Utilities Analysis - Telecoms, Steel and Energy
Companies / US Utilities Oct 28, 2007 - 01:53 AM GMTBy: Roger_Conrad
Is cable's goose cooked? Is the jig up on what's been torrid growth for the past few years? Are the big phone companies finally going to bury them?
That's certainly the line being trumpeted by the financial media this week. Once investor darlings, cable television stocks have plummeted in recent weeks, with the selling accelerating as third quarter earnings season has gotten underway.
Worst hit by far has been the biggest of the bunch, COMCAST CORP. The giant has skidded from a high of $30 a share in late January to less than $22 this week, including a 10 percent-plus drop in the wake of its third quarter earnings announcement.
It's hardly the only casualty, however. TIME WARNER--the second-largest cable giant--has fallen into the mid-teens. CABLEVISION, which saw a takeover bid by the managing Dolan family collapse this week, has broken below $30 for the first time in months. Smaller outfits have fared even worse, with RCN CORP now trading at less than half its levels earlier this year.
Not surprising, few have any kind words for cable companies these days. In fact, the further prices have fallen, the greater the gloom and the more virulent the doomsaying for the sector.
The pattern of collapsing sectors is nothing new for the markets of 2007. What began as a subprime mortgage crisis has morphed into a full-scale credit crunch in many sectors--notably housing and financial services, which are both are flat on their backs.
With bank after bank reporting massive write-offs of securities, there's almost surely more damage to come. THORNBURG MORTGAGE, for example, has now suspended its distribution because management has elected to conserve capital until market conditions improve.
The interesting thing about cable stocks' collapse is there are none of these itinerant issues. In fact, when you turn down the commentary, it's hard not to conclude that the sector's numbers are actually quite strong.
Let's take Comcast. The stock's drop is hardly surprising, given the torrent of negative press surrounding its third quarter results. Forbes, for example, ran the headline “Comcast Picture Darkens,” along with the witty lead “investors are pointing their remotes at Comcast and they're pressing the off button.”
Some allege the company is the victim of the wicked slowdown in the housing market. Others state that VERIZON COMMUNICATIONS' FiOS network was rapidly chipping away at Comcast's subscriber base and, therefore, bottom line.
To be sure, Comcast's headline earnings number is a disaster, at least for lazy journalists whose analysis stops there. Specifically, earnings per share for the third quarter nosedived 53 percent from year-earlier tallies. Nine-month totals, meanwhile, were off 6 percent.
Other numbers cited by analysts as reasons for bearishness included a net loss of 65,000 basic cable customers, a reversal of last year's 11,000 gain. Growth of customers of the company's advanced services like digital cable, broadband and particularly telephone service lagged expectations, with total growth in revenue generating units slipping 6 percent from year-earlier quarter totals. Meanwhile, revenue per Internet user and per phone customer slipped slightly from second quarter levels.
Finally, management forecasted that 2007 consolidated free cash flow—cash flow less capital expenditures—would “be at least 90 percent of 2006 levels.” That implied there would be some drop off and that the company's extensive capital spending on network upgrades is at least temporarily outrunning cash flow growth.
ANOTHER VIEW
I hate when my stocks fall. And all things being equal, I would just as soon have not have had Comcast shares in the Utility Forecaster portfolio this year. In fact, its sorry performance has basically offset the strong growth we've enjoyed in the company's Big Telecom rivals, AT&T and Verizon.
In this case, however, it's pretty apparent to me the market isn't really reacting to these numbers. Rather, the selloff is part and parcel of the Wall Street mentality that continues to plague all communications companies, both Big Telecom and Big Cable.
Basically, the Street can't get away from the mentality that Big Telecom and Big Cable are in a death match. In this zero-sum prism, every success by one side portends a setback for the other. Simply, if you're high on telecom, you can't be high on cable and vice versa.
For years, the victims of this thinking were Big Telecoms. No matter what kind of positive numbers they put up from quarter to quarter, the analyst and press coverage was overwhelmingly negative. Robust growth in wireless customers, revenues and margins were shunted to the later paragraphs of reports, as the “experts” fixated on factors of decreasing importance like the slow erosion of local phone and long-distance customers and revenue.
Only recently has the Street managed to focus on the forest when it comes to Big Telecom, rather than the trees. Financial press coverage surrounding AT&T's earnings, for example, was the most positive I've seen in years. Headlines included “AT&T Sees Double-Digit Earnings Gains This Year and Next,” and “AT&T Signals Growth.”
To be sure, this change in tone is justified, if not long overdue. AT&T's earnings have been on an upward trajectory for some time now, thanks to robust growth in its wireless business and solid results in the wireline area as well.
