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Earnings Season


Blame it on Sarbanes-Oxley and subsequent populist-inspired attempts by Washington to protect investors from Wall Street fraud: Year-end filing has become so regulation-driven that fourth-quarter earnings reporting season lasts literally the entire first quarter.

As of late February fully one-third of the 216 companies tracked in Utility Forecaster have yet to release numbers. At least half won’t until sometime in March, with the last filing on the 30th.

Until a company does report, all we can do is infer the health of its underlying businesses based on other data and developments. Nothing sends a positive signal like a robust dividend increase. And a significant debt refinancing at a good rate, a credit-rating boost, an acquisition announcement, or even a rally in a company’s bonds can all be signs of good things to come.

But only the hard data will set all concerns to rest--and in at least some cases we’re going to have to wait a while to get it.

The good news is we do have enough data to draw some broad conclusions about the health of essential-service industries in general and where they fit into an income investing strategy here in February 2010.

Note Utility Forecaster has the details on individual companies, while Portfolio companies reporting this week are reviewed below for subscribers. Here are the highlights.

  • Dividends and balance sheets remain well protected.

Of the roughly 150 US electric, natural gas and energy infrastructure companies tracked in UF, only five have cut dividends since the market peaked in mid-2007. That’s in part because these companies provide essential services, demand for which never fluctuates much.

But it’s also because of the systematic de-leveraging and cutting of operating risk in these sectors since the 2001-02 bear market. In fact, the dividend-cutters were all companies that were still levered up and participating in non-regulated businesses.

The best news about fourth-quarter earnings thus far is that dividends and balance sheets remain well protected industry-wide. The typical power utility now has a payout ratio between 50 and 60 percent, with 90 percent or better of its earnings coming from either regulated operations or long-term contracts with locked-in revenue.

As for balance sheets, interest costs have dropped markedly over the past year, and companies have pushed out debt maturities, eliminating near-term refinancing risk.

With very few exceptions, utility dividends are as safe as they’ve been in many years. That’s further demonstrated by the fact that 90 percent of the regulated companies I cover have boosted distributions at least once in the past 12 months. And while credit raters are skeptical as ever--often wrong-headedly so--companies’ borrowing costs continue to decline, pointing the way toward even stronger balance sheets and a low cost of capital to fund future expansion.

  • Cost-cutting, not revenue growth, is still driving the bottom line.

A handful of reporting companies posted fourth-quarter 2009 revenue above last year’s. This group includes wireless communications giants like AT&T (NYSE: T) and Verizon Communications (NYSE: VZ), who continue to add new customers at their rivals’ expense and sell more data services through the proliferation of smart phones.

Verizon’s wireless data sales surged 45.9 percent, continuing a string of similarly robust growth in recent quarters. On the other hand, Verizon’s overall revenue growth was only about 10 percent, as its wireline business continued to feel the effects of the recession.

In the power sector, the slump in the industrial sector was again a heavy drag on results, with most companies posting year-over-year declines in the double-digits. That was especially true in what was once America’s industrial heartland of the Midwest and Northeast. But recovery is even sluggish in the Southeast, the region where heavy industry is increasingly moving thanks to better infrastructure, lower-cost labor and more favorable regulation.

Southern Company (NYSE: SO) noted a dip in industrial sales from the third to the fourth quarter. And only Entergy Corp (NYSE: ETR) posted a significant year-over-year increase in industrial sales, realizing 7.1 percent growth.

Looking out over the next several years, Entergy, Southern and others will see a mighty boost in sales from industrial users. For now, however, that’s hurting, not helping, revenue growth. And that means power companies beat Wall Street expectations during the quarter mainly on the strength of cost cutting, whether from greater efficiency in power plant and transmission operations, debt reduction or the old fashioned way with layoffs.

