Roger Conrad`s Utility Forecaster: Follow the Money !!!

Follow the Money: April 25, 2008

$1.5 trillion: That’s what The Brattle Group, an economics/finance consultancy, projects the US electric utility will have to spend through 2030 on vital infrastructure.

That includes a forecast that the 30 percent growth in power demand currently projected by the US Energy Information Administration can be cut by a third on the basis of aggressive energy efficiency programs. But it anticipates massive spending to meet even that, as well as to provide needed upgrades to our country’s aging transmission system and to tackle carbon capture from fossil fuel plants, which still produce nearly three-quarters of US electricity.

Even under those lowered projections, the country will still need at least 150 gigawatts of new and replacement plant capacity through 2030. Brattle anticipates a cost of $560 billion for the new fleet, a large chunk of which should be renewable energy. That’s without changes in carbon policy, which appear almost certain and would cost an additional $200 billion.

It also projects a needed investment of $900 billion for transmission and distribution for a range of purposes. These include connecting new renewable-based power plants to the grid, adapting “smart grid” technologies to enable greater efficiencies and gearing up for a new generation of plug-in hybrid vehicles. Brattle also anticipates an impact from rising raw material and labor costs on overall capital expenditures.

Like many voices in the ongoing environmental/energy debate, The Brattle Group is an advocate as well as a reporter. Its opinion, as is apparent in the study available at www.brattle.com, is that heavy investment in renewable energy and more efficiency along the transmission grid to increase efficiency and limit waste is needed. High-voltage transmission investments are projected to reach $233 billion, while distribution projects come in at $675 billion.

Brattle’s contention is the renewable plants will be far easier to build and site than plants running on conventional fuels such as coal and natural gas. And it believes investment made to limit the need for new generating capacity or negawatts is generally less costly than actual construction, which is subject to delays in the permitting and construction process as well as cost overruns from rising raw material, labor and legal costs. Building negawatts basically means investing in transmission and distribution.

I have no problem with any of the report’s contentions. In fact, interest in negawatts continues to mushroom throughout the industry. One way is through the proliferation of advanced meter technology. The leader here is Itron, which has clients globally and recently won contracts for a major build-out of its systems in California.

“Smart” meters allow utilities to monitor where their power is flowing, which enables them to control waste and interact better with customers in conservation matters. To date, regulators in states where such meters have been proposed have been willing to pony up the rate increases to pay for them, with the idea that the negawatt benefits would pay off in spades. California in particular has been willing to fund major spending projects undertaken by the likes of Edison International utility unit Southern California Edison.

As these projects proliferate nationally, officials’ willingness to fund them—particularly should the US economy take a while to cycle out of its current slump/recession—may be put to the test. For now, however, the capital expenditures are flowing into rate base, boosting earnings and simultaneously reducing future operating risk by expanding negawatts rather than megawatts.

Broadband over powerlines (BPL) is another promising technology for creating negawatts. To date, much of the media focus on BPL has been on its ability to create a rival high-speed broadband network to the telephone and cable companies. Not only is that highly unrealistic and improbable, but it’s served to obscure BPL’s real utility as a means of heightening grid efficiency. In fact, an investment in BPL is likely to be far more profitable for a power company if it stays out of the communications business entirely.

Tiny Ambient Corp is a pure play on BPL. This week, it won a major contract from Duke Energy and received private capital funding of $3 million. With a total market capitalization of barely $10 million, however, it’s as small as the emerging BPL industry itself. If BPL really does take off, the usual suspects in such technology are likely to take over.

Whether sector investment is made to create megawatts or negawatts, The Brattle Group’s report is just more confirmation of the sheer magnitude of the task ahead. Investment will be faster in some areas and slower than others. Politics—including what party holds the White House after inauguration day next January—will play a huge role in where money is spent first and what solutions are discarded.

One thing is clear, however: This investment will have to be made, regardless of whether Democrats or Republicans are pulling the strings. If the US economy is in recession, the government will lead the way. If the economy is booming, it will be private enterprise. Either way, investors who follow the money in these projects will prosper.

