Tuesday, May 02, 2006

Why buffett is buying utilities

Not sure if this is a really old article but i feel it illustrate why one should look at the underlying reasoning for some of WB moves.

Jubak's Journal
Why Buffett is buying utilities
The industry is consolidating, and a utility with low-cost financing is going to make a lot of money. Here are three stocks that will benefit and four more worth a look.

By Jim Jubak

On May 24, Warren Buffett bought an electric utility. Should you?

Buffett will pay $5.1 billion to buy PacifiCorp from Scottish Power (SPI, news, msgs). That's about an eighth of the more than $40 billion that Berkshire Hathaway (BRK.A, news, msgs) had in cash at the end of March. And the deal to acquire the provider of electricity to 1.6 million customers in the Pacific Northwest is the biggest for Berkshire Hathaway in the last eight years. When the deal was announced, Buffett said Berkshire Hathaway would be looking for more utility acquisitions.

All in all, it adds up to a pretty hefty endorsement of the electric utility industry from a legendary value investor. Which, of course, takes us back to my first question: If Warren Buffett is buying electric utility stocks, shouldn't you?

At first glance, this seems like an odd time for a value investor such as Buffett to invest in utilities. The Dow Jones Utility Index ($UTIL) has returned 11.5% so far in 2005 (as of June 1) after huge total returns of 25.4% in 2004 and 24% in 2003. Stocks such as AES (AES, news, msgs), up 9.15% in 2005 after returning 44.7% in 2004, American Electric Power (AEP, news, msgs), up 7.8% in 2005 after returning 17.4% in 2004, and Duke Energy (DUK, news, msgs) up 12.94% in 2005 after returning 23.8% in 2004, seem closer to the end of their runs than the beginning.

So why does Buffett think utilities are a good buy now? The answer lies in the long- and short-term potential for electric utilities.
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The long-term view: Consolidation builds profits

U.S. utilities are in the early stages of a long-term consolidation. Midsized utilities are buying small utilities, and big utilities are buying midsized players.

Right now, there's a mismatch in how the industry is structured. There are thousands of local companies that deliver electricity to their customers. Then, there are regional wholesale electricity markets dominated by a handful of efficient, large-scale electricity producers. The wholesale markets have emerged because local companies can often buy power from others for far less than the cost of generating it themselves. At the same time, some utilities have developed cost advantages that have turned generating and peddling excess electricity to other utilities into very profitable businesses.

The wholesale markets aren't going away -- in fact, they're gaining in importance. But they are undergoing a subtle transformation. The big low-cost producers aren't content with the profits that come from selling their electricity at wholesale prices. They'd like to capture more of the cash flow by eliminating the local utilities. Why sell bulk power to another utility if you can sell electricity at retail to the company's local customers? Since the electricity business is composed of regulated monopolies, the only way to be able to sell directly to the end users is to buy up the local companies -- lock, stock and customers.

That's exactly what's been going on in recent years. In 2000, American Electric Power bought Central & South West to create the country's biggest utility. Duke Energy plans to merge with Cinergy (CIN, news, msgs), and Exelon (EXC, news, msgs) has proposed the acquisition of Public Service Enterprise Group (PEG, news, msgs).

There's many a slip between projected and real cost savings, as investors know all too well. Even so, when Exelon talks about getting $400 million in cost savings in the first year of the merger by eliminating redundant operations at Public Service Enterprise -- equal to about 4% of PEG's annual revenue -- it's enough to get my attention.

Just one problem, though. There's this inconvenient law left over from the Great Depression when utilities did nasty things like water their stock and play "hide-the-assets" among related shell companies. Called the Public Utility Holding Company Act, the law prohibits nonutility companies, such as Berkshire Hathaway, from directly controlling retail electricity suppliers. The law also requires that utilities (if both are U.S. utilities) must be physically connected in order to merge. It's that latter requirement that led a Securities and Exchange Commission hearing judge to rule in early May that the American Electric Power-Central & South West merger violated the 1935 law. AEP's service area nowhere touched the Texas service area of Central & South West.

For a patient investor like Buffett, though, this is exactly the time to strike. The long-term consolidation trend is gathering speed, and efforts to repeal the 1935 law are making headway in Congress. The energy bill passed by the Senate Energy and Natural Resources Committee on May 26 would allow the large-scale utility mergers now prohibited. Passing a committee, however, isn't the same as getting through the full Senate and the House of Representatives, but the attempts to amend the Public Utility Holding Company Act will bear fruit one of these years.

It's quite possible, however, that Buffett may not have to wait even for that. Technically, Berkshire Hathaway isn't PacifiCorp's buyer. The formal buyer is Berkshire's 80%-owned MidAmerican Energy Holdings.
So, the deal works around the law's ban on nonutility companies owning retail electricity suppliers. (I should add the word "probably" here. This is an exceedingly convoluted area of the law.) Not only does Berkshire Hathaway own 80% of MidAmerican, based in Des Moines, Iowa, but Berkshire can only vote 9.9% of its shares.

The deal may also meet the requirement that the merging utilities be physically connected, since MidAmerican's transmission grid includes South Dakota, which is adjacent to PacifiCorp's grid in Wyoming.

(Of course, exactly what the 1935 act means by "physically connected" is a matter of legal interpretation. The two utilities are located in different regions of the national electricity grid -- what are called interconnects. It is, in fact, quite possible that this means the two aren't connected even if they do business in adjacent states.)

