Utilities Sector Better Positioned to Weather Recession and Dividend Cuts
Stock-Markets / US Utilities Feb 25, 2008 - 06:20 PM GMTBy: Roger_Conrad
Even in the best markets, dividend cuts are poison for income investors. Not only is your regular cash flow cut, but your principal typically takes a haircut as well.
Generally speaking, it's almost always best to avoid companies in danger of cutting dividends. The key is to pay close attention to operating businesses. As long as companies are coming in with solid numbers, dividends will be maintained and even increased.
That doesn't mean their share prices can't take hits, particularly in a fear-riddled market like this one. But it does limit downside, and it does ensure they'll recover when things inevitably turn up.
There are times, however, when it may make sense to hang in there with a company on the brink of a dividend cut. In fact, it can even make sense to buy in before a dividend is reduced.
The key is expectations. If investors are expecting a huge dividend cut before one occurs, the stock's price will already reflect it. If the eventual reduction is within expectations, there may be little additional downside in the stock. In fact, if the cut is less severe and investors perceive the business has stabilized, you may even see a rally.
During the 2001-02 utility bear market and sector collapse, a dividend cut was often a warning of more bad news to come. With 20-20 hindsight, it's now clear that overall conditions were deteriorating so rapidly then that the best course was usually to sell after the first cut, as more bad news was likely to come.
The 2001-02 market, however, was the exception in utility sector history. In fact, most of the time, utility dividend cuts have marked a bottom in companies' fortunes and, hence, share prices. It made a lot more sense to buy whatever drop followed a dividend cut because the company's fortunes were almost certain to improve.
The more news on the US economy trickles in, the more apparent it is that growth has slowed, and I suspect we've entered a recession not unlike that of 2001-02. Sooner or later, the Federal Reserve's aggressive action to pump up the money supply and spark growth will have its desired impact, and the economy will rise once more. In fact, the problem will soon likely become faster inflation, which also appears to be heating up.
As I've pointed out repeatedly in Utility & Income, the situation in the utility sector today is close to 180 degrees opposite that of 2001-2002. After five years of systematic debt reduction, there is no overleverage problem. Cost cutting has greatly streamlined operations. Regulator/utility cooperation is the best it's been since the early 1960s. There's an emerging capacity shortage rather than a building surplus. And management is conservative and focused on improving high-percentage core businesses rather than trying to rule the world.
As fourth quarter results have shown for company after company, earnings are on the rise. Dividends are increasing at historically high rates, and credit ratings are rising, despite cash outlays for capital spending, dividends and stock buybacks.
There's a looming capital challenge, as utilities gear up to meet an explosion of new demand and environmental mandates. But that's, in effect, tomorrow's problem. Today, utilities are in the pink of health and, judging from bullish 2008 guidance, aren't feeling the pain of recession. In fact, they're looking to get stronger still in the coming year.
In short, this is the kind of environment where utilities are behaving more like their old pre-deregulation selves. Stable earnings and dividends have made the best of them clearly safe havens in a volatile market with a slowing economy. And even those struggling are doing so for internal reasons that, once settled, will launch their recovery.
On the other hand, sentiment is decidedly negative in this market. That's even spread to essential service companies. We got another taste of that earlier this week, as communications stocks took a one-day bath again in the wake of announcements by first VERIZON COMMUNICATIONS and then AT&T of new flat-rate pricing for wireless service.
The specific offer of $99.99 a month by both will affect only a sliver of the pair's customers, most of which use far lower-priced plans based on minutes. In fact, combined with new rate plans for data service, it may wind up encouraging more switching from rival SPRINT NEXTEL CORP and faster growth in the data business.
The selloff, however, wasn't due to worries about what the offer itself meant for profits by itself. Rather, the panic set in when the media took to the clarion call that this marked the beginning of a price war between the two companies that would decimate profits for both.
One analyst stated Verizon has taken the first step on “potentially a dangerous and slippery slope.” And a few have publicly speculated telecoms' hands were being forced by further weakening of the US economy.
None of this, of course, was in any way evident when AT&T and Verizon announced fourth quarter earnings. Nor is it backed up by the Telecommunications Industry Association (TIA) study released today, which actually forecasts acceleration in US industry growth to 9.3 percent in 2008 from 8.3 percent in 2007, as well as a robust annual 7.2 percent rate of growth through 2011.
The study also projects a more than doubling of data service revenue as a percentage of overall wireless sales, from 16 percent in 2007 to 35 percent in 2011. Viewed in that light, the Big Two's cut in data rates and offer of unlimited minutes for $99.99 a month makes perfect sense because it will increase their ability to profit from growth in data.
Market emotions, however, have a way of running well past rational argument. At least one article on the TIA study focused not on robust projected growth trends but on the fact that growth would be faster in Asia. That's incidentally another trend that will benefit both companies as they ramp up their enterprise offerings on a global scale.
In short, the telecom reaction is just one more example of how low expectations have sunk for companies of all stripes, even for the very strongest. The good news: That also means the bar for beating expectations has been set very low, making it probably the easiest for good companies to beat in many years.
AT&T and Verizon are clearly in no danger of dividend cuts. In fact, both are near certain to ramp up payouts in 2008. And as they do so, they'll beat the market's gloomy outlook—which is clearly shown in their near 5 percent yields and price-to-earnings ratios of 10 and 12, respectively, both at sharp discounts to the fare in the infinitely more challenged S&P 500.
