The Scott Brown Effect

 |  Includes: DUK, ETR, GOOG, GSK, SO
by: Roger S. Conrad

Partisan press aside, it’s far too early to write off the Obama administration as a one-term wonder. Democrats still control the US Senate by one of the biggest margins in history at 59-41, and they actually picked up a House seat in the November 2009 elections. The president himself remains broadly popular with the public, which in the latest polls still gives him favorable ratings on everything from handling terrorism to the economy.

Clearly, however, the election of Republican Scott Brown to the US Senate has reshuffled America’s political deck. And there are profound implications for income investors.

Front and center is the breaking of the Democrats’ supermajority in the US Senate. The obvious impact is that the opposition party now has what it hasn’t since Norm Coleman conceded the Minnesota Senate race last summer to Al Franken: the ability to filibuster legislation.

The first casualty is likely to be health care legislation now in joint House-Senate conference. Not only can a united Republican opposition prevent even a vote on the bill in the Senate. But House Speaker Nancy Pelosi (D-CA) has publicly stated she doesn’t have the votes in the lower chamber to pass even the Senate compromise. That, of course, was what was hammered out by Majority Leader Harry Reid (D-NV) to garner needed votes from all 60 Democrats before Brown’s victory.

There’s a possibility now that we’ll see genuine dialog between the parties on health care legislation, which many of their contributors strongly back. And with the US Supreme Court’s 5-4 vote this week sweeping away virtually all restrictions on corporate giving to political campaigns, they’re likely to be out in force to get what they want.

It’s possible, however, that Republicans will see Scott Brown’s victory as a mandate to oppose any health care legislation. Meanwhile, Pelosi’s comments about the Senate bill may signal a new strategy to propose more populist legislation they know won’t pass but will re-energize supporters.

Either way, the environment looks better for health care companies, at least for the coming year. For income investors, that means it’s time to take another look at major pharmaceutical companies that pay high and rising dividends, such as GlaxoSmithKline (NYSE: GSK).

Even before the Brown election, carbon dioxide (CO2) regulation was facing steep hurdles in the US Senate, not the least of which was a stark lack of bipartisanship. The conventional wisdom now is that the entire issue is dead.

That may indeed be true of the cap-and-trade system proposed in the legislation passing the House. In fact, though chief Senate proponents Joe Lieberman (I-CT) and John Kerry (D-MA) are still pushing, several high-ranking Democrats in both houses have now expressed support for dropping it.

CO2 regulation, however, is still coming, via new rules now being devised by the US Environmental Protection Agency (EPA). This was put in motion last year by the EPA’s decision to declare CO2 as potentially hazardous and therefore within its purview to regulate. As a result, without Congressional action to set rules, companies across a whole range of industries will find themselves facing new regulations this year--rules they’ll have little or no influence in setting.

It’s this last point that may in the end save some form of cap-and-trade. As far as investors are concerned, the Brown election means two things. First, any legislation that does pass will contain many more carrots than sticks; it will be focused on increasing incentives to use more low- and no-CO2 energy rather than on punishing use of high-CO2 energy.

The Obama administration has already been quite generous with regard to incentives to boost renewable energy production and technology to conserve energy, namely the “smart grid” initiative. Resurgent Republicans in Congress are now likely to push hard to extend the initiatives to boost production of natural gas as well as nuclear energy.

A new energy bill may or may not include an overall renewable energy standard to be applied nationwide. But expanding support for low-CO2 energy will, at a minimum, compliment the renewable and alternative energy portfolio standards that have been enacted in 36 states and the District of Columbia.

That means more spending on utility infrastructure, boosting rate bases and profits. It also means more business for owners and operators of a wide range of assets, from wind farms to natural gas pipelines, which also adds up continued robust growth in profits and dividends.

Of course, utilities’ ability to profit from infrastructure investment depends on continued regulatory cooperation. That’s never been a given and never will be, particularly when high unemployment has made the public restive. Ongoing utility bashing in Florida is a stark reminder of the risk of regulatory reversals that can literally occur anywhere.

The good news is utility-regulator relations in virtually every other state still appear to be in a cooperative mode. That includes Michigan, where unemployment is the highest in the nation at 14.6 percent. This week, for example, regulators in South Carolina approved a substantial rate increase for Duke Energy (NYSE: DUK), part of a compromise that combined with lower fuel rates will actually cut customers’ energy costs.

