Roger S. Conrad's  Instablog

Letting your politics dictate your investments is a terrible “strategy”--just ask the Obama-haters who stayed out of the stock market last year or the Bush-haters who avoided the bull market of 2003-07.

On the other hand, Washington doles out trillions of dollars every year. And when there’s that much money floating around, it pays to know where it’s going, and who’s likely to get their hands on it.

Even the most popular president won’t get everything in the annual budget submitted to Congress. Last year President Obama was denied several key items, both on taxes and spending. This year, the president isn’t nearly as popular and will get even less of what he wants. But his proposals touch virtually every industry in America. And budgets only require a majority vote--filibusters aren’t a threat. Accordingly, Democrats are likely to push most of Obama’s spending measures through, though all bets are off for taxes in an election year.

Where the Democrats put the nation’s money was important in 2009, a year when the government’s stimulus efforts played a big role in the economy’s recovery. And, like it or not, the government will have a big hand in the domestic economy this year. That’s why I combed through the president’s budget at www.whitehouse.gov/omb/, with a particular eye on what appears to be his favorite industry--energy.

The yawning federal budget deficits of the Bush years have expanded under Obama. There are plenty of candidates for blame, including the recession, mushrooming entitlements, the cost of fighting two wars, faulty projections by the Bush administration unemployment under 5 percent and interest costs that rise with every dollar borrowed.

Needless to say, Uncle Sam’s discretionary spending has shrunk markedly; only a handful of departments have actually seen their own budgets grow. Among the winners is the Dept of Energy, which picked up 7 percent more money on top of last year’s gains.

The president’s plans for cap-and-trade legislation to regulate carbon dioxide (CO2) emissions passed the US House of Representatives many months ago. However, it remains hung up in the US Senate, where there were enough votes to filibuster even before Republican Scott Brown won the seat held by Ted Kennedy.

Unwillingness to sponsor anything resembling a tax in an election year is probably the biggest reason the Senate remains gridlocked. Controlling CO2 has always been a regional issue. The coal-burning states of the Midwest, Rocky Mountains and Southeast oppose such restrictions, the Northeast and far West--where relatively little coal is used—are usually the primary proponents.

Ironically, CO2 is also a profoundly bipartisan issue. Proponents of regulation range from Senator John Kerry (D-MA) to Senator Lindsey Graham (R-SC), who has recently kept the issue alive by reframing it as pro-energy security. Opponents and skeptics range from Agriculture Chairwoman Blanche Lincoln (D-Ark.) and Budget Chairman Kent Conrad (D-ND) to Senators Byron Dorgan (D-ND) and Judd Gregg (R-NH).

For the past several years, opponents of CO2 regulation have been on the defensive, as study after study has confirmed that man-made emissions are changing the atmosphere and hence the climate. The past several months, however, it’s been the proponents defending their positions.

First were the pirated email chains that suggested some scientists were silencing others. Then the 2007 report from the United Nations Intergovernmental Panel on Climate Change--which won a Nobel Prize--came under attack for faulty sourcing, typos on key dates and other errors.

Few intelligent people give any credence to the argument that record snowstorms hitting the East Coast the past week refute climate change science. But added to everything else, they’re just one more reason why senators are going to be reluctant to do anything on CO2 this year. And that’s why even President Obama himself is talking openly about scrapping a cap-and-trade program for a bill with incentives for alternative energy--in other words, all carrots and few if any sticks.

There’s still a chance the Environmental Protection Agency will impose strict new limits on CO2 emissions, now that it’s claimed jurisdiction over them as “hazardous” to human health. Anything with real teeth, however, is likely to be challenged fiercely in the courts and alienate supporters in Congress.

Accordingly, many have pronounced the alternative energy industry boom over. That’s a mistake for two big reasons.

First, 36 states and the District of Columbia have mandates in place for utilities to use renewable energy, and most call for at least a five-fold increase in output over the next 10 to 15 years. Utilities are building and buying capacity to meet those mandates, and the dollars are flowing.

The second reason is the US Dept of Energy budget and its implications. The $28.354 billion proposed in discretionary budget authority includes massive funding for research and development for everything from renewable energy and smart grid technologies to nuclear power.

Nuclear power spending includes finding an alternative to storing waste at Yucca Mountain, NV and other permanent locations. The budget deems the Yucca site “not a workable option,” doubtless at the behest of Senate Majority Leader Harry Reid (D-NV). There’s also room to authorize an additional $36 billion in guaranteed loan volume for advanced nuclear reactors, bringing the total allocated to $54.5 billion.

Such lavish support for nuclear energy is a clear sign of the prominence of Energy Secretary Stephen Chu within the administration. Fierce “NIMBY” (not in my backyard) opposition to greenfield nuclear power plants and unpredictable regulators are still strong disincentives for power producers to build new nuclear plants. But the loan guarantees do remove a major hurdle to construction for new reactors built at existing plant sites--where support is ironically strong--in regions like the Southeast.