Like all big telecoms, it's still bleeding basic copper phone line customers. But that's more than made up for by growth in margins, as it adds more broadband and entertainment business.
The iPhone launch was less than spectacular but, nonetheless, steady. And merger integration from the addition of BELLSOUTH has generated greater savings than expected.
All in all, this is the picture of a very healthy company with a bright future. The market's recognition of that, however, hardly signals a new enlightenment about the communications industry, which can clearly support both Big Telecom and Big Cable profitably. Rather, it's now clear that Wall Street has simply switched sides in what far too many still consider to be a death match between phone and cable.
Exhibit A is that Comcast's numbers—though disappointing to some analysts—are hardly a disaster. And they should hardly have generated such an extreme reaction. In fact, they paint a picture of continued, robust growth.
For one thing, factoring out a series of big, one-time gains last year, earnings per share were actually 6 percent higher for the three months and 17 percent higher for the first nine months of 2007. The baseline number of 18 cents a share was right on target with the 18 cents forecasted by Reuters Estimates.
Revenue growth actually topped consensus with a 21 percent rise to $7.78 billion, while overall operating cash flow surged 20 percent. Operating income was up 14 percent. Pro-forma cable revenue—which is adjusted for acquisitions—rose 11 percent, while cable operating cash flow ticked up another 13 percent.
The linchpin of Comcast's strategy over the past few years has been growing so-called “revenue generating units” (RGU). This basically involves upselling its basic cable customers to other services, such as digital cable, broadband Internet and phone service. A customer who gets a bundle of all four services, for example, accounts for four RGUs.
One number harped on by some analysts following the earnings report was the drop in growth of RGUs during the third quarter. The company added roughly 1.4 million net RGUs at the cable business, down from a little less than 1.5 million in the year earlier quarter.
On the other hand, nine-month net RGU additions were a record 4.8 million, up nearly 40 percent from growth in the first nine months of 2006. Overall RGUs were 13 percent higher than a year ago.
The upshot: A jump in operating cash flow margin to 40.2 percent from 39.6 percent a year earlier. Simply, Comcast may not have grown as fast as some thought it would. But it's growing its profitability per unit of sales at the same time it's growing those sales at a double-digit annual clip.
In other words, profits are rising as the company is growing. That's hardly the picture of a dying organization or even of one that's getting into trouble.
Of course, however impressive a company's past growth may be, the market is always looking ahead. Much of the negative commentary concerned potential competitive threats from Big Telecom. Others blamed the slowdown in the housing market that has forecasted further slowdowns on that score.
Again, the market's verdict on a company should never be wholly ignored. Where there's smoke there's often fire, and that's definitely what the prevailing opinion is now for the entire cable sector.
In the case of Comcast, however, the damage has been done to the share price. And disappointed analysts or no, if the company maintains the underlying numbers it did make in the third quarter, the market mood is sooner or later going to shift to a considerably more positive tone, just as it has for Big Telecom now. And at a current price of just 1.57 times the value of what are still very productive assets, there's a lot of room for upside surprises.
I'm more firmly convinced than ever that the communications marketplace can support at least two very profitable competitors. It's clearly a growing market on many fronts, from high-speed broadband to the many manifestations of wireless service.
One of the more important metrics I follow on Comcast is its penetration rates. Increasing RGUs is all about inducing more people to take new services, i.e., boosting their penetration rates.
In terms of sheer numbers, Comcast added fewer new customers than Wall Street expected for phone and high-speed Internet service. It handily beat, however, forecasts for digital cable customer growth, the service for which the company holds the biggest competitive advantage.
More importantly, it continued to grow its penetration rates. Some 27 percent of customers now take the company's Internet service. That's up from 26 percent in the second quarter and 23.6 percent a year ago.
Digital cable penetration has grown to 60.7 percent, up from 50.1 percent a year ago and 58.5 percent as of June 30 of this year. “Digital Voice” or phone service penetration, meanwhile, is up to 9.4 percent from 4.4 percent a year ago and 8.2 percent in the second quarter.
Put another way, despite the hoopla about potential Big Telecom competition, the company still increased penetration rates for all its advanced services and at an impressive pace. Obviously, if those numbers start falling, it's a different story. But as long as those numbers are growing, so will Comcast's profitability, and the bear case will remain just what it is now—simply speculation that more difficult times lie ahead.
Further, as long as those numbers are growing, Comcast's business will be becoming more valuable. And in the long term, that's what will determine where its shares trade, not the prevailing market mood and the latest “inside baseball” about a supposed “death match” with Big Telecom.
There are even a couple more reasons to be positive. The company announced this week that it's increasing its stock buyback by an additional $7 billion to a total of $8.2 billion. That's roughly 12.5 percent of current market capitalization.
