Tag Archives: debt

A Word Of Caution About New Purchases In The Utility Sector

My first purchase of an electric utility stock was 400 shares of Duke Energy (NYSE: DUK ) around 1978. Somewhere along the way, I sold those shares for reasons that I no longer recall. I am not expressing a word of caution about the long term benefits that have flowed through buying and holding quality utility stocks and reinvesting the dividends. The ten year annualized total return numbers for a number of electric utility stocks are superior to the 7.83% annualized total return of the S&P 500 ETF (NYSEARCA: SPY ) through 2/13/15. Some examples include the ten year annualized performance numbers of American Electric Power (NYSE: AEP ), Dominion Resources (NYSE: D ), Edison International (NYSE: EIX ), NextEra Energy (NYSE: NEE ) and Wisconsin Energy (NYSE: WEC ) Ten Year Annualized Total Returns Through 2/13/15 Computed by Morningstar: AEP +8.09% D + 9.93% EIX + 8.72% NEE +12.15% WEC +13.03% Several other well known “utility” stocks have come close to matching the S & P 500 ten year annualized total return without the same decree of drama. AT&T +7.69% SCANA +6.86% Southern Co +6.75% Verizon Communications +7.54% The question that I am addressing now is whether new buys can be justified based on current yields and valuations. I started to look at this question a few days ago when making a comment here at SA about the impact of rising rates on REIT and utility stocks. Both of those industry sectors have attracted a large number of investors searching for yield. For many investors, REITs and utility stocks are viewed as “bond substitutes”. I started an analysis simply be looking at the current yield of the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ), a low cost sector fund that owns primarily electric utility stocks. Yield: As of 2/12/15, the sponsor calculated the dividend yield at 3.28%. The attractiveness of that yield will depend on an investor’s view about the direction of interest rates. Notwithstanding the abundance of contradictory evidence, the Bond Ghouls have been predicting that a Japan Scenario will envelope the U.S. until the end of days, a slight exaggeration, based on the pricing of a thirty year treasury bond at a record low 2.25% yield recently. If an investor believes that deflation will alternate with periods of abnormally low inflation for the next 30 years, then the pricing of several long term sovereign bonds may at least appear to be rational rather than delusional. The current yields of a U.S. electric utility stock, with modest earnings and dividend growth, may even look good compared to those yields and the dire future predicted by those sovereign bond yields (U.S., Germany, Switzerland, Netherlands, Japan, etc.) The 30 year German government bond closed last Friday at a .92% yield. German Government Bonds – Bloomberg The average annual inflation rate in Germany between 1950-2015 was 2.46%. Just assume for a moment that the future will be similar to the past, with some hot and low inflation numbers and possibly a brief period of slight deflation. The .92% 30 year German government bond would produce a 1.54% negative annualized real rate of return before taxes. The average annual U.S. inflation rate between 1914-2015 was 3.32%. When the 30 year treasury hit a 2.25% earlier this year, and assuming the historical average annual rate of inflation, the total annualized return before taxes would be -1.07%. The first item for investors to consider is why are so many predicting the Japan Scenario given the recent U.S. economic numbers and the non-existence of a single annual deflation number since 1955 other than the understandable -.4% reported for 2009. Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis When looking a long term charts, it is hard to see the underlying support for what the Bond Ghouls are saying about the future. (click to enlarge) (click to enlarge) (click to enlarge) The DSR ratio highlights that U.S. households have more disposable income after debt service payments to pay down debt, to spend, or to save. I view this chart as bullish long term for stocks but not far bonds. I have been making the same point here at SA for over three years now without convincing a single bear of my point. An example of banging my head against the wall was a series of comments to this SA article published in February 2013: Sorry Bulls, But This Is Still A Secular Bear Market-Seeking Alpha It is interesting to go back and read some of those comments from other investors. Yes, I am referring to the bears here who were predicting a bear market starting in 2012 just before the S & P 500 took off on a 700 points move up, not down by the way. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) Links to some other relevant charts: Financial Stress-St. Louis Fed Household Financial Obligations as a percent of Disposable Personal Income-St. Louis Fed Mortgage Debt Service Payments as a Percent of Disposable Personal Income-St. Louis Fed Charge-Off Rate On All Loans, All Commercial Banks-St. Louis Fed Retail Sales: Total (Excluding Food Services)-St. Louis Fed E-Commerce Retail Sales-St. Louis Fed Light Weight Vehicle Sales: Autos & Light Trucks- St. Louis Fed Corporate Net Cash Flow with IVA -St. Louis Fed ISM Non-manufacturing-St. Louis Fed And what are the current economic statistics (not the ones generated through reality creations) that support the long term Japan Scenario prediction that underlies current intermediate and long term bond prices? I will just drag and drop here my recent