Communications: An Industry That's Working

 |  Includes: AAPL, CMS, FPL-OLD, GOOG, SO, T, VZ, XEL
by: Roger S. Conrad

Activist advocates for consumers or patient guardians of vital sectors: The correct role of the regulator has always been a matter of debate for the state and federal officials who oversee industries from electricity and communications to banking.

History’s verdict is clear. The game has to have rules, and regulators must enforce them. But it’s equally critical for officials to avoid the temptation to shape the eventual outcome.

The collapse of the US financial system last year is a pretty stark reminder of what happens when all the firewalls are taken out and long-established rules are ignored by industry and regulator alike. So was the sudden bankruptcy of Enron in late 2001, which nearly took down the whole utility industry.

On the other hand, decades of micromanagement of power utilities in the Northeast and California may have made some politicians popular. But it’s left both regions with extremely high power prices and antiquated infrastructure that officials are now being forced to address at great cost.

In stark contrast to that are the policies of the states of the Old Confederacy. Here, regulators have often come under fire for allegedly working too closely with power companies. Officials and politicians alike, for example, fought tooth and nail in the last decade against deregulation, largely at the behest of giants like Southern Company (NYSE: SO).

The end result of this relentless cooperation, however, has been some of the lowest power prices in the nation for both consumers and business. And infrastructure is largely state-of-the-art as well, routinely bouncing back from the severe storms that blanket the region in every season. That’s a major reason why manufacturing is still moving from North to South, and why the latter region continues to capture the lion’s share of foreign industrial investment as well.

As I pointed out last week and explored in detail in my advisory Utility Forecaster, some regulatory environments have deteriorated in recent months. That’s because the recession has put pressure on officials to hold down customer rates, even if denying a fair return on investment would mean a greater cost of capital and much higher rates later on.

Only time will tell, for example, if Florida Governor Charlie Crist’s stacking of the state Public Service Commission will seriously degrade regulator/utility relations, or will benefit his run for the US Senate. But it is clear that even a Republican governor with generally pro-business credentials may baldly risk the health of a vital and historically successful system, if there’s enough potential political gain in it. And that’s a clear warning to investors that desperate times can bring desperate measures, including destructive ones, almost anywhere.

Fortunately, I don’t anticipate much of an impact on FPL Group (NYSE: FPL). Should the Florida regulatory climate really deteriorate, the company will simply deploy its capital into its unregulated NextEra Energy unit, which is actually benefiting from regulation at the state and federal level to boost renewable energy use by whatever means. NextEra is already set to contribute nearly two-thirds of FPL’s earnings in 2010, as it continues to open new facilities around the country.

Utility/regulator relations are also still in good stead in most states. Companies like CMS Energy (NYSE: CMS) in Michigan and Xcel Energy (NYSE: XEL) in Minnesota have had to accept lesser rate increases in recent weeks than they had previously requested. But officials have left plenty of room to revisit issues when the economy cycles back.

Moreover, the fact that boosts are being granted at all is a clear signal that officials are still balancing interests to ensure low-cost and reliable energy long-term--in other words they’re still doing their jobs as stewards of a vital industry.

From the Capital

On the federal level, the Federal Energy Regulatory Commission (FERC)--now under a 3-to-2 Democratic majority due to the election of President Obama--has remained highly supportive of industry. That’s partly because the highly technical issues faced by FERC have historically made it a non-partisan body. But it’s also because the goals of the power and gas industry and the Obama administration are so closely aligned.

Washington, in other words, wants new power transmission built as badly as utilities want to earn a return constructing it. Utilities are completely on board with Obama administration efforts to encourage “smart grid” and renewable energy development, as that too adds to earnings. And Energy Secretary Stephen Chu has emerged as a forceful advocate for greater development of nuclear power as well as clean coal.

Even recent Environmental Protection Agency measures to regulate carbon dioxide emissions are not really directed at utilities. Rather, they’re mainly an effort to force Congress to keep moving what’s basically pro-industry legislation, in order to produce a final bill later this year for the president’s signature.

The bottom line is, Florida follies notwithstanding, energy utility regulation is still striking a solid balance here in late 2009, despite the worst recession in decades and surging unemployment. It remains to be seen, however, if the same can be said about those who regulate US connectivity and communications, namely the Federal Communications Commission (FCC).

Without a doubt, over the past decade the US communications industry has emerged as one of the most successful in the world. Share prices are still nowhere close to the lofty heights they held during the 1990s, just like most other technology leaders of that time. But the industry has been able to roll out one technological advance after the other.

Once an impossible dream and constant frustration, particularly for the business traveler, connectivity is now ubiquitous. Smart phones today perform functions that were up until recently inconceivable even on desktop computers--and at much greater speeds as well.

Consumers are paying more money to their providers of cable entertainment, wireless/wireline voice and broadband Internet services. But they’re also getting phenomenally more for their money. Communications companies for their part are able to offer individual services at ever-lower rates, even giving some away thanks to ever-greater reach and economies of scale.