Covering the Costs

The opportunity in electric power is staggering by any measure. And based on how things have shaped up in prior cycles, the dollars spent will vastly exceed projections, including The Brattle Group’s, which seem most outrageous now.

For one thing, there’s politics. Few issues are stirring the pot here in early 2008 more than global warming. As I reported here a couple weeks ago, some advocacy groups have taken extreme positions on the issue, such as opposing all new coal and natural gas power plants and going to court to see older ones closed down.

Their actions are no doubt well intentioned. But they’re also certain to add to system costs by delaying or preventing projects that could actually reduce carbon emissions—such as replacing old, inefficient and polluting coal-fired plants with new ones that emit virtually no acid rain, mercury and other pollutants and can later be retrofitted to reduce carbon dioxide (CO2).

Furthermore, insisting that every new plant be built to run on wind or solar is pushing up the price of needed components for this type of facility. That fact is made crystal clear in the robust profit reports of those who make them, such as SunPower and Vestas Wind Systems. Of course, even these companies are being challenged by higher raw material costs and capacity constraints to meet the kind of demand we’re seeing.

Inflation is another key concern. The double-digit inflation of the 1970s was a major reason the last power plant construction cycle wound up costing far more than envisioned. Those cost overruns subsequently led to massive disallowances by regulators, which in turn led to monumental writedowns, dividend cuts and even a handful of bankruptcies.

We can expect the same thing this time around. In fact, regulators in some states are clearly telegraphing they intend to take a very hard line on rate increases, no matter what they’re supposed to pay for.

This week, New Mexico regulators granted a $33 million rate hike to PNM Resources. That was less than half the $76.1 million originally requested. The allowed return on equity of 10.1 percent was equally meager and well below the 10.75 percent requested by the company.

Furthermore, regulators denied the utility’s request that changes in fuel and purchased power costs be automatically reflected in rates, as they are in most of the country—though regulators still plan to hear the utility’s request for an emergency fuel adjustment at a hearing slated for May 15.

The catastrophic plunge in PNM’s share price since early November 2007 is a clear sign of the high stakes involved in this rate case, mainly the extremely negative impact of unrecovered costs on its financial health. It’s also a clear warning for utilities elsewhere of the growing political pressures faced by regulators nationwide and the fact that officials will always be tempted to go for the expedient solution, rather than what makes sense long term.

Consolidated Edison got a similar shock in mid-March, as New York regulators granted only $425 million of its proposed $1.2 billion rate hike. Furthermore, 55 percent of the amount received is subject to refund, pending an investigation of $1.6 billion in utility capital expenditures for 2005-08. Return on equity was set at just 9.1 percent, one of the lowest in the country.

The decision triggered an immediate cut in the company’s credit ratings from Fitch, and Moody’s cut its outlook from stable to negative. Both raters cited the decision as raising doubt about whether or not regulators would support Con Ed’s credit quality, which is critical in view of its anticipated $2 billion a year in needed capital spending for vital system upgrades and conservation.

The New York Public Service Commission, of course, has been rocked by the political uncertainty in the state over the past year, as well as the weakening economy. That situation has likely been made worse by the sudden, ignominious departure of former Gov. Eliot Spitzer and his replacement by a relative unknown.

For example, even with the massive disallowances in this rate decision, state Assemblyman Michael Gianaris (D-Queens) is quoted as calling the increase “profoundly irresponsible.” He went on to call it “the highest rate increase in history” and charged Con Ed is in need of “dramatic reforms” to “fix” its management.

That’s obviously a politically appealing position to take, particularly when the economy is slumping and the price of energy is soaring in all forms. Unfortunately, it doesn’t do a lot to help Con Ed actually do something about the problem, such as massively investing in negawatts as management has proposed. And to the extent the added financial risk prevents or discourages Con Ed from investing the needed dollars, it could well make matters a lot worse.

Self-serving politicians are just part of the equation when it comes to paying for electricity. But they’re sure to become increasingly important going forward, as utilities ramp up capital expenditures in coming years to meet the combined challenges of updating basic infrastructure, meeting new demand with either negawatts or megawatts and complying with environmental regulations, particularly those dealing with regulating CO2.