The one essential-service sector that appears to have a sustainable revenue growth model for 2010 is midstream energy. These companies are using their record-low cost of capital to build and acquire assets such as energy pipelines, storage facilities and processing centers at an unprecedented pace. These assets immediately add to revenue and cash flow, which flow through to distributions, particularly if companies are organized as master limited partnerships.

Here too, however, maintaining that revenue growth in 2010 and beyond will depend on the economy getting back on its feet. In the meantime, as is the case with other companies, maintaining efficiency is critical to health.

  • Not all overseas operations are helping earnings.

Spectra Energy’s (NYSE: SE) midstream energy operations in Western Canada provided a big lift to its fourth quarter 2009 earnings thanks to better gathering and processing revenues, but also because of the jump in the Canadian dollar’s exchange value versus the US dollar.

Companies with operations in Asia and parts of Latin America benefited from reviving economic growth in those countries as well. In contrast, the recent drop in the euro and the Continent’s slumping economies have hurt US companies invested there. This dichotomy is likely to continue well into 2010.

Note that companies like Enel (OTC: ENLAY, ESOCF) and Telefonica (NYSE: TEF) are based in Europe and priced in euros but have extensive operations in Latin America and Asia that continue to drive growth. Any selling by association to Europe is a buying opportunity.

Telefonica  is teaming up with China to spur growth, both through a growing interest (currently 8.37 percent) in China Unicom (NYSE: CHU)--the country’s No. 2 operator--and via an alliance inked this week with major Chinese equipment maker ZTE Corp (Hong Kong: 0763, OTC: ZTCOF) to sell handsets in Latin America.

  • Capital spending is still a positive for earnings.

The utility formula for growth is to buy or build revenue-generating infrastructure and earn a return on the investment. If the return is fair, it will boost revenue, earnings, dividends and, ultimately, share prices. If it’s not, earnings, dividends, share prices and even solvency may be at risk.

The linchpin is regulation. Since the bottom in late 2002--when some two dozen utilities were either in Chapter 11 or on the brink of it--regulators and companies have generally worked together to ensure capital investment is rewarded in a way that doesn’t lead to rate spikes.

This regulatory compact continues to hold in every state but one, Florida, where Governor Crist took up utility-bashing in a desperate attempt to shore up his apparently fading chances of reaching the US Senate. As a result, capital investment continued to add to bottom lines of most regulated power companies in the fourth quarter of 2009.

Looking ahead to 2010, most utilities have throttled back rate increases until the economy gets a bit stronger. As a result, capital spending will likely have less of an impact on earnings this year than it did in 2009 for most regulated businesses.

In contrast, capital spending in what are mostly unregulated businesses, like wireless communications and midstream energy infrastructure, should continue to flow to the bottom line.

  • Commodity-related businesses are showing signs of rebound.

Year-over-year comparisons for energy producers--and unregulated power producers--were generally unfavorable in the fourth quarter. That was even true of companies that ramped up their output last year.

Meanwhile, businesses with exposure to commodity prices have also found their credit ratings increasingly under attack. Credit raters have taken an exceptionally gloomy view of where energy prices are headed and are imputing much lower returns for 2010. Ironically--but not too surprisingly given raters’ record of perpetually fighting the last war rather than preparing for the next one--commodity-related businesses are showing distinct signs of a rebound.

Weak industrial sales and still-low natural gas prices will continue to weigh on electricity prices in the spot market at least in early 2010. But energy prices are well off last year’s lows, and oil and gas producers are reporting sequential profit gains. Power markets are supported by the fact that long-term contracts now account for the majority of sales, as well as demand for renewable energy that’s now mandated by 36 states and the District of Columbia.

Even if carbon dioxide regulation doesn’t happen in this country, the old baseload coal plants are wearing out and in dire need of replacement. Both Exelon Corp (NYSE: EXC) and Progress Energy (NYSE: PGN) have announced plans to take a huge amount of old coal capacity offline the next few years rather than upgrade with scrubbers.