Renewable energy is another major winner in the Obama budget, and competition for these dollars will be fierce. Some small companies will win big by snaring a contract or two, but many will fail and vanish. Larger players have the best chance to win deals, but a contract will also have considerably less impact on the bottom line.

The good news for investors is that renewable and nuclear energy companies are no longer in favor--inaction in Senate has obscured the federal budget and state-level developments. If American Superconductor’s (NSDQ: AMSC) fourth-quarter results are any guide--the firm’s revenues doubled--the dollars are still flowing. Only perception has changed, and that’s always fleeting. Follow the money.

Roger Conrad is chief strategist of Portfolio 2020 and editor of Utility Forecaster.

It’s Always Sunny in San Diego

Want to know more about how to profit from tomorrow's growth trends? Join Roger Conrad in sunny San Diego, California, April 23-24 for the 2010 Wealth Society Member Summit. You’ll have a chance to sit down with Roger one-on-one to talk about where to find the best ideas to generate total returns and how to position your portfolio for the year ahead.

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FirstEnergy Corp (NYSE: FE) and Allegheny Energy (NYSE: AYE) have announced the power industry’s biggest merger in years. The immediate winners of the $8.5 billion deal are shareholders of Allegheny, who received a premium of 32 percent to the company’s pre-announcement share price.

The deal is all in stock, with each share of Allegheny fetching 0.667 shares of FirstEnergy. The ultimate value of that offer will depend on what happens to FirstEnergy shares over the projected 12 to 14 months needed to win regulatory approval and close. That will require the OK from regulators in seven states as well as the Federal Energy Regulatory Commission (FERC) and the US Dept of Justice (DoJ).

As in every utility industry merger before it, however, the real value of this transaction is long term in nature. Not once in the century-plus history of this sector has a merger failed to eventually create value, mainly by adding scale in an industry where it’s paramount.

Larger utilities reach more people to spread over the inevitable capital costs. They command more attention in the capital markets, enabling them to raise cash more easily to spend on growth. They’re financially better able to withstand negative weather events. And they have more market power when it comes to dealing with vendors and purchasing raw materials and energy.

Not one merger between regulated power companies has ever failed, even when they involved utes that were very weak. The foundation of FirstEnergy itself by the union of nearly bankrupt Centerior Energy and Ohio Edison is a good case in point.

When it occurred back in the 1990s, I termed it a “mindless” merger, weakening an otherwise strong Ohio Edison with a company (Centerior) with a well-deserved reputation for failure. Negligence at a power line owned by Centerior, for example, was eventually blamed for a 2003 power outage that blacked out virtually the entire Northeast US and huge chunks of the Midwest. Centerior’s nuclear plants were also chronic underperformers and even a safety risk.

FirstEnergy’s move to join forces with Allegheny will make a considerably stronger combination. The new company will have 24,000 megawatts (MW) of generating capacity, 21,000 of which will be sold into unregulated wholesale markets. Allegheny’s low-cost newer coal plants will vastly upgrade the quality of FirstEnergy’s fleet. The company will also run 10 regulated utilities in seven states providing mostly transmission and distribution services.

The merger should have little impact on either company’s cost of capital in the near term. Meanwhile, the considerable synergies and potential savings of this deal should strengthen the combination’s balance sheet over the longer haul.

As a result, it should be that much more successful that much faster and deserves a “yes” vote for shareholders of both, though predictably shares of the acquirer have slipped while target Allegheny’s have rallied since the deal was announced. And with Allegheny shares still well below takeover value, there’s little risk to holding on if the merger should fail.

The Big Picture

Neither Allegheny nor FirstEnergy are Portfolio holdings in Utility Forecaster as yet. That’s why I’m even more interested in the implications of this deal for other power utility companies, both regarding the prospects for future sector mergers and regulation in general.

Even before the financial crisis hit, sector merger activity was slowing down dramatically from its mid-decade peak. This was in part due to tightening credit conditions, but also to the fact that regulators in more than a few states were becoming more skeptical of the value of these deals.

FPL Group’s (NYSE: FPL) attempt to join forces with Constellation Energy Group (NYSE: CEG) was basically shot down by the Democratic-controlled Maryland legislature. The leadership of that body used the deal as an opportunity to bash utilities and score points against an increasingly unpopular Republican governor.

Exelon Corp’s (NYSE: EXC) attempt to buy out Public Service Enterprise Group (NYSE: PEG), meanwhile, was flunked by New Jersey regulators on the basis that it could hurt ratepayers. That’s despite the fact that the Garden State has lately had very positive utility-regulator relations.

