Investing Daily

After decades of tough regulation, an industry absolutely essential to the health of the US economy is opened up. The immediate result: A good business becomes a great one. The top executives get rich, as do many further down the chain.

Fatter profits, however, ratchet up the pressure to keep the big bucks rolling in. Without firm regulations, there’s nothing holding anyone back from taking greater risks and piling on the leverage in pursuit of the big payoff.

When business conditions inevitably sour, the mountain of debt comes crashing down. With few--if any--firewalls in place, the contagion engulfs the entire sector, eventually forcing the government to step in with money as well as new regulation to prevent future calamities.

I could well be describing the situation in America’s financial services industry now. But the sector I’m really talking about is energy utilities circa 1994-2002.

The idea of deregulating power and natural gas monopolies first started to get traction in the early ’90s. Proponents predicted opening these markets would unleash a tidal wave of new investment in the sector, with the result of newer, more efficient infrastructure as well as lower rates for consumers.

In the early years, state after state abandoned the regulated monopoly model for the brave new world of competition. Ironically, the states that embraced deregulation in a bear hug were in the deep blue Northeast and California, while the red states of the Deep South and much of the Midwest stuck with the tried-and-true regulated model.

The aftermath was the great utility crash of 2001-02, which saw the Dow Jones Utility Average slide nearly 60 percent from the late 2000 high to the ultimate bottom in late 2002. The sudden collapse of Enron—the poster child for deregulation—was the headline event. But by early 2003, more than two dozen other utilities were either in bankruptcy or perilously close.

The utility crisis, of course, had a very happy ending. The process was long and, in some cases, very painful for shareholders. But in the end, companies went back to doing what they had done best for decades: operating largely regulated essential services businesses. Recognizing the precarious state of the industry, regulators abandoned the “tear it down” philosophy of the ’90s and forged a new compact with companies.

Management slashed operating risk and debt. Credit ratings stabilized and began to rise again, even as companies boosted dividends. The result was the biggest bull market in history for the sector, with the big utility stock averages eventually reaching a level of more than twice the 2000 market top. And even after 15 months of intensifying bear market stress tests, the vast majority of utilities are still running very healthy businesses.

It’s too early to tell exactly how the current crisis in the finance industry will play out. But the utility industry’s recovery is definitely a hopeful example.

As we saw from this week’s wild action, the damage to the system is both wide and deep. Federal bailouts have headed off the worst for mortgage giants Fannie Mae and Freddie Mac, as well as insurance behemoth American International Group. But the situation for a half dozen other major financial institutions remains extremely precarious, and the potential for more meltdowns is great.

The key is essential element of recovery is now in place: That’s basically a coordinated effort of the world’s central banks to flood the system with money where it’s needed. The details of the effort are still taking shape, including a potential “Resolution Trust Corp”-type entity to sort out the bad mortgages. And just as the utility industry reregulated to restore confidence, the financial services industry will as well.

The world has changed since the Great Depression of the 1930s and the US can’t go completely back to Glass Steagall and all the other safeguards put in place then. But with both the Democratic and Republican candidates in the presidential race calling for comprehensive reform, the sector’s “Wild West” days are over, at least for now.

Rather, we’re likely to see a more conservative system emerge with more regulations, higher capital requirements and firewalls to prevent future calamities. US finance will still be a good business, just not a great one where everyone gets rich overnight.

As I pointed out in the September issue of Utility Forecaster, utility sector earnings were quite healthy in the second quarter. Despite the turmoil raging in the financial markets, the slowing economy and high raw material costs, the vast majority of companies turned in good numbers as sales remained steady and costs were passed through in rate base. Even unregulated companies saw strength, as power prices remained robust.

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Weather may slow some power sales in the third quarter, but I expect strong results once again. For one thing, demand isn’t going to fall much no matter what happens. Electricity is an essential service, and as the adage goes the last thing people will stop paying for no matter how bad the economy gets.

The housing market in much of Southern Company’s service territory, for example, has slowed dramatically. The utility, however, actually recorded modest customer growth and a solid earnings gain in the second quarter. The same was true even of Sierra Pacific Resources, which operates in dramatically slowed Nevada.

One area of the industry, however, has come under increased scrutiny for its exposure to potential credit shocks: energy marketing. This was the area of real trouble for utilities during the last crash. Every company involved was wounded, some fatally.