discussions of this data. Is that dire long term U.S. inflation and growth forecasts embedded in those historically abnormal yields justified by the 5% real Gross Domestic Product growth in the 3rd quarter perhaps slowing to 3% in the 2014 4th quarter with personal consumption expenditures accelerating; the lowest readings on record in the debt service payments to disposable income ratio (DSR) ; the decline in the unemployment rate to 5.7% with 257,000 jobs added in January with a 12 cent rise in average hourly earnings and a 147,000 upward revision for the prior two months; a decline in the 4-week moving of initial unemployment claims to the historical lows over the past four decades; the long term forecasts of benign inflation; a temporary decline in inflation caused by a precipitous drop in a commodity’s price, the consistent and long term movement in the ISM PMI indexes in expansion territory; capacity utilization returning to its long term average where business investment has traditionally increased by 8% , or perhaps some other “negative” data set. That kind of data has to be negative rather than positive, right? Even the government’s annual inflation numbers for 2014 showed a + 3.4% increase in food prices; a 2.4% increase in medical service costs, a 2.9% increase in shelter expenses, and a 4.8% increase in medical commodities. The BLS called the rise in food prices “a substantial increase” over the 1.1% rate for 2013. While I am not predicting here a return to $80+ crude, the price may have already bottomed and the disinflationary impact created by the 50%+ decline is consequently a temporary abnormality that will self correct with supply and demand moving back into balance. Consumer Price Index Summary While it is too early to know whether intermediate and long term rates have started to turn back up, the recent movement is certainly cautionary and resembles the lift off in interest rates that started in May 2013, when the ten year was at a 1.68% yield, and culminated in a rate spike to 3.04% for that note by year end. 7 to 30 Year Treasury Yields 2/2/15 to 2/13/15 Daily Treasury Yield Curve Rates When looking at that table, it is important to keep in mind that a ten year treasury yield of 2.00% is abnormally low by historical standards since 1962: (click to enlarge) 10-Year Treasury Constant Maturity Rate – FRED – St. Louis Fed And this brings me to my word of caution about utility stocks. A 3% dividend yield is not too hot using history as a guideline. To be justified, the investor will have to buy into most of the Bond Ghouls Japan Scenario unfolding in the U.S. rather than a gradual return to something close to normal inflation and GDP growth. Valuation: For me, valuation is the kicker. What S & P sector currently has the highest P.E.G. ratio? Back in the late 1990s, I would have said technology stocks without looking to verify the answer. I said utility stocks now and I took the time to verify that response. An investor can download the current E.P.S. estimates for the S & P 500 and the various sectors from S & P in the XLS format. I can not link the document here, but anyone interested can find it using the exact google search phrase “XLS S & P Dow Jones Indices”. It should be the first result. As of 2/12/15, the estimated forward 5 year estimated P.E.G. for the utility sector is a stunningly high 3.65, and this sector has traditionally been one of the slowest growing sectors. Technology is at a 1.27 P.E.G. The P/E based on estimated 2015 earnings is 17.12. The data given by the sponsor of XLU immediately set off alarm bells when I looked at it recently. In addition to the vulnerability of stock prices due to a rising interest rate environment, the sponsor calculated the forward P/E at 17.14, which is normally a non-GAAP ex-items number, a 7.23 multiple to cash flow, and a projected 3 to 5 year estimated E.P.S. growth rate of only 4.86%, or a similar P.E.G. to one calculated by S & P and mentioned above. The Vanguard Utilities ETF (NYSEARCA: VPU ) has another set of data that is even more concerning than the XLU valuation information: As of 1/31/15, this fund owned 78 stocks, with a P/E of 20.8 times and a 2% growth rate. Portfolio & Management Taking into consideration the possible or even probable rise in rates, the low starting yields for utility stock purchases now, the high P/E and abnormally high P.E.G. ratio, I am just saying be careful out there. I will be discussing in my next blog a reduction in my position in the Duff & Phelps Global Utility Income Fund Inc. (NYSE: DPG ), a closed end fund that has performed well for me since my purchases. I may not start writing that blog until Monday after taking the time to write this one in my usual stream of consciousness writing mode. CEFConnect Page for DPG According to Morningstar, the Utilities Select Sector ETF ( XLU ) had a 2014 total return based on price of 28.73%, much better than SPY, and was up YTD 2.33% through 1/31/15. The tide has turned with the recent rise in rates since the end of last month. The total return for XLU is now at -4.34% YTD through 2/12/15. Just as a reminder, I only have cash accounts and consequently do not short stocks. I do not borrow money to buy anything. I have never bought an option or a futures contract. I am not paid anything to write these SA Instablogs or SA articles or any of my almost 2000 blogs written since early October 2008, mostly very long ones, published at Stocks, Bonds & Politics . I do not own any of those short ETFs. I am currently substantially underweighted in the Utility sector.

