The Numbers and the Future

The more data we see, the more obvious it is that the economy hit a brick wall in October. Today’s blockbuster number was retail sales, which plunged by the largest amount on record, 2.8 percent versus 2.65 percent in November 2001. But it’s just the latest in a steady string of lousy numbers, ranging from surging unemployment to weak manufacturing.

If there’s good news in all of this, it’s that the lending freeze that caused it continues to thaw. Treasury Secretary Henry Paulson’s statements earlier this week that the authorities were shifting tactics was hardly embraced by a panicky market. But we’re starting to see more companies come to market with their debt, and the key London Interbank Offered Rate (LIBOR) has returned to still elevated--but much closer to normal--levels.

Meanwhile, the world’s central banks and governments remain committed to keeping the liquidity flowing to the system and trying to spur growth. China’s blockbuster move to ramp up infrastructure spending is just one of many around the globe. And similar action in the US looks set when the rapidly forming Obama administration takes office in January, if not before.

The die is cast here. Until the global economy bottoms, the authorities are going to keep the money coming, whether by direct spending, interest rate cuts or direct assistance to financial institutions and other industries such as autos. It may take a while for their actions to fully turn what to now has been a deflationary tide. But eventually, if they keep at it, there will be a huge impact. And the political and social ramifications of abandoning their efforts are a pretty good incentive to keep at it.

The stock market has been responding to all this in a typically erratic fashion. Prices are clearly washed out, and valuations are the lowest in several years. On good days such as Thursday of this week, the bargain hunters come out in force, while the short sellers booked profits. On the bad days, however, the psychology shifts radically to a focus on bad economic news and the expectations that things could easily get worse. And even the more recession resistant stocks sell off sharply as investors flee for the safety of Treasury bills.

As I’ve said for several weeks now, almost everything has taken a bath since early September, when the clouds suddenly blew up around the US financial system. Companies that have succumbed to the bear market’s underlying stress tests—higher input costs, the weakening US economy and tight credit conditions—have taken the greater fall. But even the strongest have been sold off hard.

Where the real difference in performance has been, however, is on the good days. Then, the companies whose earnings appear to be resisting the downturn have been making power moves of 10, 15 and even 20 percent, often within an hour or two of trading.

The implication is pretty clear. The strong companies that weather the economic challenges now have real potential to come back in a hurry.

It will be some time before we see fourth quarter numbers and find out the real impact of the October meltdown on individual company earnings. It’s a safe bet some companies will show a pretty radical deterioration of results. That doesn’t mean they won’t ultimately recover their share market losses. But it does mean that recovery is going to take a lot longer.

What we do have, however, is third quarter numbers, virtually all of which are now in for essential services industries. The third quarter is almost certain to prove more vibrant than the fourth. But it also had its share of challenges, including the first negative US economic growth rate in half a decade and the first month of the accelerating lending freeze in September.

Being able to post solid earnings in this environment was, therefore, no mean feat. In fact, the general tenor of the reports from the now almost ended reporting season was decidedly negative, with companies across a wide spectrum of industries failing to meet Wall Street targets. Worse, a large number of companies have also pointed to even weaker results in the fourth quarter and beyond, ratcheting down prior projections.

Essential services enjoy some insulation from economic ups and downs by virtue of being always needed. But there were casualties in the third quarter that look set for even worse in the fourth and beyond.

The telecom sector was an area showing particular weakness. Much came on the wireline side, where the loss of local phone line connections accelerated for some companies and broadband additions slowed. But even the wireless arena produced duds.

Sprint, for example, lost 1.3 million customers and reported a 12 percent drop in its third quarter revenue, as it continues to lose business to rivals AT&T and Verizon. The company’s offerings appear to be particularly vulnerable to the popular iPhone. Moreover, these results were posted despite general resiliency of wireless sales and continued industry growth of data revenue. Things could get really dark, should these trends take a breather.

On the wireline side, FairPoint Communications’ efforts to “cut over” the former northern New England customers of Verizon to its network made its third quarter earnings very difficult to draw comparisons on. The company announced its efforts were now complete and that an independent auditor had passed it on all but one item, which it was now correcting. All that remains is regulatory approval in Maine, New Hampshire and Vermont, and that’s expected by the company’s latest cutover date of late January.

