoly laissez faire ended with the Great Depression, when the Public Utility Holding Company Act of 1935 broke up what had become a de facto, countrywide monopoly owned by JP Morgan. On the operating level, however, regulators remained very supportive as power companies continued to build out infrastructure.

The utility/regulator relationship shifted dramatically for the worse in the 1970s and '80s. Rising costs for building infrastructure and inflation pushed up rates at the same time corporate America began to encounter lower cost competition, particularly in manufacturing. The result was a wave of cost disallowances in the power sector and finally an attempt to break up essential service monopolies in everything from communications to power.

The ENRON and WORLDCOM bankruptcies—and subsequent sectorwide meltdowns in power and communications early this decade—triggered yet another dramatic turn in utility/regulator relations. For the past five years, regulators nationwide have supported the restoration of essential service companies' financial health, helping them reduce the leverage and business risk taken on during the '90s.

Now, however, the relationship is entering a new phase, as these industries ponder a post-deregulation future. The biggest question is how to pay for trillions of dollars in new infrastructure investment, at a time when costs of raw materials are skyrocketing around the world.

If regulators and utilities work together well, the new spending will benefit consumers with increased reliability and ultimately lower costs. Companies and their investors will realize higher earnings and dividends. In places where the relationship turns acrimonious, however, reliability will suffer, costs will rise and utility investors will see their dividends cut and stocks sink.

The bottom line: Even as we utility and essential service stock investors enjoy another strong year, it's increasingly important to monitor regulation. Where it's good, there are more good times ahead. When it turns ugly, however, we want to be out.

BIG MOVES

Usually, regulation moves at a glacial pace. Sometimes, however, events occur that can really shake things up. Amazing, two such potential earth-movers occurred this week in the communications industry.

The one that generated the most industry press was VERIZON COMMUNICATIONS' decision to open its wireless network to devices other than the phones sold in its stores. Specifically, the company promised to issue guidelines early next year to manufacturers with the goal of opening up its network by the second half of 2008.

There are limits to the opening. Mainly, it will only apply to devices that are compatible with Verizon's network, which runs on CDMA rather than the GSM technology used by rival AT&T and most networks globally. That will become less of a problem when Verizon and its partner VODAFONE move to their next-generation network, which also promises to unify their systems globally.

It does, for the moment at least, exclude the popular iPhone from the mix. Devices will also have to be tested in a Verizon lab in order to ensure they work on the network.

The move, however, is an abrupt reversal from management's previous position to resist opening its network. And it raises several important questions. First, from the standpoint of Verizon shareholders such as myself, is this a good move for the company? Second, how much will this move shape the industry?

Since telecom deregulation became law in 1996, Verizon's management has made all the right moves in a very challenging environment. The end result has been to convert what was basically a regional, copper-wire, former monopoly into a global powerhouse with leading positions in wireless and business communications and a budding broadband network (FiOS) that's threatening to take the country by storm.

Along the way, the company has beaten back a wide range of upstarts, from competitive local exchange carriers to Voice over Internet Protocol service providers, all of which were heavily financed by hundreds of billions of dollars in Wall Street money that ultimately evaporated. It also defeated and absorbed long-distance giant MCI COMMUNICATIONS, which was long viewed as a threat to subsume its entire business.

Given this track record, I'm inclined to believe management has calculated this is in the company's best interest. That's also at least the early consensus on Wall Street, as the shares have acted well in the wake of the announcement.

The range of discussion of Verizon's move has, of course, been extremely varied thus far. Some have gone so far as to declare it “caving in” to the power of GOOGLE, which has been threatening to build its own wireless network to compete with existing providers.

The giant Web company has definitely been putting its financial and market muscle to work lately, lobbying the US Congress and the Federal Communications Commission (FCC) to order service providers to open their networks under so-called “network neutrality” legislation. To date, Congress has refused to act on this, with a majority of both Republicans and Democrats opposed.

FCC Chairman Kevin Martin, however, has picked up the cause of opening wireless networks to different devices. His biggest move to date has been setting the rules of an upcoming wireless spectrum auction to reserve a portion for providers pledging such open access.

