By the Numbers

Living by the numbers is the key to being a successful income investor. Most focus on the dividend yield. But far more important are the business numbers behind it–the operating results and financial position that ultimately determine whether that payout will rise, fall or stay the same.

If any earnings season in recent memory came with low expectations, fourth quarter 2008 was it. Not only had the global economy plunged into recession, but the world’s financial system also experienced its worst meltdown in nearly 80 years. Many companies were simply unable to access credit or the capital markets, as lending froze, stock prices plunged and bond issues evaporated.

Already this earnings season we’ve seen household name companies take billions of dollars in writeoffs. Ford (NYSE: F) announced this week it lost $5.9 billion in the fourth quarter alone. Companies like Starbucks (NSDQ: SBUX), Allstate (NYSE: ALL) and Microsoft (NSDQ: MSFT) have slashed jobs, driving unemployment insurance claims to an all-time high. Orders to US factories for big-ticket items have now plunged for five consecutive months, pressuring manufacturers and their suppliers up and down the value chain.

Market sentiment for 2009 could scarcely be lower. Consumer confidence continues to slip as housing prices fall, even in the strongest markets. Output is falling as nation after nation slides into official recession. And unemployment appears to be on a collision course with double-digits in the coming months.

It’s also clear, however, that we didn’t get to this point overnight. The US economy, for example, is now reckoned to have slipped into a recession in late 2007, well over a year ago. And there’s ample evidence the most vulnerable areas of the country were headed that way considerably earlier. Moreover, the credit and capital markets began to tighten not in late 2008, but rather in the second half of 2007, evidenced by the abrupt end of the private-capital takeover wave.

In short, things haven’t been good for some time. In fact, individual companies and industries have been facing severe stress tests–volatile commodity prices and currency swings, rapidly sliding economic growth and scarce credit–for at least six quarters. That’s plenty of time for all their faults to come into graphic relief.

Things may indeed worsen in 2009, as the Street consensus anticipates. Despite the easiest monetary policy in decades and $1 trillion-plus in fiscal largesse likely to be passed by Washington in coming days, the US economy may not revive. The vicious cycle of falling confidence, rising joblessness and sinking output may accelerate, and the world overall may indeed continue to languish.

In my view, however, if a company hasn’t come apart under what’s happened thus far, it isn’t likely to in 2009. That’s especially true now that credit conditions have been easing for several months and money is again flowing to more creditworthy borrowers. It’s also true that money is tight and the highly leveraged are still under a lot of financial pressure. But if a company hasn’t felt credit pressure the last year and a half, there isn’t a lot that can happen now to put it at risk.

Clearly, given the acceleration of negative macro factors in the fourth quarter, there was a real possibility that even companies thriving through the third quarter would crack. After all, the fourth quarter was the first in which what had been mainstays of growth–Asian economies, for example–began to slow in earnest. And it included the nearly two-month-long freezing of the credit market from mid-September through mid-November.

To be sure, more than a few companies in a wide range of industries did crack, cutting dividends and defaulting on debt. Even more reported atrocious fourth quarter earnings after generally holding firm in the third. And the risk that the same would happen to others has sent stocks of similar companies tumbling as well.

Finally, there’s the tenor of market commentary prior to the release of numbers, which ranks among the most pessimistic in memory. Even the strongest companies haven’t been spared the gloom.

The good news: Thus far, fourth quarter numbers for Utility Forecaster recommendations are shaping up as strong as their third quarter tallies. In fact, most have beaten Wall Street estimates handily and covered their distributions by a wide margin–and they’ve guided toward equally solid numbers for 2009 and in some cases 2010 as well.

That’s very good news for two major reasons. First, it augurs well for their performance for the rest of this bear market, as long as it lasts. Again, if a company didn’t succumb to credit pressures in the fourth quarter–when conditions were far tighter than now–it’s less and less likely it will in 2009, or for the rest of the cycle. And while a deepening of the recession will almost surely hurt sales, we’ve already had at least a year of negative growth. Any company that’s been able to grow through it has proven its ability to shake it off, either thanks to a superior market position in a strong niche, a powerful balance sheet or both.

Second, our picks’ share prices have come down in the past few months and are now pricing in the up-to-now mistaken assumption that they’ll be felled by weakening growth and tight credit markets. If that doesn’t happen by the time this cycle ends, they’re in for the mother of all rallies, as their battered share prices recover to levels more reflective of their growth potential, safety and generally high and growing yields.

Breaking It Down

Last week I reported on the handful of early reporters, companies that released either actual fourth quarter numbers or else guidance ahead of their peers.

As I noted then, the news and numbers we had augured well for the rest. Strength in the unregulated nuclear power operations of Exelon (NYSE: EXC) and Entergy (NYSE: ENT)–the two largest nuke owners in America–was a clear indication that not only were these companies continuing to run their operations effectively, but that wholesale power markets were still solid enough to support good growth for the strongest players.