Finally, reviving economic growth means more demand for electricity. Recovery still looks like it will be slow. But any company still operating a commodity-related business after the past couple years’ devastation is now battle-hardened and capable of waiting until economic growth revives. That’s a major reason why so many resource companies have issued much higher guidance for 2010 and 2011 than they earned in 2009--and it’s a good reason to stay bullish on these companies.

  • The recovery is not yet bailing out weak companies.

Just as the strong have stayed strong the past two years, the weak economic environment is still battering weak companies. The old adage that if you really need credit you can’t get it certainly holds true still, and operations that slumped in previous quarters did again in the fourth of 2009.

That’s the clear message from perusing earnings of companies like Otter Tail Corp (NSDQ: OTTR), who’s strategy of investing in virtually anything outside its core power production business has backfired, big time, during the recent recession.

Management is still holding the dividend and projecting earnings for 2010 that would cover it. But its operations in plastics, health care and manufacturing are still bleeding red ink, and in December the company was forced to issue six-year debt at the whopping rate of 9 percent to pay off a credit balance. Some operations, such as food ingredient processing, are doing well. But with a payout ratio of 167.6 percent, owning Otter Tail is clearly a bet that the economy will bail you out. And the yield of less than 6 percent is hardly compensation for the risk it won’t.

The clear message is it’s still absolutely critical to unload any investment where the underlying business is weakening. That’s even true for companies that yield a lot more than Otter Tail and therefore compensate better for the risks.

This economy is in far better shape than it was a year ago and, despite challenges in some sectors such as commercial real estate, it will improve as the year goes on. That means companies that have stayed strong the past couple years are less and less likely to stumble. It doesn’t mean, however, we can count on weaklings to make it back. Sell them.

Question of the Week

Here in Northern Virginia we’re still digging out from the recent “snowpocalypse.” As a result, I haven’t been able to get to all my reader correspondence this week. But here’s my answer to a question I’ve encountered more than once over the past week. Send your question to

  • You’ve written that dividends paid by Canadian trusts held in IRA accounts should no longer be subject to the 15 percent withholding tax in Canada. Can you provide any more detail?

The US-Canada tax treaty was last amended in December 2008. Details are available on the Revenue Canada website, as well as from the US Treasury Dept.

Based on a plain-English reading of the relevant passages, Canadian equities held in US IRAs should not be subject to the 15 percent withholding tax as of Feb. 1, 2009. Conversely, Canadian investors who hold US stocks in their tax-deferred retirement accounts are also not subject to the tax.

In our view, US investors are being withheld for three main reasons. First, tax treaties are generally obscure documents. Many brokers and transfer agents we’ve spoken to have been genuinely unaware of these developments and are now acting to make needed changes.

Second, avoiding withholding depends on having the stock or trust registered in the right place. This is also a job for your broker and many are acting to correct the situation now.

Third, the tax treaty applies to Canadian equities held in IRAs. And, despite trusts’ statements to the contrary, some brokerages don’t consider them to be equities. The good news is this problem will go away as soon as trusts convert to corporations, thereby coming under these brokerages’ definition of equities. The bad news is until then dividends will still be withheld at 15 percent.

The biggest problem with this issue is confusion. Fortunately, since we took our first whack at this hornet’s nest, a number of investors have contacted us at Canadian Edge stating they’ve been able to resolve this to their satisfaction just by working with their broker. That remains my strongest advice now.

You may not be able to claw back what’s been withheld in 2009. You may not even get your broker to agree that trusts are equities and shouldn’t be withheld. Some may even refuse at first to exempt Canadian common stocks from withholding. But you won’t get anywhere without at least trying.

For more on this issue, see the weekly compliment to my Canadian Edge advisory, Maple Leaf Memo.

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 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.

Roger Conrad is Editor of Canadian Edge, Utility Forecaster, Chief Strategist of Portfolio2020, and Co-Editor of MLP Profits.

Disclosure: "No Positions"