Verizon had long battled the chairman's decision and had been attempting to convince legislators and the other commissioners to oppose it, on the grounds that it was too regulatory. This week's move is a sharp reversal from that position and almost certainly indicates the company concluded its argument was unwinnable.

Caving in, however, clearly has its advantages. First, it allows Verizon to bid all-out for the entire spectrum in the auction, including that reserved for open access. We won't know the results of the bidding until early next year.

At the very least, Verizon has dramatically upped its odds of a huge success, which would all but eliminate the possibility of a new rival wireless network outside the existing providers. That will keep profit margins firm for network owners like Verizon.

Google had previously announced it would set aside $4.6 billion to bid on spectrum. With Verizon bidding against it, however, that money won't go nearly as far as it would have with Verizon out. If AT&T and SPRINT NEXTEL CORP relent and decide to open their networks, the competition would get fiercer still, further diminishing the prospects that Google would walk away with anything workable.

Trying to guess what a company's management will do, of course, requires a certain level of clairvoyancy and mind-reading ability I don't possess. But there are some indications that Google may have already gotten what it wanted on the open-access question.

It may still bid for spectrum, which is an increasingly valuable commodity in its own right. But there's definitely an argument that it won't go full-out and try to build its own network. Mainly, an open Verizon combined with its own “free handsets” alliance would give it the ability to accomplish what it wants in advertising and equipment, without the hassles of owning and operating its own network, which have tripped up many before it.

Obviously, nothing comes without a cost. In this case, Verizon will almost surely lose some sales on the device front. It also loses some control over what happens on its network long term as equipment providers drive consumer demand with the latest shiny objects.

On the other hand, what has it really lost? In Asian countries, open networks have led to a system where consumers shop for cell phones as they would television sets. Network providers such as NT&T DOCOMO still sell phones, usually at heavily subsidized rates financed by higher service fees, though regulators are studying completely separating these businesses. Wireless in Asia, however, is still a highly profitable business, as providers such as SINGAPORE TELECOM, Vodafone and even DoCoMo are demonstrating.

To date, Verizon and the other major US carriers have heavily subsidized equipment sales and made up for it by requiring users to sign service contracts. Under the company's new model, it would still do this, though it would be allowing other devices it didn't sell on the network as well.

Rather than the Asian model, however, Verizon Wireless' evolution is more likely to follow the European model—which, incidentally, 45 percent owner Vodafone is intimately familiar with. In contrast to Asia, most European consumers continue to buy subsidized phones from their providers. That's partly to avoid the hassle of buying a phone and contracting service from two separate companies. But it's also because of sticker shock because the price of the latest technology never comes cheap.

As for upside, allowing other devices definitely makes Verizon's network a more complete product. It will very likely ensure against defections to other networks, keeping Verizon Wireless' churn rate low.

And it increases long-run competitiveness by bringing Verizon much closer to the way the rest of the world does business. That's increasingly important to keeping the company ahead of the game in the exploding global wireless data market, particularly for business customers.

The biggest benefit to Verizon from this move, however, will almost surely be regulatory. Not only has the company won the praise of Kevin Martin and the FCC. But it's now well positioned no matter who wins 2008 national elections as a company committed to free markets and consumer choice. That may be the biggest reason the stock market has smiled on the move thus far.

Verizon's move is in marked contrast to the other major regulatory development in communications this week: the apparent victory of cable television companies over Martin in his attempt to increase oversight of their market and provide greater consumer choice.

Alleging that the cable industry had met the so-called “70-70” threshold, the chairman argued the FCC should now be given more authority to regulate the likes of COMCAST CORP and TIME WARNER under a 1984 law setting a broad mandate for more diversity and competition in cable. The basis was a recent study stating more than 70 percent of US households have access to at least 36 cable channels and that more than 70 percent of those homes subscribe to a service.

The cable industry's reaction was immediate and vehement and demonstrates its substantial lobbying power in Washington and Wall Street as well. The government campaign centered on casting doubt on the 70-70 claim, with the industry purporting only 54 percent of households with access to cable as subscribers. In New York, the theme was best echoed in a “Wall Street Journal” editorial, which decried the FCC's attempt to overregulate and attacked Kevin Martin personally.