FairPoint’s overall revenue was basically flat and cash flow—which is being devoted to funding the cut over—fell short of covering the distribution. The good news is wireline losses decelerated from prior quarters and capital spending will drop sharply next year when the cutover is completed, at which time cash flow will again cover the dividend plus capital spending.

FairPoint is still very much a speculation until the cutover is completed and cash flow again covers the payout plus capital spending. But most other rural wireline phone companies also saw more local wireline connections dropped and broadband connections, which had been balancing them out, drop off some. Consolidated Communications, for example, saw its credit rating cut by Standard & Poor’s in response to larger than expected wireline losses.

The good news is a number of wireline companies—including Frontier Communications, Iowa Telecom, Otelco and Windstream—did report numbers that indicate the impact on free cash flow from local wireline losses is still being more than offset by the combination of broadband additions, cost cutting, stock buybacks and early debt retirement. That’s always been the basic story of this industry, with huge free cash flow allowing payment of big distributions. And, at least through the third quarter of 2008, it’s still very much intact for the stronger players.

All of these companies have become major acquirers of small systems over the past couple of years. That’s another way to replace lost revenue from local line losses, and increase the pool of available customers to sell advanced services to. And all are also potential takeover targets in the wake of the CenturyTel buyout of former Sprint spinoff Embarq.

As I’ve pointed out previously, AT&T posted very strong third quarter earnings, indicating little or no erosion of its core business to the weakening economy. That strength was also mirrored in the results of the other two “Big Three” US communications players: Comcast and Verizon.

Like AT&T, Verizon’s strength is owed in large part to its unmatched wireless network. The company won its last needed regulatory approval to buy rural wireless giant Alltel and the deal should now be completed by end-year, creating the largest wireless provider in the US. Many of Alltel’s systems were once part of Verizon Wireless, the product of many years of swapping. As a result, the company should be able to realize some major synergies relatively quickly. Data revenue surged 42 percent in the quarter, another major trend that will push earnings higher over time. And the company continued to sign on new FiOS customers at a rate above projections.

With the big phone companies doing so well, some expected to see cable giant Comcast falter. They were sorely disappointed; however, consumers didn’t cancel the company’s bundles of entertainment/data/phone service, and they continued to buy them in large doses. The company generated nearly $1 billion free cash flow during the quarter and posted a 33 percent jump in earnings, beating Street expectations.

Of course, there may be a point where consumers start to cut back on wireless and cable wireline services. And that may come in the fourth quarter, with the worsening of the economic crisis. The point is it hasn’t happened yet. And the companies themselves, while warning results could be nicked in the fourth quarter and into 2009, are still projecting fairly steady returns. Again, that’s no guarantee of anything. But as long as it holds up, it’s wildly at odds with these companies’ low share prices and portends a sharp recovery.

On the energy utility side, the biggest reason for most earnings shortfalls was the weather, mainly either a mild summer or storm damage. Some highly leveraged merchant power companies such as Reliant Resources had a difficult time due to toughening credit markets and softening power prices in some areas. For the most part, however, results were in line enough for companies to hold to previous earnings projections for the remainder of the year.

Many investors have apparently assumed AES Corp would fall into the same debt/weakening markets trap it did in 2001-02, when its share price actually broke $1 on the downside. But the company posted a 47 percent increase in earnings per share, excluding items, as well as a 9 percent jump in cash flow. The company marked down its expected earnings for 2008 and 2009 slightly, largely due to currency swings. But cash flow is expected to remain strong and 93 percent of debt is now denominated in local currency, limiting the further impact of the US dollar on cash flow.

That’s 180 degrees from the weakened condition the company found itself in six years ago. Again, things could get worse should the global economic picture weaken. But as long as the company keeps posting results like these, it’s poised for recovery. And the same goes for the company’s fixed income securities, which have also been punished on the same up-to-now wrongheaded assumption of weakness at AES.

A number of regulated power companies did report slowing customer growth. TECO Energy even lost customers as its western Florida service area remained in the dumps. More often than not, however, the reduction of growth in users was offset by a more powerful factor: capital spending on new supply, transmission capacity or environmental controls, which is being added to rate base through rate increases.

That salutary factor pushed earnings higher at Michigan-based CMS Energy, which also made substantial progress cutting debt. Sierra Pacific Resources’ Nevada service territory is perhaps even more challenged than CMS’. But the company nonetheless posted customer growth, both in the Las Vegas area and in the northern part of the state. That enabled management to boost the dividend 25 percent.

