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Income Investing

Utility Talk

By Roger S. Conrad, on Oct. 4, 2013

Editor’s Note: Last week, Roger Conrad hosted a five-hour Live Chat to celebrate the launch of Conrad’s Utility Investor. This week’s installment of Income Insights consists of excerpts from this wide-ranging conversation. Subscribe to Conrad’s Utility Investor today to read the entire transcript.

Question: What is your view on the government shut down? Should I hold off any buying until after this and the debt ceiling are resolved ?

Answer: It certainly is not helping the stock market that Washington is again playing with fire on the issue of debt default. My feeling is the shutdown will hurt the economy, but the pain will be slow. The most important result will be economic growth that’s weaker than it would have been, and Federal Reserve policy that will likely stay more accommodative longer than it would have. That’s probably good for utility stocks, though as I’ve pointed out before, the argument about utility stocks’ sensitivity to interest rates is overstated.

The real danger to the markets is if the politicians allow a default. The risk of that probably means stock prices are going to come off until there’s a deal on extending the debt ceiling, and a lot more if they don’t come up with one in time. But I think as far as buying goes, the important thing is still to focus on buy targets that are based on earnings and dividend power balanced by an assessment of risk. That’s what I’m going to continue providing in Conrad’s Utility Investor.

Question: Is Southern Company (NYSE: SO) a safe investment?

Answer: I like Southern Company and I think the risks of its construction program are overstated. The Vogtle nuclear plant project remains on track and the needed rate increases to finish it are not great–the company has been recovering the cost all along. I’m not saying there may not be some write-off as there was at Kemper. But it won’t affect the company’s financial health or dividend growth unless a whole lot more goes wrong. And while I watch earnings closely and wrote the stock up in the September issue of Conrad’s Utility Investor, I don’t see any evidence of that at this point.

Question: I realize that this is a broad question, but what are a few of your favorite high-dividend stocks that are in largely regulated states and that you feel are likely to continue to periodically raise their dividends in the future?

Answer: In the utilities space, I generally prefer the South because of the greater regulatory certainty and ability of companies to therefore do long term planning. My favorites in the region now are Southern Company, Duke Energy Corp (NYSE: DUK) and Dominion Resources (NYSE: D), though the latter is a bit high priced right now. I also like Xcel Energy (NYSE: XEL) as a long-term holding, though it too is a bit pricey.

Question: Why have shares of Duke Energy sold off?  

Answer: My guess would be people who have bought into the conventional wisdom that utilities are bond substitutes and will sell off hard when the Federal Reserve abandons its current easy money policy.

My two problems with that are: 1.) Utilities are stocks and follow the stock market, not the bond market over time and 2.) It’s quite premature to call an end to Fed easing, particularly with Congress shutting down the government and the economy moving at a tepid pace even before that.

Duke’s future is going to be shaped by how well management executes its investment strategy and stays on the good side of regulators. As I point out in this month’s Conrad’s Utility Investor, they reported some really positive developments last month, including resolutions of basically all outstanding rate cases. They’re making a big move in renewable energy, and in a way that locks in cash flows. And they even seem to be transitioning their coal fleet effectively.

I wouldn’t pay more than $68.00 per share for Duke Energy–at least until the company boosts the dividend a bit more. But it’s in a good place now. And again, the interest rate sensitivity rap has made the stock cheap again

Question: Please give your current analysis of Frontier Communications Corp (NSDQ: FTR and Consolidated Communications (NSDQ: CNSL)

Answer: These two tend to get lumped together as high yielding wireline telecoms. But there are some pretty big differences. The biggest is CNSL now relies on consumer voice for only a small fraction of its cash flow (less than 15%), with the rest coming from broadband and enterprise. Frontier is moving in this direction, but isn’t nearly so far along. That means its revenue is likely to shrink for several quarters more, and that will put pressure on the company to cut expenses and debt. Consolidated on the other hand has pretty much achieved revenue stability, so the risk to its dividend is far, far less.

One thing both of these have in common is a large amount of short interest. That shouldn’t surprise anyone, given that wireline telecoms have been a real trainwreck the past few years. But it does make for an interesting possibility that these companies will achieve revenue stability ahead of the market’s gloomy forecast and thereby shore up dividend safety. If and when that happens, we could see the mother of all short squeezes in some of these stocks. CNSL is by far the better choice for safety.

Question: What utility stocks in your model portfolios stand the best chance of being taken over?

Answer: Unlike any other industry, all of the thousands of utility mergers over the past century plus have produced stronger companies eventually.