Perhaps more impressive, Standard & Poor's immediately affirmed this massive buyback would have no impact on the company's current BBB+ credit rating. Again, that's hardly the sign of dying business.
Also, the company's programming division, though only a bit more than 4 percent of total revenue, saw sales grow 27 percent in the third quarter, while operating cash flow rose 11 percent. That's a good sign it's fitting well into management's network-focused growth strategy.
Frankly, I'd rather see some of the company's still massive free cash flow—which even at the low end of management estimates will still reach $2 billion-plus—go to pay a dividend. Based on these results, however, this is still very much a growing business that's gaining value over time. And again, that's the primary criterion for holding any stock for the long haul.
As for the rest of the cable television industry, I'm somewhat less than bullish. Time Warner is still dogged by results at its AOL unit. Cablevision shares look like they'll be weak for a while, now that shareholders have rejected the managing Dolan family's takeover bid. And that company does compete full bore with resurgent Verizon in its home New York City market, on which it's heavily dependent.
Fry like RCN still aren't profitable and also lack the scale to compete with communications sector giants. And Charter Communications appears to be perpetually one step away from Chapter 11.
If these stocks fall much further, however, there will no doubt be some real bargains. Remember, no profitable and rapidly growing industry has ever been unable to support at least two major competitors. And with the likes of VONAGE falling off the radar screen—and SPRINTNEXTEL looking close to following—Big Cable and Big Telecom are it when it comes to communications.
MARKET WATCH
Earnings reporting season is always an important time for the stock market. This year, with credit worries and even recession fears thick in the air, the impact appears to be particularly pronounced, as the reaction to Comcast's earnings this week demonstrates.
On the plus side, most utilities appear to be coming in with solid results. Giants like AMERICAN ELECTRIC POWER, ENTERGY CORP, SOUTHERN CO and XCEL ENERGY have all reported either in line or expectation-beating results. So have smaller players like ENERGEN CORP and MDU RESOURCES, which also rely on natural resource production.
On the negative side, except for Entergy, none of these stocks has gotten much upside carry-through on the results. That's likely to be the case as long as the market is worried about credit and the potential for a recession. But at least good results have kept them on the plus side in a turbulent market.
The other critical factor affecting income stocks is interest rates. The benchmark 10-year Treasury yield has slipped to the 4.3 to 4.4 percent range. That's about a full point below the summer highs.
The Treasuries' run can mainly be attributed to concerns about the US economy and betting that the Federal Reserve's next move will be to cut the fed funds rate again. Fed funds futures rates are again leaning toward the probability of a cut in the next several months.
Specifically, traders are now discounting a 100 percent chance of a 25-basis-point cut in the fed funds rate to 4.5 percent at the Oct. 31 meeting of Federal Open Market Committee meeting. And every negative reading on the economy tends to increase positions betting on future cuts.
In one sense, such high expectations for a move mean the overall market would be very disappointed in anything less. If the Fed should decline to take action, the impact could be very negative for stocks.
On the other hand, this is also a pretty clear indication that the market is a lot more worried about the possibility of a severe slowdown in economic growth than it is about inflation. As long as that's the case, interest rates will be at worst a neutral factor for income-oriented stocks.
As I've written here before, the key to dodging the worst of a recession is to stick with high-quality stocks. As the Comcast example shows, even a high-quality company can take a big hit in this kind of market, if it does something to disappoint the market. But it's the market's cats and dogs that will fare worst if things really do start to slow.
I remain convinced, however, that the Fed won't let the worst happen to the US economy. And as long as that's the case, credit risk will continue to drop, at least for high-quality stocks.
That leaves the question of what follows. Will the Fed step on the accelerator so much that it will create a repeat of 1999—when inflation and interest rates rose and investors fled from income-oriented stocks? Or will it find a more benign balance?
In the final analysis, despite the recession talk dominating the airwaves, it still makes sense to hedge ourselves against this potential risk. We can do that foremost by sticking to quality stocks, i.e., those attached to growing businesses. Our bonds should be of limited duration or some combination of improving credit and near-term maturity. And we should own some resource stocks as well, preferably some outside energy, because these have always done well in times of rising inflation.
In the past several issues of Utility & Income, I've made mention of a new service I'm co-editing with Yiannis Mostrous, Vital Resource Investor. Here's a recent article he's written for our service on steel, along with a link for those who want more.
SURGING STEEL
The steel sector is one of the most vibrant and exciting in the commodities universe, as steel has become extremely important for economic growth around the world.
As the emerging economies continue to improve, investment in construction is booming. And steel construction is the biggest area; 58 percent of the steel in China is now used in construction.
