Second Leg of the 'Big W'

by: Roger S. Conrad

Florida Governor Charlie Crist is running for US Senate in 2010--and darned if he’s going to let power utilities’ need for capital during a recession stand in his way.

On Thursday, Crist effectively fired two long-standing members of the Sunshine State’s Public Service Commission, replacing them with wholly inexperienced former editorial page editor David Klement and Benjamin Stevens, the chief financial officer for the Pensacola Sheriffs’ Office.

It doesn’t take PhD in political science to get the message here: Florida utility regulators will, in Crist’s words, “put consumers first”--i.e., reject the pending rate hike requests from FPL Group (NYSE: FPL) for $1.3 billion and Progress Energy (NYSE: PGN) for $500 million or else.

Equally obvious is that Crist is responding to political pressure in a state hard hit by recession, where many residents want utilities to feel their pain. That’s par for the course during recession. And, even in a worst case, neither FPL nor Progress is likely to be hurt much in the near term.

The same day Crist was making his power move, FPL’s unregulated NextEra Energy Resources unit announced the purchase of 184.5 megawatts of wind power capacity from Babcock & Brown Power [Australia: BBP] for $352 million.

NextEra already contributes more than half of FPL’s overall profit and, fueled by mandates in 33 states to use renewable energy, is projected to grow to two-thirds of next year’s earnings.

Crist’s move will almost certainly make rate cases more contentious in Florida, and by extension make it more difficult for companies to recover regulated utility investment. FPL’s response, however, will likely be to simply to cut costs and deploy capital at NextEra. That will keep its earnings and balance sheet healthy. Similarly, Progress Energy will now be more likely to invest in the Carolinas, where regulation is still considerably less political.

Ultimately, Florida consumers will suffer most if Crist’s moves really signal a shift to so-called pro-consumer regulation in what’s historically been a model state for utility/regulator relations. Long-term planning for power needs will become problematic, and utilities will pull back capital spending rather than see their balance sheets weakened.

What is surprising is that this upheaval isn’t taking place in an historically contentious state like Missouri or New York. Rather, this is happening in Florida, heretofore a state with very constructive utility/regulator relations.

Moreover, Crist is a Republican and the sacked commissioners were hired by his predecessor, Republican Governor Jeb Bush.

Clearly, we’ve reached what could be a tipping point in US utility regulation, brought on by a gripping recession. With unemployment hitting levels not seen in decades, risk is rising that regulators in at least some states will abandon the new regulatory compact forged since the demise of Enron in late 2001. And that’s posing a growing threat to utilities nationwide.

The October 2009 issue of Utility Forecaster features my 50-state analysis of regulation in these recessionary times. I highlight where the risk is greatest and where it’s least, and the companies most and least affected by it.

The good news here is that most states are still positively regulated, despite the economic pressures. And even in riskier states, most companies are well protected against a relapse to the negative regulation of the past, thanks to successful unregulated enterprises, low operating risk and debt reduction.

Throw in what have been exceptionally conservative dividend policies and the vast majority of companies won’t feel any pain unless the economic news gets much, much worse.

Perpetual Fear

Unfortunately, the same can’t be said for many industries. And as a result this market remains in perpetual fear that the better economic news we’ve seen of late actually just marks the second leg of a “Big W” recession.

In other words, in late 2008 and early 2009, we saw the first sharp down-leg for the economy and the stock market. Since the bottom in March, we’ve been coming up the first up-leg. Now the stage is set for another terrifying down-leg, before we at last cycle our way out of this recession.

Like many of you, I’ve read the opinions of others forecasting just such a scenario. For many, it seems, the possibility of living through another horrific selloff like late 2008 is just too much to bear. And the upshot is the kind of market we have now, and have had for well over a year.

Basically, on one side we have US Treasury bonds, the US dollar and, somewhat surprisingly, gold. On the other side is virtually everything else, from energy and technology to dividend-paying stocks that as companies have proven to be recession-resistant thus far.

When the news on the economy seems to indicate a positive direction, the action is positive, often greatly so. On the other hand, when the news on the economy arouses fears of a Big W, everything sells off, often with stocks of the most recession-resistant businesses leading the way down.

Adding to the confusion, the action on any given day is more often than not completely reversed the next. Take this week, for example.

Early in the week the S&P 500 was flirting with a new 2009 high. Then Thursday dawned, the first day of the fourth quarter. Unemployment insurance claims came in at 551,000, rather than the 535,000 consensus of economists, raising the specter that unemployment for September would hit 10 percent. That was accompanied by a dip in auto sales and the Institute for Supply Management’s index of manufacturing.

Ironically, there was actually another month of positive news from the sector whose demise started the recession: housing. But it was largely ignored in the rush to close out long positions before the full jobs report announcement on Friday.

In contrast, Thursday’s action left gold prices at nearly $1,000 and the benchmark 10-year Treasury note yield at 3.194 percent.

The market’s up again, down again pattern and erratic economic news are good reasons why investors need to focus on high-quality companies. That means companies that have strong underlying businesses with growth potential, recession-resistant niches, strong balance sheets and preferably well-funded dividends.