Exelon’s takeover offer for independent power producer NRG Energy (NYSE: NRG) didn’t face that kind of hurdle because of the latter’s lack of regulated operations. But it, too, failed, as NRG’s management fought very hard to remain independent and wound up convincing a majority of big shareholders it was better off that way.

As major producers of electricity from coal plants--and therefore huge emitters of carbon dioxide (CO₂)--FirstEnergy and Allegheny stood to be losers if cap-and-trade legislation had passed the US Senate. With such legislation looking considerably less likely to be able to garner needed votes in the upper chamber, neither company faces that kind of threat to its bottom line. Rather, the Obama administration is trying to accomplish its climate change goals by subsidizing cleaner energy and measures to enhance power grid efficiency.

FirstEnergy’s coal plants, however, are considerably older and less efficient than Allegheny’s. As a result, this deal will help it to clean up its overall fleet and realize the benefits of producing from what’s still a relatively low-cost way to produce electricity, i.e. from coal. That and considerable possibility to realize cost savings are the primary drivers of this deal. And, as the economy regains it balance, they’ll benefit from revived demand for power as well.

That’s a compelling indication economics that may spur other utility mergers in the coming months. Companies like Duke Energy (NYSE: DUK) and others have made no bones about their desire to build further scale. And there’s no shortage of potential targets.

Whether this or any other deal succeeds or fails, however, will depend on how regulators, customers, credit raters and investors view them. And on that basis, FirstEnergy-Allegheny is more than just one deal. It’s a litmus test for whether utility mergers can succeed in a regulatory environment that remains generally positive in the US, though it is challenged by economic-weakness-fueled populism.

For starters, the merger will have to pass muster in seven states. Three are considered to be extremely positive climates, namely New Jersey, Pennsylvania and Virginia. Pennsylvania regulators, however, may take a hard look at this deal because it would create the state’s biggest utility, with 2 million-plus customers.

Ohio--FirstEnergy’s original state--is also a fairly good jurisdiction in which to do business. But those involved in the process are already saying officials could take a harder line on this deal. The other three states--Maryland, New York and West Virginia--have proven problematic recently.

According to some reports FirstEnergy won’t need New York regulators to officially sign off on the deal. But the staff of the New York State Public Service Commission has been increasingly belligerent toward the state’s utilities in recent months, advising recently that Entergy Corp’s (NYSE: ETR) planned spinoff of its unregulated nuclear plants as Enexus is “not in the public interest.”

That’s just the latest example of erratic regulation in the Empire State in recent years. The pending gubernatorial election could improve things before the Commission rules on FirstEnergy-Allegheny, depending on the outcome. But that’s largely an unknown factor now.

Perhaps the biggest unknown on the regulatory front is the Obama administration’s willingness to allow power industry consolidation. To date, there’s been relatively little obvious change in FERC policy versus during the Bush administration, just as there wasn’t much between the Bush and Clinton years. Rather, the FERC has traditionally been apolitical and nonpartisan, a policy that’s promoted sector investment, particularly in transmission.

On the other hand, recent comments by FERC Chairman and Obama appointee Jon Wellinghof have sounded like those of a man striving to make his mark on the industry, whether needed or not. A high profile merger approval proceeding like FirstEnergy-Allegheny could be just the venue for him to try his luck.

That could mean forcing the companies to weigh accepting some onerous regulation--he’s known to be a proponent of using regulation to promote so-called competition--or to simply walk away from their deal. The same holds with the DoJ, where Obama appointees have yet to show their real intentions.

In my view, this is not the kind of case where I want to predict what’s going to happen. And in any case, both FirstEnergy and Allegheny are capable of surviving on their own, as they proved during the recession/credit crisis. But this is our best opportunity to see if utility merger activity is going to resume in coming years as the US economy recovers.

It will also provide the first real evidence of who’s calling the shots on utility regulation in the Obama administration, i.e. whether or not it’s someone who’s proven to be pro-investment, such as Energy Secretary Stephen Chu. It will also be yet another indication of how state regulation is being affected by still high unemployment, and whether the era of good feelings in the past decade will endure.

These merger proceedings are likely to be frustrating for investors in Allegheny and FirstEnergy, for the time needed to complete them alone. But it’s a critical opportunity to determine what kind of regulatory climate we’re going to face in the next few years.

Will regulators and utilities continue to cooperate as they’ve done now around the country for nearly 10 years, or has that era now given way to a new where utility-bashing is again in vogue? There’s literally no more important question for any investors in utility stocks.

Simply, if regulators are still cooperative there will be record capital spending in coming years on new plants, transmission and networks. That will flow through to investors in the form of higher earnings, dividends and share prices as companies earn a fair return on what’s spent.

If regulators are going back to the bad old days of the ’70s we’re headed for a period of hostility, where companies will spend less and be granted still less of a return by regulators. That won’t help anyone--customers or investors. But it’s the kind of thing that happens when politicians are desperate, as they are now. Buyer, be careful.