Sierra’s ability to make investments on its long-term energy plan and pass them into rate base is, of course, highly dependent on consistent regulation in the state. That cause was upheld in the November election, as Nevada voters re-elected their governor. That should ensure the company will be able to execute on its build out plan for the foreseeable future, pushing up earnings and restoring its financial health.

As this downturn has accelerated, energy infrastructure partnerships have been punished on two fronts. First, many investors have become very concerned about their access to capital markets, which is critical to continuing building on new projects, which are essential to pushing up cash flow and distributions. Second, some have also become concerned about throughput based on the assumption that slower energy demand would reduce their fee-based revenue.

As it’s turned out, many pipelines and other infrastructure did see some drop in throughput in the third quarter. That could well accelerate in the fourth quarter. To date, however, the drop in activity at individual assets has been offset by tariff increases. Meanwhile, new projects are still coming on stream and lifting cash flow, allowing limited partnerships (LP) to lift distributions over the past month at the same time many speculated they were coming apart.

LPs’ behavior in the stock market has truly been a wonder. Most have recovered sharply off the bottoms set roughly a month ago. But most also remain sharply discounted to where they stood a year ago, posting yields as high as 10 percent. That’s a great reason to own a basket of them.

Not surprising, water utilities have proven pretty resilient in the face of the economic pressures. Aqua America’s third quarter net rose 20 percent on 7 percent revenue growth, as it successfully followed its formula of absorbing smaller systems, upgrading them and winning rate increases. And its lead was followed by others such as American Water Works, California Water and Middlesex Water.

As with the regulated electrics, customer growth has slowed somewhat. But that still appears to be more than offset by cost controls and capital spending, which has been flowing through into rates. The tougher the economy gets, the more loath regulators may be to push through more rate increases. As of now, however, that hasn’t happened, and the need for new infrastructure remains grave in much of the country, even as overall water rates remain a relatively small part of consumers’ budgets.

On the opposite side of the essential service spectrum are companies that produce oil, gas, coal or some other form of energy as part of their business. The colossal drop in oil prices toward $50 a barrel combined with the drying up of available credit has already dramatically slowed the development of new energy projects.

We’ve seen dozens cancelled and dozens more put on hold or scaled back, as the builders have been simply unable to get funding or interest. Oil sands development spending for 2009, for example, has now been scaled back by 20 percent, with even many larger players pulling in their horns a bit.

Cutting back spending on all manner of energy projects is a natural economic response to what’s happened in the big picture. It does, however, ensure we’ll see a resumption of the bull market for energy when the economy does cycle out. That’s also the clear conclusion of the International Energy Agency (IEA) in its recent report, which noted an accelerated decline at the world’s major oilfields.

None of that is having any impact on share prices now, which generally remain under selling pressure. But the companies that weather the crisis with their productive bases intact are due a massive recovery. That certainly includes the super oils like Chevron, which posted a very strong third quarter on much improved refining and other downstream operations. It applies to utility/producers such as Energen and MDU Resources, both of which posted strong third quarter results but have guided fourth quarter and 2009 numbers lower on reduced pricing expectations.

It also applies to Canadian producer trusts, several of which now trade at prices not seen since oil last traded under $30 a barrel. Third quarter results were big up and down the industry, just as second quarter tallies were. The fourth quarter is certain to be less stellar, as oil and gas prices have declined and directly affect revenue for non-hedged output.

We’ve seen several trusts such as ARC Energy Trust, Enerplus and Provident Energy roll back distributions over the past month. That’s hardly surprising given the price action for energy. But there’s something more going on here. Mainly, none of these trusts were forced to make reductions now. Rather, they elected to do so in order to shepherd cash flow for project development and to minimize any need to borrow money or issue additional trust units in such as difficult environment.

Interestingly, none of this trio has been punished in the market place for its moves. One reason is the fact that they’ve been pricing in a lot worse already. But another might be that, at this level, investors are starting to perceive two things: First, they’re going to make it as businesses. Second, as long as they do, they’re virtually guaranteed a dramatic recovery. All we have to do now is take positions and hold on through what’s likely to remain a rocky ride for the next several months. And we’ll get paid dividends of 15 to 20 percent while we wait.