The key difference between now and then is that marketing has been largely abandoned by most companies, or at least confined to a tiny corner of their business for hedging, not speculation. This summer, for example, one of the last holdouts Great Plains Energy dumped its Strategic Energy unit for cash, electing instead to deploy its funds to acquiring neighboring regulated utility Aquila. PNM Resources is now taking the same action to unload its disastrous marketing business in Texas, though shareholders have paid the price of a steep dividend cut.

The big utility story this week was Constellation Energy. Rather than abandon energy trading and marketing in the wake of the Enron collapse, the company has aggressively expanded its presence, becoming one of the country’s biggest players in the process.

Unlike Enron’s cowboy approach, the Maryland-based company has been conservative with its positions, hedging at every opportunity and largely avoiding the turmoil of volatile power and fossil fuel prices this year. As a result, it’s been one of America’s most consistently profitable utilities in recent years and, up until recently, a Wall Street darling.

Energy marketing, however, has another key exposure: The need to post collateral to cover debt used to ensure the liquidity of trades. Constellation’s troubles began when the company released its second quarter 10-Q, revealing for the first time that it would have to come up with more than $3 billion in collateral if its credit rating were cut to junk (below BBB-) by Standard & Poor’s.

That was a full $1.6 billion more than had been originally disclosed, and the result was a one-day 20 percent haircut in the shares. But the worst was yet to come.

The disclosure immediately induced Standard & Poor’s to cut the company’s rating to BBB, setting off more selling. The rater affirmed Constellation’s outlook as “stable” and Electricite de France took advantage of the dip to double its stake in the company to 9.9 percent.

Then came the bankruptcy of Lehman Brothers this week, along with the US government’s decision not to bail it out. Constellation issued a release affirming that it had a credit line worth more than $3 billion, even without Lehman’s $150 million share. The company also affirmed that its business was sound and its trades were healthy. It repeated its expectation of earning upwards of $5 a share in 2008.

Unfortunately, with panic spreading throughout the financial system and doubts rising about other institutions’ ability to make good on credit lines, investors weren’t listening. The stock continued to plunge. The coup de grace came mid-week, when Standard & Poor’s put the company on watch for another downgrade. That raised the specter that Constellation would be cut to junk. At the same time, it would be unable to access enough credit to meet the needed $3 billion in collateral. The stock went into freefall, hitting a low of close to $15 a share on Wednesday.

Enter Warren Buffett. Long rumored to be mulling an acquisition, the world’s most revered value investor struck almost at the bottom: reaching a friendly deal to acquire Constellation for $26.50 a share in cash, a price less than a quarter of the stock’s 52-week high of $107.97. The deal includes an immediate $1 billion cash infusion in the form of preferred stock to be issued by Constellation.

The ruler of Berkshire Hathaway’s vast empire has been targeting the utility business for expansion since the late 1990s, when he acquired MidAmerican Energy and its CEO David Sokol. At the time, both men billed the move as a first entry into what they considered to be an undervalued, increasingly essential business.

Sokol had already enjoyed success in the utility merger: The first acquisition of a regulated utility (Midwest Energy) by an unregulated independent power producer (then CalEnergy). And many assumed Berkshire would immediately launch a mass wave of buyouts. That speculation has grown as the company added other able executives such as current MidAmerican CEO Gregory Abel.

But that isn’t Buffett’s way. Rather, Berkshire has since taken an incremental investing approach to the industry, spending its time building its business, plotting its moves--finally striking when the sellers were willing and the prices were low.

Not surprising, the first big move came at the height of the 2001-02 bear market in the acquisition of a major pipeline business from Williams Companies in exchange for much-needed cash to keep the latter afloat. That was part of a deal included a $1 billion, one-year loan to Williams at loan shark-like 30 percent interest.

The second monster move was to buy PacifiCorp from another anxious seller, Scottish Power. PacifiCorp—itself forged from a series of mergers—handed Berkshire a wealth of low-cost power plants and stable utility system throughout the mountain west. It also gave Berkshire a major push into the rapidly growing renewable energy business, which Sokol had been deeply involved in with CalEnergy.

Taking Constellation is in many ways the equivalent of getting a $1 million dollar home for the price of taking over a $10,000 mortgage in danger of default. The deal values the company at just 67 percent of book value and 20 percent of annual sales. The purchase price of $4.7 billion plus the assumption of $4.8 billion in debt and $1 billion in new preferred stock is basically the value of Constellation’s property, plant and equipment, which itself is on the books at well below replacement cost.