The bottom line here is simply this: Companies that can recover their increased investment are going to see much higher earnings, dividends and share prices. In short, they’re going to be among the best investments around anywhere, particularly in an environment where companies, consumers and the economy as a whole is squeezed by rising costs for everything from raw materials to money.

On the other hand, companies that are forced to make huge expenditures they can’t recover are in for some rough sledding. They’re going to be absolutely horrendous investments.

In the US utility business, success or failure will boil down to working out a deal with regulators to recover costs and avoid rate shock for consumers. That, in turn, will depend on controlling the cost of capital spending and operating expenses, as well as maintaining good relations with the officials themselves.

The rules of the game will be slightly different when it comes to other infrastructure spending plays. But the basic premise is the same: If a company can earn a return on its investment—be it in bridges, roads, communications networks or water mains—the potential rewards are truly staggering. If, on the other hand, dollars go out but don’t come back in sufficiently, the fall from grace will be destructive in equal measure.

The global tab for infrastructure by 2030 is currently projected at $41 trillion. A lot of that is happening in Asia, where millions of people are leaving the rural areas for cities each year. The strain on resources from foodstuffs to basic metals is immense, which is why Yiannis Mostrous and I have launched Vital Resource Investor (www.vitalresourceinvestor.com).

But the surge in needed spending also extends to developed countries outside the US. Canada, for example, has an estimated infrastructure deficit of $335 billion to fill in the next few years. That’s the legacy of 40 years of underinvesting in everything from roads to water treatment facilities.

Moreover, given the country’s recent prosperity and huge federal budget surpluses, it’s easy to see the money is there to take on a project of this immensity. The country’s nonresidential construction cycle, for example, has been on the upswing now for more than four years, with very little impact from the US recession.

Again, the key is finding ways to ensure the money will flow once the investment has been made and the assets are up and running. That will require management skill and investor vigilance to ensure they’re still succeeding.

The companies that succeed will reward investors with big returns for many years. And that’s worth the trouble of finding them.

A Taste of Stagflation

Covering costs—or rather passing costs through to customers—is the biggest test for any business going forward. And it’s only going to become more so, at least for the next few quarters and possibly for several years.

For one thing, the decades-long massive gains in productivity we’ve seen for the US and world economy may be petering out. One reason is these gains were based on a scenario of very low labor costs in countries such as China, which put downward pressure on wages globally as they increased trade with the rest of the world. Without downward wage pressures, productivity gains depend on technology, which has advanced in some areas—particularly the Internet—but are generally a lot more difficult to come by.

Back in the ’70s, the price of energy and commodities was far more significant to US GDP than it is now, largely because the manufacturing sector was much larger relative to GDP. The low inflation of the ’80s and ’90s was due in large part to their lessened importance to the overall economy as manufacturing’s share of GDP shrank and prices fell.

Here in the latter half of the ’00s, however, energy and commodities have again taken on massive importance. Manufacturing is a smaller slice of the overall US economy than ever. But we’re more connected to the rest of the world than ever, too, and use of these vital resources has never been greater. As a result, rising prices are starting to have the same impact on the overall US economy—and individual companies—that they did during the ’70s.

Not every industry is being squeezed yet. But there are certainly some very good examples popping up.

The $10 billion combined first quarter losses of merging Delta Air Lines and Northwest Airlines Corp are pretty clear signs of the massive crunch on airline industry profits. The airlines have seen a massive increase in the cost of jet fuel but have been unable to pass it along to consumers in ticket prices. That’s in part due to competition in the industry, and it may also be due to airlines’ fears that demand will prove more elastic than expected, i.e., rising ticket prices bring a drop in traffic and revenue.

Another industry on the ropes now is refining. The cost of oil and natural gas has risen sharply in recent months. However, refiners have been unable to push along those increases to the price of gasoline.

That no doubt seems incredulous to many consumers, given the spike in prices we’ve already seen at the pump over the past few years. But it’s plain as day from the collapse in margins at refiners in recent quarters. And it shows little sign of abating.