Wholesale power, of course, has been in a bull market over the past couple of years, as the power glut left by overbuilding in the late 1990s has dried up in the face of strong demand. Speculation, however, has been that a weakening economy would drive down demand, hence wholesale power prices. The effect in some markets, like Texas, would in turn be magnified by the drop in natural gas prices, to which power prices in the Lone Star State are pegged.

Entergy does sell power in Texas, and its results did lag Exelon’s, whose major markets are in the Northeast and Midwest. This week’s numbers, however, show clearly that wholesale power producers are still immensely profitable for the best-positioned players.

Southern Company’s (NYSE: SO) Southern Power unit, for example, posted a 150 percent jump in fourth quarter earnings, as it continued to sign on customers to highly profitable long-term contracts and enjoyed the benefit of falling natural prices on fuel costs. The company’s recently inked contract for power sales from a to-be-built 720 megawatt natural gas plant with a Carolina municipal power company and a cooperative illustrates there are still huge opportunities for growth in this area, even with the Southeast economy slumping.

Dominion Resources’ (NYSE: D) wholesale power operation in New England and the Midwest was also extremely profitable in the fourth quarter. Generation division earnings rose 73.9 percent in the fourth quarter from year earlier levels and were up 83.5 percent for all of 2008.

In fact, it was the single biggest reason that overall company earnings rose 16 percent, topping Wall Street expectations and offsetting the impact of mild weather on regulated Virginia utility operations. Wholesale electricity sales are also the most important factor behind management’s expectations of steady profit growth in 2009 and 2010, and accelerating gains thereafter.

Much of Dominion’s output is from conventional power sources, such as nuclear, coal and natural gas. A drop in fuel costs for the two fossil fuels was a major reason profitability improved in the fourth quarter and is expected to be strong in the coming year. But the company is also moving into what’s rapidly becoming the fastest-growing segment of wholesale power: Wind energy, most recently through a partnership in Virginia with Super Oil BP (NYSE: BP).

Wind, solar and other renewable energies are highly favored by President Obama, who has hailed them as a way to both reduce America’s dependence on Middle East oil and contribution to global climate change. Thanks to massive innovation in industry scale and scope, wind has become the most economic form of renewable energy, with projects proliferating nationwide.

Growth of wind, solar and other renewable energy, however, is plagued by a rather inconvenient truth: The credit crunch and collapse of oil and gas prices have dried up funding for new projects, for all but the strongest industry players who don’t depend on bank loans and capital markets. Scores of renewable energy developers–both public and private–have met their demise in recent months.

The good news: Companies that don’t depend so much on leverage are getting the projects. And that trend is set to continue as the president’s renewable energy investment-heavy stimulus package blasts its way through the US Congress.

At the same time smaller renewable energy companies have had trouble making ends meet, FPL Group (NYSE: FPL) reported its “best year ever,” with earnings per share soaring 82 percent. The company’s south Florida utility service territory has suffered more than most during the economic slowdown. But the renewables-heavy wholesale power unit NextEra Energy Resources (formerly FPL Energy) turned in a 267 percent boost in profits per share, as it continued to build out its fleet of wind power plants nationally, taking advantage of state mandates for wind and the lack of viable competitors.

The company also affirmed its earnings forecast for 2009 and 2010, basically asserting it will continue to grow rapidly despite the economy. That had clearly bullish implications, both for the company’s superior market position and the renewable energy market.

Propane sales were another utility-type business that many expected to suffer from economic weakness. But superior results at AmeriGas Partners (NYSE: APU) were pretty clear proof that hasn’t happened yet, at least not enough to derail a well-managed, well-capitalized provider.

To be sure, business did suffer some from customer conservation, just as it has in prior periods. But the limited partnership’s (LP) increase in size and scale–coupled with the benefit of lower wholesale propane costs–more than offset any impact. And the LP managed to boost its outlook for fiscal year 2009 (ended Sept. 30) as well.

The fourth quarter earnings warning from Super Oil Chevron (NYSE: CVX) earlier this month was a pretty clear sign that oil and gas producers were in for a rough quarter. That was hardly any surprise, given the $100 per barrel drop in oil prices since mid-2008 and the nearly 70 percent decline in natural gas prices.

What was somewhat more surprising was the quite strong earnings performance of utility producers like Energen (NYSE: EGN), which combines an Alabama-based natural gas distribution utility with a low-risk oil and gas production arm. At this point, production is about 80 percent of overall earnings. Management, however, has run this operation with utility-like risk aversion, hedging the vast majority of output well in advance and investing in mainly proven and producing wells.

The positive results of this strategy showed up clearly in Energen’s fourth quarter 2008 and full-year profits, which surged to a record $4.47 per share. Thanks to hedges on 72 percent of output, average realized prices for the year fell only 9 percent, versus a 30 percent plunge had nothing been hedged. Production rose 4 percent.

