Where to Find Yield and Value

June 19th, 2014
in contributors

Investing Daily Article of the Week

by David Dittman, Australian Edge

If you’re a utility investor, it’s almost impossible not to fixate on the June 2, 2014, rollout by the US Environmental Protection Agency (EPA) of proposed rules governing greenhouse gas emissions (GHG) from existing power generation facilities.

Follow up:

The EPA’s plan, if it takes effect, would lead to the reduction of GHG from power plants by 30 percent from 2005 levels by 2030, equivalent, according to the agency, to removing two-thirds of all cars and trucks in the US from the road.

While the rule seeks a 30 percent reduction in GHG emissions nationwide, each state would have a different goal based on its ability to implement the emission reduction methods available under the rule.

Unlike regulations for new power plants the rule doesn’t set a firm emissions cap for generating facilities, instead allowing states flexibility in attaining the target reductions. And states that currently rely most heavily on coal-fired generation and will have the most difficulty introducing renewable generation will be required to make the smallest emission reductions.

The EPA has identified four “building blocks” for use in state plans: improving heat rates at existing power plants; substituting less carbon-intensive generation such as natural gas combined-cycle (NGCC) technology; substituting renewable energy sources such as solar or nuclear; and boosting energy efficiency.

It’s uncertain exactly how states will employ these “building blocks” and the EPA recognizes that no individual component will be sufficient to achieve the goal. But it’s likely that displacement of coal and oil/gas-fired steam generation with NGCC generation will constitute a substantial portion of reductions.

Existing coal facilities won’t be required to install carbon capture and sequestration technology (CCS), but CCS may be among the tools state regulators use in their implementation plans.

The EPA forecast that 30 percent of electricity in the US will be produced from coal by 2030, down from about 40 percent today.

The EPA is now taking public comments on the proposal and will spend the next year completing it before releasing the final rule in June 2015. States will then be given another year to submit compliance plans or apply for an extension.

The EPA proposal would affect utilities differently depending upon which states they operate in, the profile of their electric generation fleet and what they’ve done to date to reduce emissions in anticipation of a federal mandate.

So there’s clearly more to come. Utility Forecaster Contributing Editor Richard Stavros will take a deeper look at the new EPA proposal in next week’s Utility & Income.

It’s also hard to turn away from the continuing drive for scale in the telecom sector, where speculation has turned to a Sprint Corp. (NYSE: S) tie-up with T-Mobile US Inc. (NYSE: TMUS) that could finally establish a challenger to the Verizon Communications Inc. (NYSE: VZ) AT&T Inc. (NYSE: T) duopoly that dominates the US wireless market.

The buzz around Sprint-T-Mobile – after short-lived and misplaced rumors about Verizon and DISH Network Corp. (NASDAQ: DISH) – swarmed AT&T-DirecTV (NYSE: DTV) in mid-May. Before that it was Comcast Corp. (NASDAQ: CMCSA) Time Warner Cable Inc. (NYSE: TWC).

All three proposed combinations must overcome regulatory phalanxes that must surely be aware that scale and scope have done little ensure the availability of either world-class broadband Internet or world-class wireless telephone service in the US – where, it should be noted the Internet and prevailing telecom technologies were, literally, invented.

According to recent study by Ookla Speedtest, the US ranks 31st in the world in terms of average download speeds. The leaders in the world are Hong Kong at 72.49 megabits per second (Mbps) and Singapore on 58.84 Mbps. Average speeds of 20.77 Mbps put the US behind countries such as Estonia, Hungary, Slovakia and Uruguay.

US upload speeds are even worse: The US ranks 42nd with an average upload speed of 6.31 Mbps, behind Lesotho, Belarus and Slovenia, among others most of us would be unable to pinpoint on a world map.

And Ookla also found that the US has one of the worst-performing LTE networks in the world. US carriers, on average, offered 13.2 Mbps download speeds on LTE over the course of 2013, carriers in Australia, Canada and the UK delivered speeds nearly two to three times faster. Out of the 40 countries and territories with the most LTE tests in 2013, the US offered slower speeds than all of them, with the exception of Puerto Rico, the Philippines and India.

And US consumers are paying a lot for this underperformance: Verizon charged roughly $4.05 per Mbps of LTE download speed in 2013 compared to just $2.25 for UK carrier EE.