Betting Against Japan: The Straddle Of The Century

Japan has accumulated an enormous and growing debt load. The Japanese Central Bank’s bond buying may prevent a crisis. The yen is likely to continue weakening. Investors can profit from the JCB’s moves. Japan emerged from the ashes of World War II to becoming one of the largest economic powers in the world by the 1980s. By creating high quality products and making highly publicized corporate purchases, Japan was both respected and feared by competing economic powers. Japan’s economic advancement came to an abrupt end when the Japanese market crashed in the late 1980s and never truly recovered. The once mighty power is now heavily indebted and dealing with a declining population and a declining economy. A crisis is possible, but like with crises of the past, a major Japanese economic event can become a great opportunity, particularly with the right investments. The debt load of the Japanese government stands at just under 1.2 quadrillion yen ($10.1 trillion), greatly exceeding their 484 trillion yen ($4.07 trillion) economy and the 96 trillion yen budget ($812 billion), with projected revenue at only 54.5 trillion yen. This is a precarious financial position, and at a 4.5% interest rate, the projected revenues would only cover debt service. But because the Japanese Central Bank (JCB) is such a large buyer of Japanese government bonds, the interest rate for a 10-year bond stands at under 0.5% as of the time of this writing. Given that this 1.2 quadrillion yen is a debt level unlikely to be paid off, hyperinflation or default would appear to be the only realistic options for addressing the debt. To counter a possible collapse, the JCB started buying larger amounts of bonds than the Japanese government was creating. It’s likely the JCB plans to buy up a large percentage of the outstanding bonds ( it owns about 16% now ) and simply write off the bonds, and hence, that portion of Japanese government debt. If this were to work without destroying the economy, the Japanese government strengthens its financial position by returning to sustainable debt levels. If it fails and Japanese bonds rise to double or even triple digit interest rates, default becomes a possibility. Another possible scenario involves weakening the yen. This has been seen in earnest since 2012 and born of the JCB’s larger levels of aggressive stimulus. The JCB created more yen and pumped the currency into the economy, sending the Nikkei to highs not seen since the 1990s. The price of this stimulus has been a greatly devalued yen falling from 76 to the dollar in early 2012 to the low 120s in early 2015 . Experts such as Kyle Bass predict the yen will fall beyond 140 to the dollar by year-end and further beyond this year. The potential danger of this approach is that more yen chasing the same amount of goods will devalue the yen to the point that investors lose confidence in the currency. In addition to making Japanese consumers poorer, the devalued currency could also lead to higher interest rates that also make the government debt load untenable. Investors can protect themselves from this horrifying yet plausible scenario with a different take on the straddle bet, one based on different vehicles instead of up or down bets on the same investment. In this case, it would be a position betting against Japanese government bonds (the JGBS ETF is the easiest way to accomplish this) coupled with a second bet against the value of the Japanese yen (versus a precious metal or a currency such as the US Dollar). If the JCB can successfully write off a large amount of government debt, investors can still profit from what’s likely to be substantial yen devaluation. If the worst case bond crash occurs, investors can profit or at least protect themselves from what would be a devastating economic event. The once-mighty Japanese economy now finds itself in a situation where the JCB struggles to maintain economic strength. An economic collapse would be the most devastating occurrence to hit Japan since their loss in World War II, and a catastrophic blow to a world economy where Japan exerts wide influence. However, this situation also presents a great opportunity for the prepared investor. Whether the high debt resolves itself through a dramatic collapse or by the JCB engineering a large-scale debt write off, bets on a weaker yen and higher interest rates will likely bring investors outsized returns and possibly protection in a crisis. Disclosure: The author is long JGBS, GYEN. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Sabesp: High Risk, Less Reward

