Beating the Street (37 page)

Even in the recent era, when the demand for electricity has slowed in most parts of the country and utilities are no longer regarded as great growth stocks, there have been some big winners in the group, including Southern Company ($11 to $33 in five years), Oklahoma Gas and Electric ($13 to $40), and Philadelphia Electric ($9 to $26).

For brief periods at Magellan, I had 10 percent of the fund invested in utilities. Usually this happened when interest rates were declining and the economy was in a sputter. In other words, I treated the utilities as interest-rate cyclicals, and tried to time my entrances and my exits accordingly.

But the utilities with which I've done the best have been the troubled ones. At Fidelity, we made a bundle for our shareholders on General Public Utilities after the Three Mile Island disaster, and more bundles on Public Service of New Hampshire bonds, Long Island Lighting, Gulf States Utilities, and the old Middle South Utilities, which has changed its name to Entergy. This brings us to Peter's Principle #20:

Corporations, like people, change their names for one of two reasons: either they've gotten married, or they've been involved in some fiasco that they hope the public will forget.

Each of the troubled utilities mentioned above had problems with nuke plants or the financing of nuke plants that never got built, and the nuke fears depressed the stock prices.

The reason my record with troubled utilities is better than with troubled companies in general is that utilities are regulated by the government. A utility may declare bankruptcy and/or eliminate its dividend, but as long as people need electricity, a way must be found for the utility to continue to function.

The regulatory system determines what prices the utility can charge for the electricity or gas, what profit it's allowed to make, and whether the costs of its mistakes can be passed along to the customer. Since the state government has a vested interest in the survival of the enterprise, the odds are overwhelming that the troubled utility will be given the wherewithal to overcome its problems.

Recently, the work of three analysts at the NatWest Investment Banking Group (Kathleen Lally, John Kellenyi, and Philip Smyth) was brought to my attention. Kellenyi I've known for years. He's an excellent analyst.

These utility watchers have identified what they called “the troubled utility cycle,” and they give four examples of companies that have lived through it: Consolidated Edison, which faced a cash crisis after the surge in oil prices during the 1973 embargo; Entergy Corporation, which was saddled with a lavish nuke plant it couldn't afford; Long Island Lighting, which built a nuke plant and then couldn't get a license for it; and General Public Utilities, the owner of Three Mile Island Unit Two, which had a famous accident.

The stocks of all four of these utilities in distress fell so far and so fast that their shareholders also were left in distress, and those who sold in the panic have been even more distressed to see the prices quadruple or quintuple on the rebound. Meanwhile, the buyers of these downtrodden shares are celebrating their good fortune, which proves once again that one person's distress is another's opportunity. You had a long time to profit from each of these four recoveries, which, according to the three analysts, proceeded through four recognizable stages.

In the first stage, disaster strikes. The utility is faced with a sudden
loss of earnings, either because some huge cost (the increase in fuel prices in Con Ed's case) cannot be passed along to customers, or because a huge asset (usually the nuke plant) is mothballed and removed from the rate base. The stock suffers accordingly and loses anywhere from 40 percent to 80 percent of its value in a one- to two-year period: Con Ed dropped from $6 to $1.50 in 1974, Entergy from $16.75 to $9.25 in 1983–84, General Public Utilities from $9 to $3.88 in 1979–81, and Long Island Lighting from $17.50 to $3.75 in 1983–84. These drops are horrifying to people who regard utilities as safe and stable investments.

Soon enough, the distressed utility is trading at 20–30 percent of its book value. The stock has taken this drubbing because Wall Street is worried that the damage to the company may be fatal, especially when a multibillion-dollar nuke plant has been shut down. How long it takes to reverse this impression varies from disaster to disaster. With Long Island Lighting, the threat of bankruptcy kept the stock selling at 30 percent of book value for four years.

In the second stage, which our trio of experts calls “crisis management,” the utility attempts to respond to the disaster by cutting capital spending and adopting an austerity budget. As part of the austerity, the dividend on the stock is reduced or eliminated. It is beginning to look as if the company will survive its difficulties, but the stock price doesn't reflect the improved prospects.