It’s also more important than ever to maintain basic portfolio discipline, for example diversification, balancing holdings and averaging in to new positions. Averaging down a position that’s losing value remains almost universally a bad idea, particularly when there’s clear evidence that the underlying business is either weakening or is at risk to unraveling.

I’m not convinced at all, however, that this is a time to run for the hills, or even that there’s a reasonable possibility of another late 2008-style meltdown in the stock market.

Fact is, selloffs of the magnitude of the one that occurred after the fall of Lehman Brothers occur only very rarely in market history. That’s because they require a unique combination of relatively high stock valuations--i.e., high investor expectations--and a series of extremely unfortunate events.

Despite the run-up we’ve seen in many stocks since early March, it’s hard to make the case there’s anything approaching high investor expectations now. In fact, that thesis is directly contradicted by the violence of selloffs like Thursday’s in the face of economic numbers that are hardly catastrophic. People still fear a Big W, and stock prices reflect that.

Second, it’s absolutely true that at least some of the federal government stimulus has made its way into the system, and the economy is still hardly in the pink of health. Much of the money, however, was earmarked to major projects that take longer to deploy funds for.

This, ironically, was a major criticism of the stimulus package in general, but it means that there’s still a lot more money out there, in addition to still-easy monetary policy globally.

We may not see a dramatic improvement in unemployment anytime soon. But neither are we likely to see the kind of dramatic increases we’ve seen over the past year. And the same pattern is evident in economic data across the board, including from the housing market.

There are still US financial institutions at grave risk, as the CIT Group (NYSE: CIT) restructuring this week clearly demonstrates. Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has seen its reserves drop dramatically as it’s been forced to rescue the largest number of banks in decades.

On the other hand, however, monetary authorities, including the US Federal Reserve, have now been on the case of cleaning up the banks for more than a year now. Officials know where vulnerabilities lay, and potential accidents are now being cleared up almost before they occur.

On top of that, cash is flowing to creditworthy borrowers, both corporations and individuals. The spread between yields on newly minted A-rated utility bonds and the 10-year Treasury note has again sunk below 150 basis points, adding up to the lowest overall yields in years.

Even non-investment grade, or junk, bonds have surged, as evidenced by the open-end fund Northeast Investors Trust’s (NTHEX) total return of more than 50 percent since the beginning of 2009.

The credit market is still largely frozen to the weak and desperate. FairPoint Communications (NYSE: FRP), for example, defaulted on its credit agreement this week. That’s the likely first step in a wholesale reorganization likely to wipe out all but a sliver of shareholder value.

In contrast, the credit market has rarely been more open to the financially strong, and they’re taking advantage to cut interest costs and strengthen balance sheets. Even companies involved in aggressive acquisitions likeFrontier Communications (NYSE: FTR) have been able to refinance debt at preferential rates.

The situation in the credit market is perhaps the biggest difference between now and a year ago, when teetering financial institutions froze credit markets and drove the economy and stock market off a cliff. If there is to be another catastrophic down leg for the market, it won’t be triggered in the credit market as the last one was.

We may see another down-leg for the economy, as many fear. But there will have to be another catalyst entirely--and at least one on par with last year’s financial system meltdown--to induce investors to run for the hills.

As the market’s ups and down show, expectations are very low. And there are very few potential candidates with the power to drive actual economic events below them.

Question of the Week

In this new section of Utility & Income, I answer a frequently asked question from readers: According to latest figures, prices of commercial real estate are down more than 30 percent nationwide. Given the possibility for further declines, why should anyone hold real estate investment trusts (REIT)?

The main reason is abysmally low expectations.

The Dow Jones Real Estate Index hit a high of 93 in early 2007 after climbing almost uninterrupted since early 2000. At that point, there weren’t too many bearish voices for REITs or for commercial real estate in particular, and almost nobody was talking about subprime loans as a problem for banks or property values.

Today, that same index is 56 percent below that high point. True, commercial real estate prices are down almost as much. Vacancies have risen nationwide, and rents are also well off. An unprecedented number of REITs have cut distributions over the past 12 months. And we’ve yet to see the fire sales of property that are typical of downturns.

But REITs have had the stuffing beaten out of them, and not all the fundamentals news is bad, particularly for the stronger fare.

Residential real estate in general, for example, has been hit by rising vacancies and bad debt. But Mid-America Apartment (NYS: MAA) actually raised its profit forecast in August, as it has continued to hold vacancies and rents steady.

Shopping malls have been devastated by weak retail sales and bankruptcies. But mall owner Simon Property Group’s (NYSE: SPG) 10-year bonds trade at a premium of only around 300 basis points to Treasuries, and the REIT is aggressively pursuing acquisitions. So is office property magnate Vornado Realty Trust (NYSE: VNO), which last week issued $400 million in 30-year bonds at a yield of just 7.875 percent.

Even at the lowest Wall Street expectations for funds from operations next year, strong REITs will cover their distributions handily. And many REITs’ shares are selling at their lowest multiples to book value since early 2000.

A real W move by the economy will make conditions difficult for even the strongest REITs. But again, that’s exactly what’s baked into today’s prices, and it’s why the best of this group are again attractive buys.