Producers of vital resources such as copper have seen unprecedented revenue increases from rising prices over the past year, even if they’ve been unable to maintain production levels. Some, however, have felt a squeeze in certain regions of the world, from the spiking cost of electricity needed for effective mining. And of course, the power producers themselves are feeling the pinch from rising coal and natural gas prices this year, even though the price of electricity itself in wholesale markets continues to rise.

Financing costs are emerging as another squeeze in certain industries. The Federal Reserve hasn’t been shy about cutting the federal funds rate, with another reduction likely next week. Neither has it been averse to pulling other levers to shore up the financial system.

Nonetheless, borrowing costs have risen sharply over the past few months. Even investment-grade credits are paying premiums over the benchmark Treasury note yield that are twice as high as in mid-2007. And non-investment-grade credits are paying 700 to 800 basis points above equivalent Treasury paper, several times the spread before the credit crisis erupted.

The situation is graver still with companies that rely heavily on credit lines based on the London Interbank, or LIBOR, rate, which has spiked in recent weeks. These companies’ rising interest costs will have to come out of something.

If they pay high dividends, they may have to cut them. If they don’t, it will come out of growth budgets. Either way, it’s bad news for investors.

Financial services are an obvious point of vulnerability. And judging from the first quarter earnings results we’ve seen thus far, there are almost certainly more asset writedowns and losses ahead.

This sector has already been pounded in the stock market. And with every successive blow doing progressively less damage to the group, it’s increasingly likely the worst is well baked into share prices already.

That—plus the fact that financials will be the biggest winners when visibility clears on the credit crunch and economy—is a good reason to hang onto the best, such as Regions Financial and Well Fargo, in a small corner of your portfolio. Both companies have successfully navigated their ways thus far through the crisis. Both should be watched closely for weakness but look increasingly like the worst is behind them.

In contrast, there are sectors getting relatively little notice where rising financial costs could have a much larger impact and where the potential damage isn’t reflected in share prices. Last week, I underscored the importance of really examining first quarter financials, not just for headline numbers but particularly for exposure to near-term refinancing risk.

Credit conditions will almost surely improve over the next year or so and almost definitely over the next five. But the more debt a company has coming due in the near future, the more at risk it is to a spike in costs. And nothing is more exposed to rate swings now than a credit line tied to LIBOR.

In the May issue of Utility Forecaster—available for subscribers May 3 at www.utilityforecaster.com—I survey my entire universe of 215 essential service companies for their five-year debt exposure. One company that looks vulnerable is Consolidated Communications, which has credit lines and less than five-year debt that are greater than its entire market value. In addition, the credit lines it took on to finance recent acquisitions are tied to LIBOR.

Ironically, the telecom business itself has thus far been remarkably resilient in the face of the weakening US economy and credit crunch. AT&T, for example, reported blockbuster numbers, showing continued robust growth in wireless but also progress expanding its wireline broadband business. Even Consolidated has been covering its generous distribution by a healthy margin, which should help it navigate any difficulties from LIBOR.

There are other industries as well that appear to be standing up to cost pressures and are earning more money than ever. Entergy Corp’s huge first quarter earnings gain is a pretty good sign all is well in the power business, at least as long as producers can recover their fuel costs and run their plants well.

General Electric’s booming infrastructure business is the best possible sign for that sector, though financial services underperformance hurt the bottom line. Goodyear’s tire business also appears to be absorbing cost and recession pressures, judging from the robust profits announced today.

My general rule is anything that does put up good first quarter numbers can be considered stress tested. The economy may get weaker still in coming months. But they’ve proven themselves able to function amid the weakness.

If we’ve seen anything over the past few months, it’s that not everything is going to measure up. The silver lining, however, is we can have a lot of confidence in what is. Moreover, there’s a lot of risk priced in now with the S&P 500 nearly 200 points off its 52-week high.

There will almost surely be more damage ahead, particularly from companies that don’t measure up as businesses and cost-vulnerable sectors. But as long as companies perform, the risks from here are low, and there’s a lot of upside ahead when the overall situation—inevitably—shifts back in our favor.