That said, it’s tough to predict just when deals will occur. It’s clear that the Obama Administration views merger applications as an opportunity to extract regulatory concessions from companies. And the way the Exelon/Constellation and Duke/Progress mergers were handled has probably discouraged most management teams from doing anything, at least until a new president takes office. Looking at what I have in the model portfolios now, MDU Resources (NYSE: MDU) and NRG Energy (NYSE: NRG) are the most likely takeover targets.

Question: It would seem that the government is so far in debt that there is no way it can dig its way out without there being some kind of a major shock to the economy. Are you taking this into account?

Answer: That’s certainly what a lot of people think, which I believe makes a stock market crisis from a federal debt crisis a lot less likely. The big crashes in history have only been possible when enough people were leaning the wrong way at the same time. That was definitely the case in 2008, but even though the stock market is at new highs now I don’t see anything close to the kind of leverage we had prior to the 2008 crash. People are still hunkered down to a large extent.

That’s not to say the federal debt isn’t a huge concern, particularly for those of us with children and who hope to be around another 40 years plus. And no one really knows what will happen if Congress and the president can’t pass a bill to raise the federal debt ceiling. That would be a self-inflicted wound with a lot of possible implications. The absolute debt level, however, is unlikely to precipitate a crisis on its own.

What I think you should be concerned about is the sluggish economic growth we’ve seen now for more than a decade, and the fact that not every company is capable of paying a big dividend under these conditions–though many are trying.

That’s what I take into account with every pick: Can it hold its dividend under less than idea conditions? And I look at regulatory, financial and operating criteria to make that kind of decision. 

Question: I see Keyera Corp (TSX: KEY, OTC: KEYUF) just raised CA$305 million in private placement debt. Do you know the terms: interest rate? Do you have an opinion about the company?

Answer: I’ve liked Keyera Corp for nearly a decade as a Canadian energy midstream company with strong built-in growth of earnings and dividends. I like the deal they just did with Kinder Morgan for an oil terminal, and they just raised their monthly dividend by 11.1%, another huge vote of confidence in the company’s steady growth. I’ll cover Keyera Corp and other Canadian midstream companies at length in the next issue of Energy & Income Advisor.

The bond issue was a private placement, so there’s not a current market. But the bonds were from 12 to 15 years at rates between 4.75% and 5.34%, which are very good. It’s very good news for this company and strengthens its capital structure.

Question: What do you think the approximate timeframe will be for interest rates increasing significantly? What effect do you think that trend will have on dividend plays like utility stocks?

Answer: Utility stocks have an undeserved rap as being bond surrogates, when market history shows they follow the S&P 500 far more closely. I think we have seen some selling this year on the mistaken assumption that the Fed is about to jack up interest rates and that the company will suffer disproportionately because of it. Consequently, they’re already pricing in a risk that has not been significant to them over the past 20 years.

This is a subject I’ve addressed repeatedly in Conrad’s Utility Investor. But the bottom line is interest rates are only significant to utility stock returns in how they affect profit and dividend growth. And the only way rates are going to rise significantly is if growth picks up, in which case so will utility dividend and profit growth. The key is to keep tabs on the individual companies to see which will grow and which falter.

Question: Do you have any comments on the current state of the Entergy Corp’s (NYSE: ETR) off of transmission assets to ITC Holdings Corp (NYSE: ITC)

The companies have refiled for approval from Texas regulators after including some rate concessions. If they respond favorably, I would expect the other states to fall in line. And ETR shareholders will pick up $10 to $12 worth of ITC Holdings’ stock that’s not currently in the share price.

What has me a bit concerned is how political energy has become recently. The president’s nominee for chair of the Federal Energy Regulatory Commission (FERC)–actually a pretty pro-industry guy–was blocked by a group of senators protesting the administration’s policies on coal. And Texas regulators have become concerned that allowing the spinoff/merger will put transmission systems under FERC’s control. Of course, ETR has already joined the regional transmission operator, so FERC is already involved. But this is the kind of regulatory morass that these companies are trying to navigate.

The saving grace is ETR isn’t pricing in this deal, and the dividend is well covered by the regulated electric franchise profits. There’s also the possibility Indian Point relicensing could be approved in the next six months or so, which would really help the stock. For those reasons, I’m sticking with ETR, with the spinoff as blue sky. But this deal looks far from uncertain to close, even on the extended time table of Q1 next year.

Roger Conrad is co-founder and chief editor of Capitalist TimesConrad’s Utility Investor and Energy & Income Advisor.

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