3 Themes That Utility Investors Should Pay Attention To Going Into 2013

Includes: AAPL, AVA, POM, T, TMUS, VZ
by: Roger S. Conrad

Utilities weren't always paragons of strength, as anyone who remembers the implosion of Enron 11 years ago can attest. And it's a safe bet some companies will get tripped up by inadequate planning for capital needs and/or deteriorating regulatory relations in 2013. Below, I highlight three themes that could help you with your utility investment decisions going into 2013.

#1 Don't Fret Rising Interest Rates
Wall Street wisdom holds that utilities and other dividend-paying stocks are interest-rate sensitive. As a result, many fear a meltdown when today's historically low rates turn higher.

Ironically, the so-called link between benchmark interest rates and dividend-paying stocks is basically non-existent. From June 30, 2008, to March 9, 2009, the Dow Jones Utility Average crashed from above 500 to less than 300.

Bonds, however, had one of their most explosive rallies in history, with the yield on the benchmark 10-year Treasury note falling from 4 percent to barely 2 percent.

Treasuries and dividend-paying stocks also moved in opposite directions during the Flash Crash of mid-2010, the Debt Ceiling Crisis of summer 2011 and this year's spring growth scare.

Market relationships are constantly being forged and torn asunder. But dividend-paying stocks have been moving independent and opposite of shifts in interest rates for some time. And there's no reason to expect they won't keep acting like stocks rather than bond substitutes going forward.

They're economically sensitive, not rate sensitive.

#2 Dominance of AT&T and Verizon Will Persist

Last month Deutsche Telekom AG (OTCQX:DTEGF) [Germany: DTE] announced its T-Mobile USA unit would buy MetroPCS Communications Inc (NYSE: PCS). A consummated deal would create an entity with 42.5 million subscribers and about 12 percent of the US wireless market.

Barely a week later SoftBank Corp (OTCPK:SFTBF) [Japan: 9984] agreed to buy 70 percent of Sprint Nextel Corp (NYE: S), vowing to revive America's third-largest wireless company.

Some have hailed these deals as game-changers for the U.S. wireless industry, "disrupting" the emerging duopoly of AT&T Inc (NYSE: T) and Verizon Communications Inc (NYSE: VZ).

Reality is likely to prove less than spectacular.

SoftBank is providing badly needed cash to Sprint and has experience competing against larger companies in its native Japan. But the $8 billion it will eventually push to Sprint may not go that far considering the latter's $23.7 billion debt and a $15.5 billion obligation to buy iPhones from Apple Inc (NSDQ: AAPL).

Moreover, Sprint is still losing ground rapidly, shedding 459,000 contract customers during the third quarter. That's its first drop in subscribers since early 2010. And many of those users no doubt left for Verizon, which reported a gain of 1.5 million of such valuable connections. The company's loss was less than expected, but only because it cut spending and sold fewer iPhones.

The Federal Communications Commission (FCC) is likely to approve both deals next year. And T-Mobile USA particularly could see an immediate benefit, as it becomes a force in the lower-end pre-paid wireless market.

Those expecting an immediate sector shakeup are likely to be disappointed, particularly in light of third-quarter numbers showing AT&T and Verizon widening their lead in users and network quality.

That's good reason to continue steering clear of Sprint and Deutsche Telekom until today's hype is matched by deeds.

#3 Watch out For Hawkish Regulators

One trend likely to continue in some states, post-election, is the ongoing reduction in utility return on equity (ROE).

ROE is supposed to set rates to allow a fair return on investment in light of companies' cost of capital. And given the drop in borrowing rates to historic lows, there's some justification for reducing ROEs in the current environment.

Inevitably, however, some states are using ROEs as a tool to keep rates low in a soft economy without having to officially disallow investment. The immediate result is lower earnings and, eventually, diminished reliability and ability to invest.

Washington State-based electric and gas company Avista Corp (NYSE: AVA), for example, recently reached a settlement of its rate case with an ROE of just 9.8 percent. That's against an initial request for 10.9 percent.

Worse, Pepco Holdings Inc's (NYSE: POM) widely panned performance during last summer's outages earned it the unenviable moniker of "most hated company in America" in a recent survey. That unpopularity is now hitting the bottom line.

Last month District of Columbia regulators cut the company's ROE to just 9.5 percent. Settlements in Delaware, and New Jersey, would reduce ROE to just 9.75 percent, lower if regulators reject them.

Finally, Maryland regulators cut ROE to just 9.31 percent this summer, a number they could take even lower in an ongoing rate case, even as they impose punitive action for summer storm performance.

Fortunately, most utilities aren't nearly so vulnerable. Regulatory relations are still solid in most states, including some, such as Nevada, still smarting from high unemployment. Meanwhile, companies operating in less-hospitable states such as Connecticut, and New York, are limiting risk by avoiding rate cases for now.

Lower ROEs are a sobering reminder of how important a positive regulator-utility relationship is to shareholder returns.

Pepco's setbacks are a good reason to avoid its shares, and stay away from those of any other company that runs afoul of those who set its rates. For 6 more utility stocks to avoid, see my Income Investor's Blacklist.

Disclosure: I am long VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.