Insights: Investing
In the October 1999 edition of Cigar Aficionado, I wrote a column titled "These Are Not Your Father's Utility Stocks," which detailed how the deregulation of the utilities industry was dramatically altering the investment fundamentals for what were still largely perceived as stodgy old utilities stocks. My conclusion was that selected utilities stocks presented excellent investment opportunities. In 2000, utilities stocks excelled and the Gabelli Utilities Fund gained 16.4 percent compared to the Lipper Utility Fund Average's 7.5 percent advance.
This year, utilities stocks have been under pressure, in part due to the much publicized problems of California's largest publicly held utilities companies, Pacific Gas and Electric and Southern California Edison. In the following column, Tim O'Brien, the portfolio manager of the Gabelli Utilities Fund, details what went wrong in California and why we think the market fallout from California's problems has produced another great buying opportunity in the utilities sector.
California Scheming
In late January, the California legislature appropriated $10 billion of taxpayers' money to keep the lights on as Pacific Gas and Electric and Southern California Edison teetered on the brink of bankruptcy. While this may halt the bleeding temporarily, it will not heal the wounds caused by California's poorly conceived deregulation plan.
What went wrong in California? In 1996, California politicians were seeking utilities rates cuts they could wave in front of the voters on Election Day. Utilities companies were willing to oblige if the state would relieve them of "stranded costs" that were the legacy of expensive investments in nuclear power plants and uneconomic long-term supply contracts with independent power producers. Major industrial and commercial customers wanted the opportunity to shop for a better deal in a competitive wholesale power market.
A complex deal was struck. The publicly held utilities would auction off their power generating assets at a profit and use the gains to offset some of their stranded costs. The balance of the stranded costs would be securitized by state-issued bonds that would be paid off by a charge to the utilities' customers. Retail electric rates would be cut and then frozen until the stranded costs were fully recovered or until the transitional period ended in 2002. At that time, utilities would be able to on wholesale power costs to retail customers. PG&E and Edison would be required to buy, and all of the wholesale generating companies serving California would be required to sell, electricity in a spot auction market istered by the California Power Exchange. Long-term contracts between the utilities and the power generators were not permitted.
This would prove to be a costly mistake.
The hastily constructed deal worked just fine for a few years. But it was doomed to fail, because it ignored basic economic principles. Electricity is a commodity. In a truly competitive commodities market, price changes send signals to producers and consumers. When prices rise, producers increase output to take advantage of the higher prices and consumers conserve or substitute to save money. For example, when corn prices rise, farmers increase production while consumers eat oatmeal or Wheaties instead of corn flakes. Rising supply combined with weaker demand eventually brings prices back down. However, electric power is a more volatile commodity than corn, because electricity cannot be stored for future use and because consumers really can't substitute something else when prices are high.
The California plan did not create a free market for electricity. Because it is nearly impossible to get a new power plant sited and approved in-state due to California's convoluted permitting process, power producers could not build capacity to cash in on higher prices. Since retail electric rates were frozen, consumers weren't economically motivated to conserve electricity, and demand continued to grow. The fatal flaw of the California deregulation plan was exposed when natural gas prices, the primary "feedstock" for generating electricity in California, ran up sharply in 2000. Wholesale electricity prices rose rapidly, but with retail rates frozen, the utilities were unable to on the higher costs to their customers. Obliged to keep the juice flowing to its customers, PG&E and Southern California Edison borrowed to finance the unrecovered wholesale power costs until they exhausted their credit in December 2000, and wholesale generators began demanding cash up front. In January, the utilities had to resort to rolling blackouts to ration available supplies.
The irony is that municipally owned utilities, such as the Los Angeles Department of Water and Power, that were allowed to keep all of their generating assets have had no difficulties providing service to their customers and have reaped windfall profits selling excess electricity into tight wholesale markets. The wholesale generating companies, which were thought to have overpaid for the generating plants they acquired from PG&E and Edison in 1997 and 1998, have been coining money.