Summary Continued drought and weakening of the BRL exposes currency bet gone wrong. New Chief Executive Officer faces tough choices and will most likely have to cut the dividend. Long-term dividend may suffer from increased investment needs. About Sabesp ( SBS ), Companhia de Saneamento Basico do Estado de Sao Paulo, is a Brazilian waste management company – majority owned by the state of Sao Paulo (50.3%), 25.5% are traded on the Novo Mercado in Brazil, and roughly 24.2% are traded on NYSE. Sabesp is one of the largest waste management companies in the world. The share price has fallen significantly in the last 2 years. This is mainly due to the deteriorating profitability and increased financial leverage caused by the worst drought in Brazil in over 80 years. Consensus forecast From 4-traders . (click to enlarge) I believe that due to the continued drought and the weakening of the BRL, the earnings and dividend estimates may have to be reduced further. Seems like only rain can keep estimates from falling. My forecast I have made a forecast for Sabesp primarily based on their Q3 2014 report and presentation. To make the forecast and charts I have used the Corporate Risk Model from Simulationfinance.com . (click to enlarge) I have assumed a total start volume (water and sewage) of 889.4 million m3, equal to the report volume in Q3 2014. The average price of 3.17 is calculated as total revenues in Q3 2014 divided by total volume. The cost of goods sold is calculated as 2.34 – total operating costs in Q3 2014 divided by total volume. I have assumed quarterly volume growth of 1%, about the same as quarterly increase in connections. The price and costs per volume normally roughly follow the inflation rate in Brazil. Currently, the inflation rate in Brazil is about 7% . I have for simplicity assumed a flat 1% quarterly increase in prices, assuming that the inflation in Brazil levels off. I have assumed that costs per volume only increases by 0.5% per quarter. This leads to the EBITDA margin to increase from the current about 26% to about 30%. The below chart shows the historical EBITDA margin as presented by the company in their Q3 2014 report. Based on reported historical data since Q1 2012, the quarterly standard deviation in total volume has been about 3.1%. The estimated average price per total volume standard deviation has been about 7.5%. The estimated average cost per total volume standard deviation has been about 11.5%. These high standard deviations are influenced by the recent drought. In this analysis, I assume that future volatility will be somewhat lower. I assume that going forward the quarterly standard deviation for volume is 3%, for the price per volume the quarterly standard deviation is 4%, and for the costs per volume the quarterly standard deviation is 5%. Confidence analysis The below chart shows the calculated possible total volume development with included risk assumptions. (click to enlarge) The black dotted line shows the base case total quarterly forecast. Total volume is expected to grow from about 890 million m3 in Q3 2014 to about 1000 million m3 in Q4 2017. The darkest blue area shows the range that contains 75% of the calculated outcomes based on my assumption that volume has a quarterly standard deviation of 3%. The second blue area, together with the darkest blue area contains 90% of the calculated outcomes. The total blue area contains 95% of the calculated outcomes. 2.5% of the calculated outcomes are above the blue area and 2.5% of the calculated outcomes are below the blue area. The quarterly volume at the end of 2017 is calculated to be roughly between 800 million m3 and 1250 million m3. The below chart shows the calculated possible revenue development with included risk assumptions. (click to enlarge) The below chart shows the calculated possible EBITDA development. (click to enlarge) The below chart shows the calculated possible EBITDA margin development. (click to enlarge) Financial leverage From the 2013 annual report: The financial covenants related to AB Loan agreements (1983AB) consider the Company’s ratio of debt service coverage, which must be higher than or equal to 2.35:1.00; and the total adjusted debt over EBITDA, determined on a consolidated basis, which must be lower than or equal to 3.65:1.00. This agreement has a cross-default clause. See Note 15 of our Financial Statements. Report . The below chart from the Q3 2014 presentation shows the quarterly historic development in the gross debt to adjusted EBITDA ratio. The below chart from the Q3 2014 presentation shows the currency breakdown of the debt. In Q3 2014, Sabesp lost about R$300 million on exchange rate variation on their foreign currency loans. Due to