Most major international carriers were about half as expensive as Verizon. Verizon isn’t the only carrier in the US where speed comes at a premium: AT&T comes to $3.93, while Sprint – with its nascent and slow LTE network – averaged $7.50 per Mbps.

Sprint/T-Mobile, AT&T/DirecTV and Comcast/Time Warner may be forced to confront issues regarding size, competition and service quality in the US over the next many months as their various deals make their way through the regulatory process.

Good Yield and Solid Value

In the meantime, as these high-stakes rule-making and regulatory processes play out, here’s a more mundane look at six stocks with good yields trading at reasonable prices. These are non-UF Portfolio companies that are nevertheless buy-rated members of the How They Rate coverage universe.

The most important element of a sound investment decision is a quality underlying business. It follows from this first principle that you must protect yourself against losses and that you should aim for “adequate” rather than spectacular returns.

Benjamin Graham, widely recognized as Warren Buffett’s mentor and author of the essential Security Analysis, suggested that reasonably priced stocks could be identified by multiplying the price-to-earnings (P/E) ratio by the price-to-book (P/B) ratio. If the resulting number was below 22.5 the stock represented reasonable value.

We’ve calculated this number for the six stocks in the accompanying table and labeled it the “Graham Factor.”

As with most ratios, the average P/B value may vary from industry to industry. But it does provide some idea as to whether you’re paying too much for what would be left if the company went bankrupt immediately. The rule of thumb Mr. Graham applied was “1.5.”

As for the P/E ratio, anything above 15 is too much. The “Graham Factor” bright line for value is thus 22.5, or 1.5 times 15.

To gauge risk, we have the UF Safety Rating System, which is based on eight financial, operating and regulatory criteria as Mr. Graham wrote

Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”

  • We want to see a payout ratio based on the worst Wall Street estimate for full-year earnings – and right now it’s for 2014 – greater than 0 percent but lower than 80 percent.
  • A dividend increase over the trailing 12 months – a sign that underlying business conditions are healthy, despite what’s been a sluggish economic recovery – will earn a point.
  • We want to see less than 10 percent of earnings derived from unregulated operations, which ensures consistency despite fluctuations in the macro environment.
  • We prefer a bond rating equivalent to BBB- or better with a “stable” or better outlook from at least one major credit-rating agency, an indication of an investment-grade balance sheet that’s likely to avoid a downgrade.
  • As for the balance sheet, we require that minimal debt – less than 10 percent of market capitalization – be due for rollover through 2015, which is of particular importance as we contemplate the possibility of rising interest rates.
  • Determining good regulatory relations, defined by diversity and/or demonstrated cooperation with officials in key states or federal agencies, is a more subjective criterion, more fluid criterion. But it’s as important as any other, especially in light of the still-significant infrastructure investment necessary to support a 21st century electric grid.
  • Fuel-cost exposure must be neutral or positive for energy companies, including Diversified Energy, Energy Distribution and Natural Resource companies, and free cash flow-positive for other groups.
  • Finally, either geographic diversification or concentration in a recession-resistant regional economy ensures consistent performance at the top line.

The more criteria a company meets, the higher is its UF Safety Rating and the more secure its dividend.

Click to enlarge

The primary risk facing Consolidated Edison Inc. (NYSE: ED) right now is an ongoing review of the regulatory regime in its primary market, New York.

In December 2013, the New York Public Service Commission (PSC) directed its staff to explore potentially sweeping reform guided by five principles, including empowering customers, leveraging customer contributions, system-wide efficiency, fuel/resource diversity and system reliability/resiliency.

No red flags have emerged from this process, so far marked by a collaborative tone, though full details won’t be known for some time, with a target completion date of the first quarter of 2015.

We’ll know more about whether this is a threat or an opportunity as 2014 turns to 2015.

ConEd is a high-quality utility franchise with solid rate-base growth opportunities, driven primarily by New York’s distribution infrastructure needs. The regulatory review does introduce uncertainty, however.

Like most US utilities, ConEd benefitted from colder-than-normal weather in the first quarter, as earnings from continuing operations grew by 8.5 percent to $343 million, or $1.17 per share.