Steel stocks have performed extremely well and did even better in the rally that followed this summer's stock market selloff. The steel stocks we recommended in an August article for Personal Finance have posted huge gains in just a couple months.
Even so, steel companies remain reasonably valued, particularly in comparison to other vital resource sectors. Even after the recent gains, they deserve inclusion in the commodities part of your portfolio.
The dynamics in the steel industry have changed markedly in the past 15 years. For one thing, China has become the world's biggest consumer. In the 1960s, the US accounted for around 40 percent of global demand. Today, that number is around 10 percent. In contrast, China is now the 40 percent player, up from a 10 percent share in 1990.
Infrastructure growth in the developing economies and energy construction are the main drivers of steel's success. On the latter, strong oil prices will continue to support infrastructure spending for pipelines, windmills, oil rigs, and other related steel-intensive uses. Shipbuilding and growth in auto production will also be big drivers.
Apart from the growth factor, Chinese steel exports will also play a huge role on the resource's price. That's being hugely affected by China's internal demand.
According to a preliminary report by the Chinese government, China's steel export volume fell 22 percent from August to September, and exports are now at their lowest levels since February.
One major reason for the export decline is the recent reduction in the tax rebate from 8 percent to 5 percent. Others include the higher production costs that many Chinese producers face, an extremely strong domestic market for steel and high shipping costs that make overseas markets relatively unappealing to Chinese companies.
As the competition from Chinese steel diminishes, opportunities for non-Chinese companies are increasing. And we're starting to see the positive impact on their revenues.
As for the big cycle for steel, it's very much intact. The rest of Asia, the Middle East, Eastern Europe and Russia continue to grow and improve their respective infrastructure. The global economic outlook will affect the industry from quarter to quarter. But barring a full-scale global recession, economic growth will continue to support steel prices at robust levels.
My favorite stock in the sector is MECHEL, Russia's second-largest producer of long steel products. It operates one major steel mill with a capacity of close to 5 million tons of output per year. Mechel operates in Russia, Lithuania and other countries in Central and Eastern Europe.
The company's ace in the hole is a mining business that focuses on raw materials used in making steel, primarily coking coal, iron ore, nickel and steam coal. The company's steel business is 100 percent self-sufficient in coking coal, 80 percent in iron ore and 50 percent in electricity.
This aspect of Mechel (i.e., vertical integration) is critical in an environment where raw materials prices continue to rise. And it should support the stock because its performance this year has been nothing less but dazzling.
Mechel is a high-cost producer, and management has worked to cut costs while improving efficiency. Those efforts have been quietly successful up to now, and we expect this to be an ongoing positive theme. And Russia's strong domestic demand--within and outside the all-important energy sector--is an additional advantage for the company.
ENERGY OUTLOOK
As for energy, it remains very much a tale of two commodities, with oil surging to about $90 per barrel and natural gas continuing to languish. Refineries were also weak in the third quarter, as prices of refined products failed to rise as quickly as crude oil, resulting in squeezed margins.
Where companies were focused largely determined how their earnings came out. Oil producers were in third quarter clover. Gas companies and refiners took a hit. Balanced companies were somewhere in the middle, underperforming oil's spike but remaining in solid shape nonetheless.
My view with energy remains to stick with what you own. That's in large part because I don't think we're anywhere close to the end of the bull market.
There just hasn't been enough conservation or a move to alternatives to create sufficient demand destruction, even as the world's developing economies continue to grow. And the only reserves being developed are nonconventional; they need high prices to be economic.
Another factor arguing for a longer bull market is resurgent resource nationalism. As countries take control of their natural bounty and demand a bigger cut of the profits, investment will suffer. That's what happened in the '70s, and prices remained high. Companies that navigated the risk well were all the more prosperous for it, and their investors shared in the spoils.
This week, Alberta announced its plan to raise royalties on energy producers operating within its provincial borders. The increase was considerably more benign than what was originally proposed and will be tied to increases in energy prices rather than a blanket levy. It also won't take effect until 2009.
At this point, it's hard to say how the higher royalty rates will impact producers. On the plus side, if the additional revenue—projected at some $1.4 billion—is put to work building much-needed infrastructure, it could actually boost Alberta's energy productivity.
On the negative side, it could discourage development and take money out of shareholders' pockets. In any case, most of the impact should be felt outside the trust sector because its focus on mature reserves.
All in all, the best strategy is to own a basket of high-quality stocks drawn from a wide range of industries, including those that are being beaten down now. That's the best way to keep your portfolio on an even keel come what may. And it's the best way to grow your wealth in the long pull, as your holdings' businesses become increasingly valuable.
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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