Question of the Week

Here’s a question I’ve received frequently from subscribers recently. For an answer to your question, drop us a line at utilityandincome@kci-com.com.

• I’ve owned several Florida utilities for many years and have made good money with them. All of them have fallen in the wake of the FPL and Progress Energy (NYSE: PGN) rate cases, but I still have substantial capital gains, and I hate to sell stocks that have been so good to me over the years. Do you still advise selling Florida utilities?

Absolutely. As long-time readers know, I’m not a fan of frequent portfolio turnover, particularly for those living off their investments. Sometimes you may lock in a gain that would otherwise unwind a bit. But income investors who trade always wind up losing income, paying higher taxes and forfeiting the biggest advantage of yield-paying stocks backed by a strong underlying business: rising dividends and their upward effect on share prices.

On the other hand, there are two times when it does make sense to sell a dividend-paying stock. First, if a company truly outruns its prospects, it often makes sense to lighten up on it. One idea is to sell half of any stock that doubles in value, effectively taking a ride on the rest. I really don’t have any iron clad rule.

But I do strongly advise lightening up on any stock that becomes too large a part of your portfolio on its own and therefore a threat to your net worth should something unexpectedly go wrong. “Balance and conquer” is the only way to really protect yourself from this risk, and that means being willing to rebalance holdings, even if you have to pay some additional taxes.

The second reason I sell is even more important: when there’s a threat to the underlying business that can undermine a company’s ability to grow, its balance sheet and ultimately its dividend. Not everything that weakens eventually cracks, even in a very tough environment such as the one of the past couple years. But those that do crack are guaranteed to cause a lot of pain for investors.

It’s one thing to stick with a stock in a bad market, provided its underlying business is still holding up. That was in fact the single best thing many investors did in late 2008 and early 2009 when the sky seemed to be falling. The companies that held their own as businesses not only didn’t crack, but many are back near--and in some cases are above--the levels they held before the crash.

On the other hand, digging in your heels when there are real signs of business weakness is almost always the absolute worst thing you can do. The two biggest Florida utilities, FPL and Progress Energy, turned in basically solid fourth-quarter and full-year 2009 earnings. Both still have healthy balance sheets, well-run power plants and service territories with long-term histories of stability.

Unfortunately, the single biggest factor that will determine their future financial health has now turned decisively negative: Florida regulation. The biggest blow so far was, of course, the Public Service Commission of the State of Florida’s (PSC) decision to almost completely disallow requested rate hikes at the two companies. But there are signs things could get much, much worse.

For one thing, Florida statutes allowing utilities to recover capital costs when work is in progress are now under attack in the courts from so-called advocates of the consumer. That’s a major underpinning of support for these companies, whose capital costs serving an area of volatile weather are expected to be staggering in coming years.

FPL’s NextEra Energy unit has been a major profit center for the company. But it’s now accused by “whistleblowers” of using Florida ratepayers to subsidize NextEra’s growth. And with the company cancelling $10 billion in planned utility capital spending in the wake of the rate case, the heat could be turned up a lot more.

Investors need to keep in mind that professionals are no longer running the Florida PSC. Rather, Governor--and US Senate candidate--Charlie Crist has replaced one of the best commissions in the nation with a group of novices whose only qualification seems to be they promised not to raise customer rates. A new Florida governor next year may yet turn things around. But with the state’s unemployment rate still very high, it’s going to take an extraordinary politician to argue the merits of reliable regulation. And history shows us that when good regulation turns bad, it’s better to get out.

The good news is there’s still time to do that. Despite their troubles with Florida regulators, FPL and Progress do continue to enjoy solid support on Wall Street analysts. That likely explains why neither stock has fallen much in the wake of what is shockingly bad news. But that won’t last forever, particularly if the bad news starts to mount.

You’ll have to pay taxes on your gains if you sell, for example, FPL. On the other hand, even the highest-rate taxpayer will pay Uncle Sam only 15 cents per dollar of profit. Put another way, not selling just because you want to save that 15 cents will cost you 85 cents in post-tax profit. And if regulators really go after these companies, they could fall a long way from here.

Race to the Summit

How best to ride this market? Join me and my colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado for the 2010 Wealth Society Member Summit.

You’ll have the extraordinary opportunity to meet one-on-one with me, Elliott Gue, Yiannis Mostrous, Benjamin Shepherd and GS Early and ask anything you want about how to keep and grow your nest egg.

We’ll give it to you straight: the brightest trends and our best recommendations, and anything else you might want to know about how to profit in 2010 and beyond.

Space and time limit us to 100 participants, so mark the date on your calendar: April 23-24, 2010, in San Diego, where they say it’s 72 and sunny every day of the year. You may find all details at www.InvestingSummit.com. Better yet, call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table.