Three potential winners from consolidation
To profit from this consolidation over the long haul, I'd look for utilities with the ability to generate and transmit lower-cost bulk electricity. Three I like are Duke Energy, American Electric Power, and FPL Group (FPL, news, msgs).

* Duke Energy's merger with Cinergy eventually will create a utility with almost 4 million electricity customers and about 16,000 megawatts of unregulated generating capacity for the wholesale market.

* American Electric Power's position in the middle of the country and next to the Appalachian coal fields makes it a natural for expansion as the industry consolidates.

* FPL, formerly Florida Power & Light, is the industry's leader in wind-power generation. Wind power is a source of electricity that will gain a cost edge if oil and natural gas prices continue to rise. And it works well in combination with fuel sources with different patterns of peak electricity generation.

Cheaper capital equals bigger profits
Berkshire Hathaway has the one thing that every utility CEO dreams of: piles and piles of low-cost capital. One big reason that Scottish Power sold PacifiCorp was that the company needed to invest a minimum of $1 billion over the next five years to improve reliability in its service area. Some estimates run as high as $5 billion.

The profitability of that kind of investment, when the return that you earn on your investment is set by state regulators in your service area, hinges on what the company pays for the money it invests. Thanks to Berkshire Hathaway's insurance business, the company generates a flood of cash internally and enjoys access to the capital markets at extremely low rates. Also, since Berkshire Hathaway doesn't require units like MidAmerican Energy to pay a dividend to the parent company, MidAmerican will be able to put all of its own internal cash to use. So, in my opinion, MidAmerican should earn a bigger profit on its investment in the PacifiCorp system than Scottish Power could hope for.

And let's not forget the advantage that Buffett gets from taking on $4.3 billion in PacifiCorp debt. Think that it's just possible that MidAmerican Energy will be able to lower the interest cost on that debt thanks to its access to cheaper capital?

4 companies that can win with low-cost capital
So, how to profit from the short-term view of this deal? Look for capital-strapped utilities with lots of customers. A plus would be a credit rating low enough to be easily improved and/or sizeable debt that would let an acquirer quickly reduce interest costs. If the target utility owns assets such as coal mines or fiber-optic networks, so much the better. Utilities to research, in my opinion, include TXU (TXU, news, msgs), TECO Energy (TE, news, msgs), Pepco Holdings (POM, news, msgs), and Sierra Pacific Resources (SRP, news, msgs).

Of course, any decision to invest in utility stocks -- which, because of their high dividend yields, tend to rise and fall with interest rates -- requires that you consider where U.S. interest rates are headed. Utility stocks shine when interest rates are falling or are already low and stuck at low levels.

So, in my next column I'll tell you why the "no" vote on a new constitution for the European Union in France and the Netherlands means that lower U.S. interest rates will be with us for a while.

New developments on past columns
6 winners for tech's hard times
Everything seems to be falling into place for Yahoo! (YHOO, news, msgs). On April 19, the company reported first-quarter earnings two cents a share above Wall Street expectations. In the conference call, Yahoo! raised its guidance on revenue for the year to a range of $3.546 billion to $3.71 billion from the previous guidance of $3.5 billion. Since then, the company has introduced new product after new product: in-store (in partnership with Target (TGT, news, msgs) photo-prints delivery, built-in Yahoo! e-mail on Nokia (NOK, news, msgs) handsets, and video search. That's all led to a revival of momentum in the shares -- critical for investors hoping that this stock will strongly participate in the current technology rally. Relative strength (a measure of Yahoo!'s price performance versus that of all other shares on the market) has jumped to 94 in the last three months from 52 in the last six months. Our StockScouter rating for the shares has moved up to a current 8 out of a possible 10 from 6 just 90 days ago. Wall Street analysts raised their estimates for 2005 earnings per share to 57 cents from 52 cents 60 days ago. Yahoo! is set to report second-quarter earnings on July 19 and the shares are likely to follow their historical pattern of running up into the earnings report. As of June 3, I'm leaving my target price at $45 by July 2005. (Full disclosure: I own shares of Yahoo!.)

5 stocks that could soar if rates stay low
Sometimes Wall Street gets more than a little ahead of itself. That's exactly what happened to shares of Engineered Support System (EASI, news, msgs) on June 1. The stock dropped more than $3 a share after the company lowered earnings guidance for 2005 by 9 cents a share or about 4.5%. (The company actually raised revenue guidance for the year by about $50 million.) The punishment was so severe because going into the earnings announcement, several Wall Street analysts had projected that Engineered Support Systems would actually raise guidance. The problem seems to be with production delays and performance issues in a single military program, the deployable power generation and distribution system. Fixing the problems has pushed out full production and added costs that took about 7 cents a share -- accounting for most of the decrease in earnings guidance for 2005 -- out of earnings for the quarter that ended in April 2005. I think the recent quarterly miss is a one-time problem well within the power of management to fix on the schedule that the company has outlined. As of June 2, I'm keeping my target price at $45 a share but moving the timeline to October 2005 from September. (Full disclosure: I own shares of Engineered Support Systems.)

Editor's Note: A new Jubak’s Journal is posted every Tuesday and Friday.

E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American Electric Power, Engineered Support System and Yahoo!. He doesn't own short positions in any stock mentioned in this column

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