The U.K. Formula
California could have avoided its rolling blackouts by looking to the United Kingdom for a utilities deregulation plan that made economic sense. The British deregulation in 1989 allowed power distribution companies to on wholesale power costs to their customers. It also permitted distribution companies to contract with power generating companies to mitigate commodities price risk.
Of course, the Thatcher government was not trying to simultaneously bail out the utilities and give customers a politically popular free lunch in the form of an up-front rate cut. Instead, British utilities deregulation created a liquid, transparent market and trusted it to send accurate price signals to buyers and sellers.
Plans with similar characteristics have helped 23 states usher in deregulated wholesale power markets that offer consumers freedom of choice and suppliers the opportunity to compete for business, while the utilities companies that bring consumers and suppliers together earn steady regulated returns on the monopoly distribution business. As a result, outside of California, electric distribution companies have generally survived rising energy prices without harm.
California's problems have cast a cloud over the utilities sector. Although utilities stocks prices have recovered somewhat from their sharp declines at the beginning of the year, they remain under pressure. That's fine. It gives us the opportunity to pick up more bargains.
The high wholesale price environment creates opportunities for companies with unregulated or excess generating capacity that can be sold into the wholesale market. Wholesale power generators such as Southern Co., Xcel Energy, Constellation Energy and El Paso Energy (all held in the Gabelli Utilities Fund) should benefit.
We continue to favor consolidation candidates¿small and mid-sized companies likely to be acquired by their larger neighbors. The bigger companies need increased size to cut unit costs and manage risk. Buying their smaller neighbors is the only way to get there. The smaller companies have limited growth potential and no real way to significantly reduce unit costs. This puts pressure on their managements to sell out to the bigger players.
Among the Fund's small fry, our favorite takeout candidate is Kansas City Power & Light (KLT-$25.95 NYSE, as of March 7), which serves metropolitan Kansas City. KLT has been to the altar twice in the past three years. A friendly offer from Utilicorp was topped by a hostile bid from Western Resources. This turned into a comedy of errors. With Western Resources stock moving higher following its all-stock bid, Western wanted to renegotiate with KLT. KLT balked, and when Western Resources ran into trouble and its stock cratered, KLT walked away. Western Resources is now being acquired by Public Service of New Mexico.
We believe KLT is still up for grabs. Utilicorp could come calling again. Ameren, Missouri's largest utility, might be interested. Once the Western Resources acquisition is completed, Public Service of New Mexico might take a look at KLT. KLT is trading at about 12 times earnings, a slight discount to the utilities stock average of 13, and its $1.66 dividend translates into a 6 percent-plus yield. If a buyer does materialize, we could see a deal in the $32 to $33 range.
Another possible takeout company in the fund, TECO Energy (TE-$29.43 NYSE, as of March 5), the old Tampa Electric Co., diversified into several nonutilities businesses. Initially, this was successful, but in recent years these businesses have run into problems. The diversified operations have been refocused and rationalized, and now TECO's emphasis is on exploiting its wholesale power-generation assets. Even though its earnings growth is superior to the average utilities company, TE is trading at just an industry average price/earnings multiple. Last year, Carolina Power & Light bought Florida Progress in neighboring St. Petersburg at a handsome 17 P/E multiple. Valuing TECO at the same multiple would put the takeout price at about $40 per share. The lower unit costs that could be realized by one company serving both Tampa and St. Petersburg would go a long way towards recouping the that a buyer would have to pay for this utilities gem.
Conclusion
The utilities meltdown in California has taken utilities stock prices down across the board. We strongly believe California's problems are due to a faulty deregulation plan, which was not replicated in other states. We don't know what the final outcome will be for PG&E and Southern California Edison. However, as it becomes clear that California's problems are unique, non-California utilities stocks should rise to prices that reflect their strong and improving earnings potential and the prospects for values being realized through further consolidation in the industry. A year from now, we think that early 2001 will have proven to be an attractive buying opportunity.
Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.
