With an economic recovery and the status of second-half corporate earnings for this year still in question, today's Daily Interview checks in with Mark D. Luftig of the (SAMUX Quote)Strong American Utilities fund to survey the landscape of the utilities industry, which has traditionally been a defensive sector.
While the fund was down 3.9% for the year through June 30, it's managed to outperform most of its peers over that time and sports a 5-year annualized return of 15.0%, according to Morningstar.
Luftig says he's optimistic about California's energy problems being resolved and that he's confident about the fundamentals of the diversified electricity and gas companies he owns. Read on to find out why.
TSC: The utilities sector has been weak year-to-date. How should investors be situated given the current circumstances? What are the key drivers -- both positive and negative -- for the sector? Luftig: Year-to-date, we have been doing OK on a relative basis. On an absolute basis, we're disappointed. There are two reasons for that: First, the energy sector has been weak. Second, electric utilities, which have been the best-performing parts of our fund, have been temporarily hurt by the continuing political shenanigans in California. We have never been happy with California and our fund has never owned any electric utilities operating in the state, such as
PG&E,
Edison International(EIX Quote) and
San Diego Gas & Electric.
But people don't necessarily distinguish these issues. The crisis in California has also slowed down the deregulation process. But the companies that we own are doing well. The earnings of some of these companies are growing at 10% a year, which is unheard of in the electric utilities industry. We think this growth will continue for the next two to three years.
The other thing is that the stocks are still at a low P/E relative to the
S&P [500]. The electrics, for example, are selling at 11.5 times their 2002 earnings, while the S&P is about 19, 20 times its 2002 earnings. I think a 30% discount for the slower-growing industry is reasonable. A 30% discount to the S&P multiple is about 14. But to go from 11.5 to 14, we see a large upside in price movement.
We think that earnings per share for the industry will be about 7% better than the last year. They also have a yield support: The group yields about 4.5%, about four times what the S&P is yielding right now. We also think that deregulation and mergers will continue. The issues in California will be settled one way or another. We expect that some kind of resolution or movement ahead will come about by the end of this year.
TSC: Given the general malaise in the sector, which are the subsectors you prefer to be in, and which parts of the industry do you think should be avoided? Luftig: The ones that we don't own are the firms with concentration on distribution only. We also are out of generation-only companies such as
Mirant(MIR Quote) and
NRG(NRG Quote). We like the companies that have integrated and diversified operations in electricity and gas.
Our largest holding is
Dominion Resources(DCP Quote). Dominion owns what used to be
Consolidated Natural Gas. The reason we started buying Dominion two years ago was due to the excellent deregulation bill in Virginia. Integrating CNG into its operation was a great move. Essentially, Dominion has gas, which they can sell, or they can generate electricity and then sell it during peak periods.
TSC: Dominion is down about 6% from the beginning of the year. Is that largely due to the overall weakness in the sector? Luftig: That, too, but also the stock had moved ahead and pulled back. Another major holding that has had the greatest appreciation is
TXU(TXU Quote). It has done well, and constitutes about 7.1% of our fund.
TSC: Why do you like TXU? Luftig: This one has two things going for it: First is its operations in the U.K., which the company has just added in the past year. Second, the company will also benefit from the fact that the deregulation problems in Texas have been pretty much resolved. Full competition starts in January. And we think TXU has done a lot of the right things in terms not only of wholesale but also branching out into retail, selling to the consumers.
The company also has a different deregulation and legislative situation in Texas, where it has a separate company which will be responsible for supplying power to the consumers. The company can also buy power from its own independent generating company. Furthermore, we expect TXU to move into the Midwest as well as the Northeast.
Another company in which we have a large stake is
FirstEnergy(FE Quote). It is in the process of acquiring
GPU(GPU Quote), which is due to be completed by the end of September.
TSC: What strengths does this acquisition give FirstEnergy? Luftig: It provides FirstEnergy with a platform for selling its energy from nuclear power sources, which will be greatly beneficial. As a result of this acquisition, FirstEnergy will be in Ohio and New Jersey, which are two different power pools, thus allowing the company to arbitrage the cost of power back and forth between the two.
TSC: What are the most important lessons to draw from the California power problems? Does government interference always spell disaster? Luftig: Well, that's clear. But they also had a bad plan. Once you bring politics into regulation, it always turns out to be a big mess. In New York, Governor Pataki was smart to take a step back and not to have gotten involved and to have left the energy issues up to the
Public Service Commission. It never works out for the politicians, either.
The last politician who made out well regulating the utilities was Huey Long, who was the chairman of the
Public Service Commission in Louisiana about 50 years ago. Regulation of utilities is not a good political stepping-stone.
Also, the regulatory system was designed to work best handling excess capacity with lots of sellers bidding into the market. This was not the case in California. And then California went whole hog and didn't let any of the utilities companies enter into long-term contracts, therefore forcing the companies to buy everything in the spot market. California is the only state where this happened.
It's changed now and the firms are now allowed to enter into long-term contracts. It'll work out eventually as long as deregulation happens smoothly, but things will remain tight for some time.
TSC: How do you see the merger trends in the industry shaping up? Luftig: Everything has slowed down in the last six months because of the issues in California, but I expect that merger trends will pick up again. Especially now, I think, because of the recent change in the [
Financial Accounting Standards Board] rules on goodwill.
TSC: How will the rules change affect the industry? Luftig: You don't have to amortize goodwill starting next year. We have some utilities that have 40 to 50 cents a share in their earnings, which accounts for goodwill amortization. With the change in effect, their earnings then will go up considerably. Some of this goodwill is permanent stuff, and there's really no need to write it off. When an asset gets sold, then you adjust the goodwill.
TSC: What is your comment on the current oil demand as an indicator of overall economic conditions here and abroad? Luftig: We see oil demand dropping because of the global slowdown. The price of West Texas' crude is now down to $25 a barrel from well over $30 in the last 12 months. We think the price will stabilize in the low $20s. We think that earnings per share for oil companies are coming way down, but much of this is only reflected in their stock prices. We have lightened our energy positions and reduced our exposure to energy service companies.
TSC: Do you anticipate an economic recovery in the second half? Luftig: We're not trying to time it that way. The way we play it is that concerns out there can mean energy stock prices are getting weaker. We have seen
Schlumberger(SLB Quote) and
Smith International(SII Quote) drop 40% already this year. The question is where the bottom will be. But we can't bottom-fish. We would rather see stocks come back before we choose to invest heavily.
