Industry Review
May 29, 2008
As part of the review of the investment process, the Adviser's analysts prepare annual industry reviews and outlooks for presentation to the Board of Directors. These reviews bring into focus certain factors affecting the utility and REIT industries’ operating and financial performance and were presented to the Board of Directors in February of this year. Following are highlights from those reviews.
Electric Currents
The outlook for the electric utility industry remains mostly positive. However, there are obstacles that must be addressed by both companies and regulators in order for the industry to continue improving fundamentals and provide attractive investor returns.
Going with the Flow
The majority of electric utility companies continue to exhibit strong fundamentals. This is a direct result of the increased focus on the core utility business many electric utility companies adopted over the last four or five years. Time has proven that was the right strategy. Increased investment in utility infrastructure (transmission, distribution, and generation) has benefited both companies and ratepayers as the transmission grid has become more reliable, distribution service has improved, and the growing power needs of our society have been adequately addressed. Going forward, electric generation reserve margins are expected to tighten, keeping power prices firm and justifying the need for additional investment in generation.
The “greening” of America may impact this industry more than any other. Over thirty states now require electric utilities to source an increasing portion of their power needs from renewable energy resources such as wind, solar, or biomass. This provides a way for many companies to earn returns related to renewable energy investments. The prospect of greenhouse gas regulations also gives certain companies an avenue for earning additional returns. Nuclear and gas generators will potentially benefit from the expected power price increases associated with greenhouse gas compliance. While many coal-based generators will be burdened with the costs of compliance, some will profit from the investment opportunities presented by the construction of “clean coal” generating facilities.
High Impedance
The most visible obstacle that the industry faces is the potential for state regulators to deny companies the opportunity to earn adequate investment returns. We have already seen this occur in several states. There have also been high profile rate controversies in Illinois, Maryland, and Ohio. The genesis for this kind of regulatory problem is upward pressure on electricity rates. Paradoxically, the rate pressure stems from the very opportunities that we listed earlier: the need for infrastructure investment, rising commodity costs, renewable energy programs, and clean air compliance measures.
It turns out that the “greening” of America is a costly proposition. Renewable energy-generating facilities such as wind and solar, can be more expensive to install and operate than the more traditional means of generation. From a system reliability perspective, renewable technologies often require investments in additional resources such as transmission lines and back-up generation facilities. As utilities invest to comply with new greenhouse gas regulations, they will look to ratepayers to recoup the costs.
Exacerbating the rate problem even further are the rising cost projections associated with major construction projects. Planned transmission lines, coal-fired plants, gas-fired facilities, nuclear generation, wind farms, and solar plants, have all experienced significant increases in projected outlays due to skyrocketing material and labor cost estimates. The higher costs are largely attributable to a global surge in demand for electricity infrastructure, driven by the considerable requirements of China and India. Such cost increases are making it difficult for companies and regulators to commit to major projects. Recently, we have seen several planned coal plants suspended or cancelled, which even further extends the supply/demand imbalance, keeping the upward pressure on rates in place.
We are not overly concerned about the current regulatory environment. We find comfort in the fact that in many cases major portions of utility investment programs are mandated or pre-approved by state regulators. There are plenty of companies that operate in jurisdictions that remain supportive of infrastructure investment. Regulatory directed investment programs, coupled with stable fundamental outlooks, give us confidence that we will continue to find investment opportunities in electric utilities that will provide both sustainable and growing dividends to your Fund.
The Natural Gas Industry
One way to differentiate companies in the natural gas industry is by their exposure to volatile commodity prices. Local gas distribution companies (LDCs) typically have less exposure to commodity prices than other companies. They also usually pay higher dividends and are, therefore, attractive investments for your income-oriented Fund. During 2007, LDC company share prices lagged commodity-oriented gas company share prices as investors adjusted their portfolios to take advantage of both the run up and volatility of energy prices. The yield on Fund investments in this sector has consistently been higher than the yield on the universe, fulfilling the Fund’s income objective.
The LDCs have continued to focus on their core businesses, cost controls, and regulatory creativity to maneuver through the environment of high commodity prices. In general, companies pass through (with no profit) the cost of the gas they deliver to customers, but high gas prices impact them in other ways. For example, companies have experienced increases in bad debt when customers can’t pay for the more expensive gas. As well, customers have been conserving their gas usage because of high prices. In many cases, LDCs recover fixed costs through the rates customers pay on the volume of gas consumed. Conservation means that some of the LDC’s fixed costs aren’t recovered because volumes are lower. Further, delivery infrastructure (pipes and lines) needs upgrading, and companies are reluctant to commit to significant capital expenditures without some assurance of recovery of the investment in their systems.
LDCs have been filing more rate cases in recent years to address these issues. Regulators have been imaginative in their treatment of the companies’ needs while at the same time being sensitive to the impact on consumers. Remedies have included “decoupling” the recovery of fixed costs from volumes delivered, and “trackers” that provide for the recovery of pre-approved capital expenditures or bad debt in excess of a projected level. These types of mechanisms tend to keep revenues and bills more stable, which helps companies as well as consumers.As difficult as high gas prices have been for companies and users, there has been a benefit – domestic natural gas production rose significantly last year, as higher prices supported exploration of new areas and development of new technologies.