The result was the cable industry appears to have gotten what it wanted. This week, Chairman Martin announced he was delaying a vote on the cable regulation measure, a tacit admission that he didn't have the votes for passage. For the moment at least, cable companies will face no additional requirements to, for example, offer channels on an a la carte basis.

In my view, however, this may come to be viewed as something of a pyrrhic victory. For one thing, changes in cable regulation under Chairman Martin are certain to be far more benign than under a prospective chairman appointed by a potential Democratic president.

And these questions of a la carte pricing and other regulations aren't going away, particularly with cable providers continuing to raise service fees above the rate of inflation to boost already hefty cash flows. It's quite possible the cable industry will be facing a far more interventionist-minded FCC in 2009 with far more punitive ideas on how to settle these questions.

This is also a marketing and regulatory club in the hands of broadband service providers now offering competing cable service, especially Verizon, thanks to its opening move in wireless. And it reinforces cable's image as a greedy, mostly family-owned monopoly, unwilling to give up any power even in the face of unprecedented prosperity.

I'm one who believes both Big Cable and Big Telecom are going to be extremely profitable in coming years by dominating the fast-growing communications industry. And I wholly reject the idea of a cable/phone death match, from which there are no winners and only survivors.

The fact that the industry ran such a scorched earth campaign on this issue, however, isn't an encouraging sign for its long-run health. The tenor of the campaign may be more a matter of the politicians they hired to run their lobbying effort than management's real intentions.

I'm still going to make my buy/hold/sell decisions in this industry based on the numbers. Moreover, cable stocks—particularly Comcast—are very cheap now. But this is one industry that's going to ultimately have to adapt.

SAME OLD STORY

“It's such a completely different story than last night” was the quote from one Wall Street analyst Thursday morning. The reference was to an explosion in a critical US/Canada pipeline that triggered a sharp surge in oil prices after a two-day decline.

In one sense, the analyst was right. In a volatile market like this, investor psychology can and often does turn on a dime. Over and again in the past few weeks, we've seen morning rallies turn into afternoon selloffs and vice versa.

For many of the institutions that rule Wall Street, long term is a week at most. And very long term is the end of the year, when benchmarks for bonuses must be met.

In reality, however, the week's market action for oil is just another chapter in the same old story that's been playing out since oil bottomed under $10 a barrel in the late '90s. This particular incident may have only a temporary impact on the energy markets. In fact, before Thursday noon, oil had given back much of its initial gain on the announcement most of the pipes were open again.

But the market's reaction is a pretty firm confirmation that supplies are tight and the energy bull market is still alive and well. Recession or recovery, it almost certainly has at least several more years to run.

The key lies in the nature of event risk. Every commodity is always in danger of supply disruptions from any number of sources. But it's only when markets are particularly tight that there's really an impact on price.

Much of the press attention tends to focus on politically motivated interruptions. The most notable of these was the Arab Oil Embargo of the early '70s, during which a massive spike in oil prices served notice that Organization of the Petroleum Exporting Countries (OPEC)—not the West—was in control of global supplies.

Over the past few years, of course, we've seen the rise of resource nationalism: countries trying to take a bigger cut of the resource output going on inside their borders. Few, if any, are following the model of Hugo Chavez in Venezuela, in which the government has combined anti-investor rhetoric with steady encroachment on property rights to create a highly uncertain climate for investment. But many are raising the rent by hiking royalties, even Alberta, Canada.

As the example of the '70s showed, the longer a bull market in resources lasts, the more tempting it is for governments to grab for a bigger slice. Often, it's been by necessity because governments have tended to overspend oil revenues in good times and are forced to look for other sources of cash to stay in power. But whatever the motivation, the result is increased chance of supply disruptions, either from inadequate investment or government attempts to throw their weight around.

In my view, over the next several years, oil supply disruptions due to natural and manmade disasters will be even more likely than political ones. That's in large part because producers have had to go to ever-more remote places to meet rising demand. But it's also because—as demonstrated by the pipeline explosion this week—key infrastructure is aging.