The company currently has nearly two-thirds of projected output hedged for 2009. Even with that, it still projects profits to fall to a range of $3.10 to $3.50 per share, given the drop in energy prices. But it remains extremely solid, with $186 to $216 million in free cash flow expected for 2009 to fund expansion at a time when rivals are floundering. That puts the company in prime position for the next up leg in energy prices, particularly trading at barely nine times the low-end of its projected 2009 earnings range.

Wrong…Again

Since this bear market/economic slowdown began, the Street consensus has been the communications sector would be taken down. For one thing, this is the first major recession to strike with so much sector competition. Traditionally, that’s the kind of condition that has led to profit-destroying price wars, with even the best-positioned companies suffering grave wounds.

Others have been concerned about the large volume of debt traditionally carried by sector companies, which has grown larger in recent years due to consolidation and the need to build new infrastructure. A sudden lack of access to adequate credit could potentially play havoc with the entire operation, forcing drastic and again earnings-leveling action.

Some have questioned whether indeed communications remains an essential service, or just what part of it would prove to be under harsh economic conditions. Local phone service, of course, had always been. But with incumbent companies losing basic copper connections at double-digit annual rates, speculation has growth that their revenue mixes are increasingly unstable and vulnerable to weakening growth as never before.

Finally, a theory has grown up among some analysts that the rapid growth of the US wireless market is coming to an end, as the market becomes “saturated.” The demise is supposed to be hastened by the growing weakness of the US economy, which in turn will force players to compete more on price, in turn destroying margins.

In each successive quarter, in the days leading up to announcements the negative commentary has become progressively shrill. This month, we’ve seen headlines such as “US Carrier Increasingly Desperate” and “AT&T Layoffs: The Tip of a Telecom Downturn.”

For the past month, by far the most frequently quoted pundit on both AT&T (NYSE: T) and arch-rival Verizon Communications (NYSE: VZ) has been Bernstein Research analyst Craig Moffett. Earlier this month, Mr. Moffett proclaimed “overall growth expectations (for both companies) appear significantly too high.” He forecast a sharp slowdown in growth was “inevitable” and slashed earnings estimates for both companies and forecast a “dramatic” decline in wireless growth, further stating “Wireless, long the fastest growing segment, is nearing saturation, and history suggests that growth may slow abruptly in a recession.”

Mr. Moffett commands considerable attention on Wall Street, so it was no great surprise his comments had an immediate impact on the stocks of both companies. And, of course, it’s always possible 2009 will get so bad that his scary pronouncements may eventually hold some water.

That wasn’t apparent at all, however, in the actual numbers Ma Bell and Verizon released this week. Rather, both posted robust growth in wireless customers and particularly in the data business. Heavy subsidies for the iPhone did hurt AT&T’s profits per share. But the 51 percent jump in data sales shows clearly that once it gets a customer, that acquisition is immensely profitable and likely will be for some years.

Verizon, meanwhile, continued to report industry-low customer turnover or “churn,” a clear sign it isn’t losing customers to the iPhone. And strong growth in revenue per customer proves it too is realizing a windfall from the data business, which showed a 41 percent jump in sales in the fourth quarter–a continuation of past periods’ success. That favorable trend should actually accelerate in 2009, as the company integrates the roughly 10 million new, mostly rural-based users from the recently completed Alltel acquisition. Finally, Verizon management affirmed “no evidence of slowing” at Verizon Wireless, as did AT&T for its wireless operations.

Interestingly, in response to these numbers Mr. Moffett has nonetheless persisted in his bearish call for both companies. But his arguments have shifted to perceived weakness in wireline margins and sales to businesses, as well as a writedown of the company’s pension plan assets due to the drop in the stock market.

His comments have continued to feature prominently in the media, very likely because the prevailing storyline is doom and gloom. And no doubt they’ll be repeated once again–and possibly even made more dramatic–as we gear up for first quarter reports in April.

As the old saying goes, even a stopped clock is right twice a day. But investors would be well advised to consider that more than 80 percent of Verizon’s fourth quarter operating profit came from wireless operations, not wireline or enterprise operations. Moreover, sales of the company’s advanced broadband FiOS product topped all expectations as it continues to boost market share and reach. And while the legacy MCI corporate business did see a 2.3 percent drop in revenue, the company’s new service offerings showed impressive gains, particularly considering the weakness of the global economy.

Again, the strength at AT&T and Verizon may come to a crashing end sometime this year. The point is it did not in the fourth quarter, despite the toughest conditions in decades–and nor were there any signs whatsoever that operations are coming apart.

Until and unless they do, the wise course for income investors will be to stick with them. Mainly, if they haven’t cracked yet–and particularly in the credit challenged fourth quarter–they’re less and less likely to going forward. And they’re more and more likely to lead this market a lot higher when this cycle finally shifts to recovery mode.

Speaking Engagements

Make plans to visit with me, Elliott Gue, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23 to Saturday, April 25.

I’ll discuss utilities, Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street and our in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. We love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Utility & Income discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.