FirstEnergy Corp. (NYSE: FE) is perhaps the riskiest play among the six stocks listed in the table. FirstEnergy is coming off a 34.5 percent dividend cut announced in January 2014 following a “thorough” study of the company’s businesses. The board concluded that a dividend rate “aligned” with revenue and earnings generated by regulated operations “will provide the best path forward for FirstEnergy.”

The company is also focused on expanding its regulated operations. We’ve yet to see hard proof of a turnaround, as first-quarter operating earnings per share were down 48.7 percent to $0.39 due to weak results for its Competitive Energy Services unit that offset solid transmission and distribution numbers.

There is a decent risk/reward proposition here with the current share price, which is supported by current regulated operations. The competitive part of the business, so far a drag, offers potential upside.

Gas Natural Inc. (NYSE: EGAS) distributes and sells natural gas to approximately 73,000 residential, commercial and industrial customers through regulated utilities operating in Montana, Wyoming, Ohio, Pennsylvania, Maine, North Carolina and Kentucky.

Other operations include interstate pipeline, natural gas production and natural gas marketing.

Customer growth in its territories has improved, though costs have ticked up and gross margin for its non-regulated operations have shrunk. Growth driven by bolt-on acquisitions of other local distribution companies (LDC) could drive upside, though there are no deals imminent.

The Public Utilities Commission of Ohio has undertaken an investigative audit of two Gas Natural subsidiaries, citing concerns about the companies’ internal controls, the propriety of their executive compensation system and alleged self-dealing by management.

Favorable overall trends for LDCs as well as potential upside to come from an improvement in regulatory relations suggest there’s some value here, with a 5 percent-plus yield providing compensation for the risk.

Pinnacle West Capital Corp. (NYSE: PNW) is one of the few US utilities that didn’t benefit from colder winter weather, as heating-degree days for its Arizona Public Service unit declined by 51 percent due to warmer temperatures and transmission revenue dipped, leading to a 36.4 percent drop in first-quarter earnings per share to $0.14.

Customer growth was 1.6 percent, modest relative to historical standards, but management believes headwinds associated with an overbuilt housing market are in the rearview mirror and expects customer growth to gradually accelerate through 2016. And the local economy is in decent shape.

Management affirmed full-year 2014 earnings per share guidance of $3.60 to $3.75 and maintained its 4 percent annual dividend growth target.

During the second half of 2014 we should have some clarity on the Arizona Corporation Commission Utilities Division’s position on solar and distributed generation as well as Pinnacle West’s strategy going forward. Management reported having 25,000 total rooftop solar customers, with more than 2,200 installing rooftop photovoltaic power stations during the first quarter.

PPL Corp. (NYSE: PPL) announced on June 9, 2014, an agreement with Riverstone Holdings LLC to combine their merchant power generation assets to form stand-alone independent power producer Talen Energy Corp.

Talen will list on the New York Stock Exchange.

PPL, which has grown its rate-regulated business portfolio, concentrated in Kentucky, Pennsylvania and the UK, significantly over the past several years, has now completed a transition to a fully regulated utility. The spinoff will allow management to focus on core regulated operations and the strong rate-base growth opportunities available in its service territories.

Management maintained its 2014 forecast of ongoing earnings per share of $2.15 to $2.30, and introduced 2015 guidance of $2.05 to $2.25 per share, excluding the merchant business, in line with a 4 percent to 6 percent growth rate based on the midpoint of utility/parent earnings.

SCANA Corp. (NYSE: SCG) is the jewel of this set of companies, with an almost-perfect UF Safety Rating. SCANA’s Carolinas-based utilities enjoy favorable regulatory relations and operate in one of the strongest economic regions in the US.

South Carolina’s unemployment rate is 5.3 percent versus a US average of 6.3 percent. Primary subsidiary South Carolina Electric & Gas’ (SCE&G) service territory boasts an even lower 4.4 percent rate.

Customer growth is above average as well, 1 percent-plus for electric, 2.3 percent for gas.

And management is optimistic about the robust weather-adjusted sales growth in the fourth quarter of 2013 and the first quarter of 2014 developing into a trend.

First-quarter earnings per share were up 21.2 percent to $1.37 on stronger margins driven by extremely cold winter weather, customer growth and rate increases.

SCANA has raised its dividend for 15 straight years.

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