Pipelines and other energy infrastructure will require an enormous investment in new facilities to meet demand in coming years. This will generally add to earnings for those who own it, which increasingly are limited partnerships (LP) such as ENTERPRISE PRODUCTS PARTNERS and KINDER MORGAN ENERGY PARTNERS.

Pipelines, processing plants and storage facilities, however, aren't in a regulated rate base. Rather, owners earn rents for their use by locking them in under long-term contracts. As a result, new investment in these old pipes to keep them running—so-called maintenance capital spending—generally takes away from profits, namely the cash flows used to pay the distributions that make LPs so attractive.

Periodically, concerns are voiced by public health and safety advocates that much of the country's energy infrastructure is in a state of decay. During the Bush administration, these worries have generally been soft-pedaled.

A new government in Washington, however, may take a considerably more proactive view and force change. That's a substantial future concern for LPs invested in energy infrastructure and a good reason to be a very selective shopper in that sector.

The bottom line is that supply disruptions are likely to remain a serious threat in energy markets for some time. In fact, with storms, droughts and floods becoming increasingly frequent and severe throughout the world, they're likely to get a great deal worse.

Even that, however, is only half the story. It's really timing that makes this issue critical. During the '90s, for example, there were energy supply disruptions for a number of reasons. But with the exception of the 1990-91 Iraq War—when Saddam Hussein invaded Kuwait and the US responded—none were really of consequence.

Flush in excess capacity and with consumers firmly in control of the market, the effect of these interruptions was decidedly temporary. Prices resumed their downward course when the crisis passed.

In contrast, supply disruptions this decade have routinely been severe. The reason: Supplies are tight, and producers are in control of the market. Every interruption, therefore, has consequences.

To date, hurricanes Katrina and Rita in 2005 have been the supply disruptions with the greatest impact, particularly for natural gas. But the market reaction to this week's pipeline explosion is a clear sign the same dynamics are still in place.

Basically, event risk at this point is all on the side of the bulls. That's true even with the global economy currently threatened by a recession, triggered by still-mounting losses from greedy, incompetent, subprime lending practices and an ensuing credit crunch.

Energy stocks have been generally battered in recent weeks by worries about recession, some more than others. I'd be the first to admit there's plenty of junk out there, and weaker players are very much at risk to a drop in prices should recession fears become reality.

On the other hand, the long-term bull market is intact. And most producers have been selling oil $20 to $30 per barrel below the recent trading range in the $90s.

Even if oil does fall back to that range, their cash flows won't suffer. And if it doesn't, all that money that's gone to the sidelines lately will be coming back into their shares with a vengeance, and prices are going a lot higher.

One group that looks particularly interesting is the highest-quality Canadian oil and gas producer trusts. For well more than a year now, these have been pricing in the impact of the Canadian government's plan to tax them as corporations starting in 2011.

They've been hit hard by recession fears, as investors have worried about Canadian banks' willingness to lend and the impact of lower oil and gas prices on cash flows and distributions. Dividend cuts among weaker players have further added to the damage.

The reality, however, is the best of this bunch are now yielding anywhere from 12 to 15 percent and sell for half the book value multiple of other energy companies. In addition, cash flow from trusts such as ARC ENERGY TRUST, ENERPLUS RESOURCES and PENN WEST ENERGY TRUST covered distributions comfortably in the third quarter of 2007 by selling oil at $60 to $70 a barrel. And based on the action thus far, no one is having trouble lending to them.

With costs leveling off, they'll be able to keep covering dividends comfortably, even if oil revisits that low level in 2008. And if oil surprises and doesn't break down, cash flows will surge to the upside and likely will bring distributions along with them. Even natural gas may provide a boost with prices firming.

Of course, almost any energy stock worth its salt should make money over the next 12 to 18 months if I'm half right about the bull market. We may see more downside in the near term, particularly if a global recession carries oil down to the $60 to $70 range. But with energy stocks in general no where close to reflecting the current value of what they produce, the risks are low.

With most companies selling at that price level now, anyway, earnings won't be much affected. And event risk is all on our side.

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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