At a time when the US auto industry has cracked and major players in scores of other sectors are pulling in their horns, communications industry leaders are spending more than ever on upgrading their networks. And with demand for connectivity mushrooming, they’re earning a return on their billions almost immediately.

The clear implication is that this is an industry that’s working. Customers are getting more for their money. Service is not only expanding rapidly but is scaling new heights for speed, capacity and function. Equipment makers are innovating as never before. Owners of networks are confident enough to invest billions upon billions of dollars, spurring economic activity with new spending and new hires alike. And all this is happening despite the worst recession in decades.

The key question here is why anyone in their right mind would want to mess with this industry. The fear is that may be what’s in store, now that the five-member FCC has a 3-to-2 Democratic majority.

The picture at this point is highly uncertain. Freshly appointed FCC Chairman Julius Genachowski and his majority have stated they’ll release proposed rules for enforcing net neutrality on network owners on October 22. The chairman, however, has also made several speeches very supportive of industry, the latest being this week’s promise to overcome a “looming shortage” of airwaves.

The chairman also lauded moves by the two leading players in US wireless--AT&T (NYSE: T) and Verizon Communications (NYSE: VZ)--to better open their networks to more products and services, including competing applications. AT&T is allowing Apple (NSDQ: AAPL) to offer applications on its iPhone to allow third-party Internet voice applications, such as that offered by Skype Technologies.

Verizon, meanwhile, has entered a partnership with the world’s leading Internet search company Google (NSDQ: GOOG) to co-develop multiple phones based on the latter’s Android operating system. As Google and Skype (NASDAQ:EBAY) have been among the biggest lobbyists for net neutrality rules, AT&T and Verizon are obviously hoping their actions will head off more intrusive regulation. And in fact these actions may indeed spur earnings, as both companies have a vested interest in bringing popular applications and services to their networks.

Verizon’s deal with Google, for example, could be a real blockbuster for both companies, teaming the globe’s best search engine company with the top-rated US network for quality. It also throws the gauntlet down to AT&T/Apple, which have been feuding with Google over the alleged exclusion of the latter’s iPhone applications.

Of course, not even these deals are going to satisfy the industry’s critics in Congress, where there’s even still scattered support for rescinding phone company immunity from lawsuits for supporting Bush administration wiretapping. They may or may not influence the new FCC and its fledgling chairman. But in any event, we have no choice but to await the commission’s verdict.

The good news, as I’ve pointed out repeatedly here, is the bar of investor expectations is exceptionally low for this industry. Despite a mostly complete and very successful transition from the legacy copper wire network to a 21st century broadband and wireless one, companies are still trading at their lowest valuations ever.

Low expectations mean low risk, even if the FCC takes a heavy hand. Coupled with their high dividends, that makes these stocks worthy holdings for conservative and aggressive investors alike.

Question of the Week

Here’s this week’s Q-and-A.

  • Which are better suited for IRAs and tax deferred retirement accounts, Canadian trusts or master limited partnerships (MLP)?

The best investments to put in an IRA are always those that will build a maximum amount of wealth over time. There are many trusts and MLPs that fit the bill, just as there are plenty of both that I wouldn’t touch with a 10-foot pole.

The key is the strength of the underlying business. No yield is worth chasing if there’s not a healthy and growing business backing it up.

That said, there are some tax implications worth pointing out. First, if you put MLPs into an IRA you lose the tax advantage of return of capital forever. Instead, you pay the same tax on accumulated dividends and capital gains as on anything else held in that account as you withdraw the funds.

In contrast, if you hold an MLP outside an IRA you can usually defer any and all taxes until you sell, so what’s the point of putting it in an IRA? There’s also the question of unrelated business taxable income (UBTI), which is owed on MLPs whether you hold them in IRAs or not. And either you or the trustee will have to be sure to file a Form K-1 as well.

One exception to the UBTI rule is Kinder Morgan Management (NYSE: KMR), which is essentially the same investment as Kinder Morgan Energy Partners (NYSE: KMP) except it pays its dividend in MLP units.

Turning to trusts, these are treated just like any other foreign equity for tax purposes. Dividends are taxed at 15 percent if you hold them outside an IRA and at your personal rate when you withdraw funds if you hold them inside an IRA.

The one complication is that foreign governments withhold a percentage of US investor dividends--Canada takes 15 percent--that can only be recouped by filing a Form 1116 with your US taxes. Some investors tell me this is possible if you hold trusts inside an IRA, but I say check with your accountant.

In any case, there are plenty of good trusts that pay huge yields even after the 15 percent withholding. So this shouldn’t be a deterrent to holding them in an IRA, or anywhere else. Also, trust dividends are qualified for US tax purposes, so there are no K-1s to contend with.

If you’re interested in finding out more about MLPs, I invite you to check out a new advisory I author with my colleague Elliott Gue, MLP Profits. My advisory Canadian Edge is a comprehensive resource on trusts. Its weekly companion is the complimentary Maple Leaf Memo, which I coauthor with David Dittman.