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That basically assigns a negative value for the trading book, which has previously been considered among the strongest in the industry. Moreover, the regulated Maryland power utility and unregulated generation assets alone rake in $2 billion in cash flow a year, which Berkshire will be able to keep after it’s tax by virtue of not having to pay a shareholder dividend.

This deal also brings nuclear energy to Berkshire’s utility empire for the first time, an area where Buffett has professed great interest. Constellation operates a highly efficient fleet of plants and has plans to build several more. The merger effectively allies Berkshire with French nuclear giant Electricite de France—which owns 10 percent of Constellation—and its nuclear construction partner, French government-backed Areva. The pair has plans to build four advanced reactors in the US, and joining their interests to Buffett’s deep pockets could accelerate their development.

First off, this is yet another deal that makes me happy to be a long-time Berkshire shareholder. And it’s unlikely to be the last move for the company in the utility industry.

Second, saving Constellation removes what could have been a real problem for the US utility industry before it really had a chance to fester. The company has numerous counterparty agreements throughout the industry, and the risk of a Chapter 11 filing—while unlikely—would have almost surely had a cascading impact on share prices. Much of the recent weakness in the group, for example, can be traced back to the beginning of Constellation’s troubles.

Other companies with energy marketing exposure are also no doubt breathing a particular sigh of relief. There’s still the matter of Morgan Stanley, now severely weakened and a leading energy trading firm with an even greater reach. That company, however, will almost certainly get a significant capital boost in coming days, as it decides which of a long list of potential suitors to wed.

Marketing remains the riskiest part of the energy utility business, as it’s always been. And there’s still the possibility for more stumbles, particularly if energy prices remain this volatile.

Even counting Constellation’s demise, however, the magnitude of this year’s woes isn’t even in the same ballpark with what happened in 2001-02. Neither is the potential for more bad news.

Simply, utilities have been walking away from precisely this kind of risk since early 2002. There’s just nothing close to the same level of exposure, even for those still involved in the business.

Perhaps the most important implication of the Constellation takeover is the lesson it holds for all investors in this extremely volatile and fear-drenched market: Bear markets are always the best times to buy value.

Berkshire isn’t a charity organization. This deal’s biggest beneficiary is clearly Mr. Buffett and his investors. But following the investment company’s strategy of accumulating good assets when they’re cheap can benefit everyone. So is focusing on value, rather than getting caught up in the prevailing emotion of the market.

I’ll admit I’ve had a few emotional ups and downs watching the market this week, and I’ll wager most of you have as well. But if the action proved one thing, it’s that declines that appear catastrophic one day can almost completely reverse the next.

The only stocks, bonds and other vehicles we really have to worry about are those backed by businesses that succumb to the bear market’s trio of stress tests. Again, these stress tests are tight credit conditions, the weak US economy and high raw material costs. The best place to get a strong reading is always earnings reports. And as long as the numbers are holding up, so should we.

There have definitely been some severe blow-ups over the past 15 months. We dodged one of them in Canadian Edge with the sale of trust Arctic Glacier Income Fund some weeks ago. But there will almost certainly be more, and we can’t afford to be complacent.

Neither should anyone get too emotional about the high note on which this week is likely to end. True, we’ve seen some mighty comebacks in some of our stocks, particularly our Canadian trusts and limited partnerships (LP). But when you’ve just had a week with so many massive swings, it’s a safe assumption there’s more to come.

The key is to keep emotion out of it, and follow the numbers. In my view, there’s no great rush now to load up on stocks or anything else. If you’ve been buying and holding UF, CE, Vital Resource Investor or Personal Finance Income Portfolio stocks, you have plenty of exposure to this market and its ultimate recovery. Invest new money only incrementally.

There are also still no completely safe havens, and even companies that have held up to the stress tests thus far can still go down. Stay diversified among a wide range of stocks and sectors.

Finally, stick with the stocks and bonds backed by companies whose business numbers show they’re still holding up to the stress tests. Dump the stocks that post numbers that show weakness.

We may or may not have put in the ultimate bottom for this market. The rescue package for the financial system still must be put into place. And there are bound to be more blowups as long as the stress tests last.

As long as we stick with this unemotional, consistent strategy, however, we’re going to come out of this mess largely whole. And we’ll be positioned for the recovery which, believe it or not, will eventually take shape. The sun also rises.

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