Imports of natural gas from Canada continue below their peak of several years ago, as conventional production has experienced diminished growth and supplies are redirected for use in the development of oil sands. Liquefied natural gas (LNG) imports were up significantly last year. More recently, though, developments in Europe and Asia, with whom we compete for LNG supplies, are keeping global prices above domestic prices. LNG tankers sail to destinations of best pricing.
Overall, we think gas prices are likely to remain high and volatile for the foreseeable future. New production will continue to be forthcoming because of the better economics, but we must also be aware that weather has a huge impact in the short-term. Also, gas has become a more global commodity as a result of the use of LNG, and international developments could spill over into our gas markets. Nevertheless, LDCs are maneuvering through this environment, and the stocks that are held in your Fund continue to satisfy our income and growth of income objectives.
Telecommunications
Fundamentals Fine, Shame About the Economy
Following the improvements seen in 2006, telecommunication industry fundamentals remained strong in 2007. Wireless services continued to be the bright spot with growth in subscribers, revenue and margins. In addition, wireless data usage (sending digital non-voice information on a cellular phone) started to accelerate and is expected to be a key growth driver over the next few years. Broadband (the ability to rapidly transmit large amounts of data) subscriber growth in the U.S. slowed as expected, but prices remained stable or even increased which benefited corporate revenues. The introduction of telecom video products continued in 2007 and the industry is experiencing subscribers signing up in greater numbers. Most of the synergies from the merger and acquisition wave of the past few years have been realized and, in some cases, have been even better than anticipated. Not all is rosy as the wireline segment of the industry continues to experience significant line losses and a turnaround in that trend may not occur in the near future. However, most importantly, telecom companies continued to return significant amounts of money to shareholders in the form of dividends and share buybacks.
The major trends for the industry in 2008 revolve around wireless data and video. Wireless has been the growth engine in the telecom sector for some time now. With U.S. penetration at 87% and most developed European and Asian markets higher than that (i.e., European penetration is at 116%), subscriber growth naturally has to slow from its record pace. Since penetration levels are approaching maturity, the new growth opportunity for wireless carriers is data. What is driving this growth is the availability of 3G (third generation) networks, which allow faster transmission speeds and new uses. Laptop cards and smart phones, such as the Blackberry and the iPhone, are resulting in big increases in data usage for things like internet access, gaming, music, videos and global positioning systems (GPS). Wireless data growth was quite rapid in 2007, and we believe it is still early in this trend.
We believe it may be. Telecom companies globally are rolling out video products. Technologies vary by country and operator, as do capabilities such as high definition (HD) and digital video recorders (DVRs). But the service is real and is starting to matter. Over the next couple of years, we expect rapid growth in subscribers from what is currently a very low base. With that growth, we also expect revenue to grow quickly and profitability to increase as scale is achieved. An attractive video offering by the telecom companies should also assist in stabilizing the consumer wireline business both from a line loss perceptive and by increasing revenue per customer. This is a key industry theme in 2008.
Overall, the fundamentals in the telecom industry look stable for 2008, a continuation of the trends in 2007. This should translate into earnings growth, strong free cash flow generation, dividend increases and share buybacks. In addition, given the earnings momentum of the past year and the recent stock market correction, valuations are more attractive than they were this time last year. Yields also remain attractive.
REITs
Real estate investment trust (REIT) share prices declined from February 2007 to January 2008, following a seven-year period of outperformance versus the S&P 500. From mid-2005 through early 2007 in particular, share prices were driven up by the easy credit environment, which fueled increased risk tolerance of investors. In the REIT sector, private investors were buying publicly-traded REITs to take them private, break them up, and sell the individual properties at a profit. The mortgage and credit market crises and follow-on concerns about the possibility of economic recession led to a decline in risk tolerance and lower REIT stock prices. The Fund had been taking profits as the REIT market advanced and continued to do so in the first half of 2007.
In response to the credit market crisis, the Fed has cut the target federal funds rate by 200 basis points to 2.25% and the REIT equity index has rallied strongly, as it did the last time the Fed aggressively lowered short-term interest rates in 2001. Even with the rebound, REIT prices are below their highs and valuations are attractive. Indeed, the yield advantage of the REIT index over the 10-year Treasury Bond remains above its long-term average, and the stock market value of the REIT index remains below that of the estimated value of the properties owned by the group.
Supply and demand fundamentals in the non-residential property market remain solid in many of the 13 different property sectors encompassed by REITs. However, as one would expect in the current uncertain economic environment, the increase in rental rates seems to be slowing compared to last year. Nevertheless, some future pricing power should be experienced as longer-term leases reset to higher current market rental rates at renewal. This phenomenon has enabled the annual dividend growth of REITs to exceed the inflation rate every year since 1991. We expect REIT earnings to see little overall variability in 2008, amidst general market volatility and continued easing of interest rates to moderate the economic slowdown.
There can be no assurance that the Fund will achieve its investment objectives. This information does not represent an offer, or the solicitation of an offer, to buy or sell securities of the Fund.
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