For the most part, these are the kind of stocks investors are best off focusing on now. As I pointed out last week, I'm increasingly comfortable holding shares from a range of sectors, including power utilities, “wires and pipes” companies and limited partnerships, communications giants and the larger rural phone firms, water companies, conservative energy producing companies as well as Canadian trusts, US apartment REITs and even some metals plays, which are increasingly showing their ability to profit despite US weakness. I'm also an advocate of the open-end bond mutual funds issued and run by VANGUARD, particularly the GNMA FUND (VFIIX) that conveys only slightly more risk than cash.
This is where most investors should be focusing their firepower. Moreover, we should all be using fourth quarter earnings and 2008 guidance as a crucible to determine if our picks still represent solid businesses and are, therefore, worth holding.
Those that do measure up will be worth holding regardless of the market storms ahead, even if sentiment turns against them. Those that don't hold up we'll generally want to dump.
Ironically, however, with sentiment this jaded, there's an emerging opportunity in some of the dividend-cut candidates and even some that have already cut. That's because, with expectations this low in the macro environment, dividend cuts are frequently priced in well in advance.
In other words, prices have already dropped, limiting downside when there's actually a reduction. And if the actual cut isn't as severe as anticipated—or if there's an indication this is the bottom for the company itself—it's possible a rally could follow.
There are caveats. As I've said, I'm an advocate for quality. That means sticking with businesses that are thriving and generally avoiding those that aren't. Dividend cuts certainly aren't an indication of health.
Second, the rule that dividend cuts are often buying opportunities applies to only a handful of industries. Since Thomas Edison threw the first switch back in the late 19th century, the only regulated electric utilities to disappear completely off the map have been those involved in the literally thousands of sector mergers that have gradually consolidated that industry. Those filing bankruptcy have occasionally wiped out shareholders or left them with very little. But the company stayed in business.
No matter how bad things got, utilities' core regulated have always eventually returned them to health. That was true in the '80s, as GENERAL PUBLIC UTILITIES led a host of companies back to recovery following the utility generational bear market of the '70s. And it's proven true again this decade, as companies nearly driven to insolvency by too much debt, weakening markets and scandal have been able to pick up the pieces of their businesses.
No other industry can make that claim. Take the savings and loans of the late '80s. How many of them that cut dividends in the beginning of their crisis have survived, let alone recover? The wipeout of AMERICAN HOME MORTGAGE—once a proud dividend payer—is a pretty clear warning sign that once a company in the financial services industry starts to head south, it may just keep going in that direction.
That may not apply to CITIGROUP, which the US government has repeatedly treated as too big to fail, regardless of management's colossal mistakes. Even Citigroup, however, has taken huge hits from time to time. And despite cutting its dividend once already, it certainly looks vulnerable to another.
The upshot: If you want to bet on companies in this environment that have either cut dividends or are in danger of doing so, you'd better stick to tried-and-true sectors. That means businesses with the stability and track record to weather whatever bad news appears, the best examples of which are utilities and utility-like entities.
We haven't seen a regulated US utility cut dividends in some years. Several have danced around the brink, including HAWAIIAN ELECTRIC INDUSTRIES, which today allayed some fears by announcing a sharp increase in fourth quarter earnings. GREAT PLAINS ENERGY has repeatedly not earned its current dividend, in large part because of continued losses at its unregulated Strategic Energy unit. It's currently considering options, presumably to dispose of it.
Others such as THE EMPIRE DISTRICT ELECTRIC CO and now PNM RESOURCES have found their dividends literally at the mercy of regulators. Empire's Missouri regulators and PNM's New Mexico overseers still aren't granting high enough rates to keep up with these companies' costs. Unless they get them this year, there will be cuts.
The uncertainty surrounding these companies has knocked their stocks way off. PNM is down more than 60 percent from its 52-week high after announcing a steep 86.3 percent drop in its fourth quarter earnings and rise in its payout ratio to 82 percent. Projected guidance for 2008 would cover the payout by an even narrower margin, and the credit rating is now on watch at Moody's, with a downgrade to junk possible.
This one is getting interesting at just 57 percent of book value. And even in a worst case on the regulation front, it's not going out of business. But with the ongoing rate case this uncertain, a buy now could take on some water if the rate case doesn't go as expected. A decision should be made this spring.
Ditto for Empire's case in the Show Me State. The company is currently wrestling with the costs of a major ice storm and its credit rating is also on watch for a downgrade to junk. It's a little more expensive than PNM at 1.34 times book value, however, which means a lot more potential downside if things don't go its way.
Another down and outer to consider is IDEARC, the yellow pages spinoff of Verizon. The stock has now fallen more than 80 percent from its high as mildly disappointing fourth quarter numbers—a 1.7 percent drop in revenue from 2006 levels and drop in margins from 48.6 percent to 47.6 percent—have triggered a panic that the company is melting away in the face of competition and a weakening US economy. The company did warn of slightly lower 2008 revenue because of US weakness.
Nonetheless, investors—including the big analysts who have provided such useless commentary on the stock over the past year—are clearly running well past any facts yet to emerge, knocking the stock down to a current yield of more than 17 percent. That's despite the fact that the dividend was covered by earnings by more than a 2-to-1 margin in the fourth quarter and that the company made progress transitioning its business to the Internet.
Just like manias, panics often go on a lot longer than you think. But now trading at just 32 percent of sales, that's a lot of bad news priced in that hasn't even remotely shown signs of occurring this year. In fact, anything short of real bankruptcy will beat the bar for Idearc shareholders. And at this point, that's the only thing that counts.
By Roger Conrad
KCI Communications
Copyright © 2008 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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