The bottom line: Infrastructure investment is still being converted into solid investor returns, and that’s bullish for utilities.

The biggest beneficiaries of the Scott victory’s impact on CO2 regulation are the big coal burning utilities such as Southern Company (NYSE: SO). These companies are still moving in the direction of reducing CO2 emissions, as Entergy Corp’s (NYSE: ETR) purchase of 100,000 metric tons of greenhouse gas offsets this week demonstrates.

And these companies are clearly mindful of what new EPA regulations could mean. But it’s nearly certain now they’ll have plenty of time to react to changes in a way that helps not hurts shareholders. That, too, is very bullish.

Passage of a new natural gas act would no doubt be bullish for both producers and owners of infrastructure such as pipelines. But infrastructure owners organized as master limited partnerships (MLP) benefited in one other way from the Scott win. It’s now far less likely we’ll see any legislation that eliminates or curtails the tax advantages that underlie their market value.

These are basically the ability to flow-through income directly to the investor without corporate taxation. The result is the ability to pay out a much higher percentage of operating cash flow than corporations can, producing a higher dividend yield for investors. And, because expenses also flow through, these distributions are mostly considered return of capital (RoC) rather than current income.

RoC isn’t taxed in the year received but rather is subtracted from an investor’s cost basis when paid. As a result, no one pays taxes on it until they sell the MLP, when it’s taxed as a capital gain. In addition, if you will MLPs to your heirs, the cost basis automatically changes to the current price, effectively eliminating the tax burden. The result is basically high yields with little or no taxes.

MLPs’ advantages will become even more compelling if Scott’s victory leads to gridlock on another issue of key concern to income investors: extending the preferential tax rates for common stock dividends.

Changing MLP’s tax advantages--which basically allow investors to postpone paying taxes on distributions indefinitely--would require an act of legislation that will be easy to block. Unfortunately, extending the top tax rate of 15 percent on dividends and capital gains past its 2010 sunset will also require legislation, and there’s no guarantee Washington is either willing or able to make it happen.

On the one hand, it’s hard to imagine a newly installed Senator Brown opposing extending preferential tax rates for investors. Tax rates are usually included in budgets and therefore require only simple majorities in both Houses to pass. And the president is on record as in favor of making preferential rates permanent, albeit with the tradeoff of raising the top rate to 20 percent.

On the other hand, it’s also easy to see this issue getting sidetracked, which is all it would take to kill it. And unless something does happen, the top rate on dividends will revert to nearly 40 percent, where it was before 2003.

This clear and present danger is why I strongly urge readers to contact as well as their representatives in Congress. Should the preferential rate not be extended, however, MLPs’ ability to defer taxes will become all the more important and valuable for investors. All else equal, that means rising unit prices. And that’s a very good reason to hold a portfolio of MLPs backed by good businesses, even after their recent run.

Not extending the preferential dividend tax rate is also likely to make IRAs and Roth IRAs more attractive as places to hold high-yielding stocks. That includes Canadian stocks and income trusts, the vast majority of which will convert to corporations later this year. Under the latest iteration of the US-Canada tax treaty, IRA accounts are exempt from the 15 percent Canadian withholding rate.

Ironically, one group that would be less attractive for holding in IRAs will be MLPs. Investors effectively forfeit the RoC advantage, and they’ll be taxed at their regular rate as they withdraw funds.

One final caveat: Just as it’s self-destructive to let your political beliefs interfere with your investments, it’s extremely dangerous to put your money down now on where it looks the US is heading politically. To be sure, at this juncture the stars seem to be aligning for a big Republican victory in the upcoming November elections. That may include a sweep of major governorships up for election and a recapture of the US Congress.

On the other hand, November is more than nine months off, a time frame that’s literally become an eternity in American politics. How many in January 2008, for example, thought Barrack Obama would be elected president barely nine months later? Conversely, how many in January 2009 would have imagined a Republican victory in a critical election in deep-blue Massachusetts?

By the time November 2010 rolls around, we may be looking at a vastly improved employment picture or some other development that will yet again drastically alter the nation’s political mood one way or the other.

As of now, however, it looks like selected big pharma companies, power utilities and energy infrastructure MLPs are in the sweet spot. As investors, that’s where our focus needs to be.

Disclosure: No positions