continued weakening of the BRL in the fourth quarter of 2014, the losses may be about the same in Q4 2014. At the current exchange rate of about 2.85 BRL per USD, the loss in Q1 2015 looks set to also be around R$300 million. If cash is unchanged and this happens then the total debt could be about R$10.650 million at the end of Q4 2014 and R$11.000 million at the end of Q1 2015. Assuming adjusted EBITDA in Q4 2014 and Q1 2015 is R$742 million, the same as in Q3 2014, then gross debt/adjusted EBITDA could reach about 3.35 at the end of 2014 and about 3.8 at the end of Q1 2015. In order for the ratio to be below 3.5 at the end of Q1 2015 in this example, the cash reserves must be more than halved from current levels of about R$1.800. The loan covenant says that this ratio must be lower than or equal to 3.65. Regulation may also prohibit the company to pass on these currency losses to tariffs. Therefore, I assume that there will not be any dividend paid in 2015 (most likely there will be a small dividend), but that the company will have a dividend payout ratio of 35% in 2016 and onwards. The below chart shows the quarterly historic development in the gross debt to EBITDA ratio and the quarterly calculated possible development assuming that cash is unchanged, gross debt increases with R$350 million in both Q4 2014 and Q1 2015. (click to enlarge) Valuation multiples The below chart shows the quarterly calculated possible development in earnings per share including the assumed exchange variation cost in Q4 2014 and Q1 2015. (click to enlarge) The below chart shows the base case expected earnings per share and dividend per share based on all the assumptions. (click to enlarge) The below chart shows the current share price (about BRL 14) divided by base case yearly earnings per share. (click to enlarge) The below chart shows the current share price divided by base case assumed future book equity per share. (click to enlarge) The below chart shows assumed future earnings per share divided by the share price (earnings yield) and the assumed future dividends per share divided by the share price (dividend yield) . (click to enlarge) Valuation Based on the dividend growth model, assuming a cost of capital of 10% and perpetual growth in dividend from 2017 of 4%. Alternative 1 : Volume and prices have an expected quarterly change of 1% whereas Costs have an expected quarterly change of only 0.5%. This implies that the EBITDA margin increases from currently at about 26% to about 30% at the end of 2017. (click to enlarge) The distribution chart shows the distribution of valuations per share based on all the assumptions made. The horizontal axis shows the distribution of calculated fair value per share, and the vertical axis shows the calculated probability of each outcome. The percentage shown on each bar is the accumulated probability, starting from the left. The chart shows that based on all the assumptions made, there is an estimated 76.7% probability that the fair value per share is below BRL 13.2 ($4.6). Current share price is about BRL 14 ($5). Alternative 2 : Volume, prices and costs all have an expected quarterly change of 1%. This implies that the EBITDA margin is constant at current level of about 26%. (click to enlarge) The chart above shows that based on these assumptions there is an estimated 74.9% probability that the fair value per share is below BRL 10.8 ($4.6). Current share price is about BRL 14 ($3.8). Share price The below chart shows the share price history in the last 50 trading days and the possible outcomes in the next 10 trading days based on the historic share price changes the last 12 months. Source: Portfolio Model Free . (click to enlarge) The below chart shows the dispersion of possible share prices in 10 trading days from now based on the historic share price changes the last 12 months. This analysis implies that there is a 53.6% probability that the share price will be below $4.96 in 10 trading days from now. (click to enlarge) Conclusion Sabesp is an interesting long-term growth company, but short-term financial leverage issues and state majority ownership makes it a very risky investment. My guess is that the dividend has to be cut significantly. There may also be reduced longer-term opportunity in the share price as the company may be forced to increase investments in order to reduce the possibility of another water shortage in the future. The new Chief Executive Officer may announce drastic measures that can create an interesting investment opportunity, but I would not bet that the immediate effect will be positive for the share price. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.