In the third stage, “financial stabilization,” management has succeeded in cutting costs to the point that the utility can operate on the cash it receives from its bill-paying customers. The capital markets may be unwilling to lend it money for any new projects, and the utility is still not earning anything for its shareholders, but survival is no longer in doubt. The stock price has recovered somewhat, and the shares are now selling at 60-70 percent of book value. People who bought the stock in stages one or two have doubled their money.

In stage four, “recovery at last!,” the utility once again is capable of earning something for the shareholders, and Wall Street has reason to expect improved earnings and the reinstatement of the dividend. The shares now sell at book value. How things progress from here depends on two factors: (1) the reception from the capital markets, because without capital the utility cannot expand its rate base, and (2) the support, or nonsupport, of the regulators, i.e., how many costs they allow the utility to pass along to the customers in the form of higher rates.

Figures 16-1
,
16-2
,
16-3
, and
16-4
show a stock price history for each of our four examples. As you can see, you didn't have to rush into these troubled utilities to make substantial profits. In each instance, you could have waited until the crisis had abated and the doomsayers were proven wrong, and still you could have doubled, tripled, or quadrupled your money in a relatively short period.

Buy on the omission of the dividend and wait for the good news. Or, buy when the first good news has arrived in the second stage. The problem that some people have with this is that if the stock falls to $4 and then rises to $8, they think they have missed it. A troubled nuke has a long way to go, and you have to forget about the fact that you missed the bottom. There's a need here to apply some psychological Wite-Out.

The difference between a troubled nuke and an opera is that the troubled nuke is more likely to have a happy ending. This suggests a simple way to make a nice living from troubled utilities: buy them when the dividend is omitted and hold on to them until the dividend is restored. This is a strategy with a terrific success ratio.

In the summer of 1991, the experts at NatWest identified five more distressed utilities (Gulf States, Illinois Power, Niagara Mohawk, Pinnacle West, and Public Service Company of New Mexico) in various stages of recovery, all selling below their book values. But I had another idea for a
Barron's
recommendation: CMS Energy.

This used to be the old Consumers Power of Michigan. It changed its name after it built the Midland nuclear plant—something it hoped the shareholders would forget. The stock had been sailing along in the $20s and then sank to $4.50 in less than a year, hitting bottom soon after the dividend was omitted in October 1984.

CMS, né Consumers Power, was the latest 10-bagger in the wrong direction, and the latest utility to have designed and constructed an expensive nuke plant on the foolish presumption that the regulators who approved the project throughout its development would allow it to operate in the end. Like Lucy with the football, state utility commissions across the land got into the habit of supporting nuke plants until their owners were fully committed and it was too late for them to reverse direction. Then, at the last minute, the public agencies would snatch away the projects and watch the utilities fall flat on their backs.

When this happened to Consumers Power, the company was forced to take a hefty write-off of $4 billion to cover the costs of building the nuke plant it wasn't allowed to use. As Wall Street saw it, bankruptcy was not far from the doorstep.

FIGURE 16-1

But CMS did not go bankrupt, and by the end of the 1980s it had made the best of a bad situation by converting the unusable nuclear plant to natural gas. This conversion (carried out with the help of Dow Chemical, CMS's biggest customer) was expensive, but not as expensive as watching a $4 billion investment go to waste. The converted plant was opened in March of 1990, at a cost of $1,600 per kilowatt, which was somewhat under budget, and the plant seemed to be working fine. The stock had come all the way back and then some, to $36 a share, for a ninefold gain in five years. But then a couple of unfavorable rate decisions by the Michigan Public Service Commission drove the price down to $17, which is where it was when I stumbled onto it.

The story came to me through Danny Frank, manager of Fidelity's Special Situations Fund, who had brought several of the troubled nukes to Fidelity's attention. Frank had thoroughly investigated the situation at CMS. He indicated that CMS's latest problems, which mostly had to do with an unfriendly commission, did not justify the 50 percent devaluation in the price of the stock.

On January 6, 1992, I talked to CMS's new president, Victor Fryling, whom I'd met years earlier when he worked for the energy/pipeline company Coastal. Fryling mentioned a couple of positive developments. The first was that the Midland plant, converted to gas, was producing electricity at a cost of 6 cents per kilowatt, as compared to the 9.2 cents it normally costs to produce electricity from a new coal plant and the 13.3 cents from a nuke. Midland was a low-cost operation, the kind I like.