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Why Buffett is buying utilities
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So, the deal works around the law's ban on nonutility companies owning retail electricity suppliers. (I should add the word "probably" here. This is an exceedingly convoluted area of the law.) Not only does Berkshire Hathaway own 80% of MidAmerican, based in Des Moines, Iowa, but Berkshire can only vote 9.9% of its shares.
The deal may also meet the requirement that the merging utilities be physically connected, since MidAmerican's transmission grid includes South Dakota, which is adjacent to PacifiCorp's grid in Wyoming.
(Of course, exactly what the 1935 act means by "physically connected" is a matter of legal interpretation. The two utilities are located in different regions of the national electricity grid -- what are called interconnects. It is, in fact, quite possible that this means the two aren't connected even if they do business in adjacent states.)
Three potential winners from consolidation
To profit from this consolidation over the long haul, I'd look for utilities with the ability to generate and transmit lower-cost bulk electricity. Three I like are Duke Energy, American Electric Power, and FPL Group (FPL, news, msgs).
- Duke Energy's merger with Cinergy eventually will create a utility with almost 4 million electricity customers and about 16,000 megawatts of unregulated generating capacity for the wholesale market.
- American Electric Power's position in the middle of the country and next to the Appalachian coal fields makes it a natural for expansion as the industry consolidates.
- FPL, formerly Florida Power & Light, is the industry's leader in wind-power generation. Wind power is a source of electricity that will gain a cost edge if oil and natural gas prices continue to rise. And it works well in combination with fuel sources with different patterns of peak electricity generation.
Cheaper capital equals bigger profits
Berkshire Hathaway has the one thing that every utility CEO dreams of: piles and piles of low-cost capital. One big reason that Scottish Power sold PacifiCorp was that the company needed to invest a minimum of $1 billion over the next five years to improve reliability in its service area. Some estimates run as high as $5 billion.
The profitability of that kind of investment, when the return that you earn on your investment is set by state regulators in your service area, hinges on what the company pays for the money it invests. Thanks to Berkshire Hathaway's insurance business, the company generates a flood of cash internally and enjoys access to the capital markets at extremely low rates. Also, since Berkshire Hathaway doesn't require units like MidAmerican Energy to pay a dividend to the parent company, MidAmerican will be able to put all of its own internal cash to use. So, in my opinion, MidAmerican should earn a bigger profit on its investment in the PacifiCorp system than Scottish Power could hope for.
And let's not forget the advantage that Buffett gets from taking on $4.3 billion in PacifiCorp debt. Think that it's just possible that MidAmerican Energy will be able to lower the interest cost on that debt thanks to its access to cheaper capital?
4 companies that can win with low-cost capital
So, how to profit from the short-term view of this deal? Look for capital-strapped utilities with lots of customers. A plus would be a credit rating low enough to be easily improved and/or sizeable debt that would let an acquirer quickly reduce interest costs. If the target utility owns assets such as coal mines or fiber-optic networks, so much the better. Utilities to research, in my opinion, include TXU (TXU, news, msgs), TECO Energy (TE, news, msgs), Pepco Holdings (POM, news, msgs), and Sierra Pacific Resources (SRP, news, msgs).
Of course, any decision to invest in utility stocks -- which, because of their high dividend yields, tend to rise and fall with interest rates -- requires that you consider where U.S. interest rates are headed. Utility stocks shine when interest rates are falling or are already low and stuck at low levels.
So, in my next column I'll tell you why the "no" vote on a new constitution for the European Union in France and the Netherlands means that lower U.S. interest rates will be with us for a while.
New developments on past columns
6 winners for tech's hard times
Everything seems to be falling into place for Yahoo! (YHOO, news, msgs). On April 19, the company reported first-quarter earnings two cents a share above Wall Street expectations. In the conference call, Yahoo! raised its guidance on revenue for the year to a range of $3.546 billion to $3.71 billion from the previous guidance of $3.5 billion. Since then, the company has introduced new product after new product: in-store (in partnership with Target (TGT, news, msgs) photo-prints delivery, built-in Yahoo! e-mail on Nokia (NOK, news, msgs) handsets, and video search. That's all led to a revival of momentum in the shares -- critical for investors hoping that this stock will strongly participate in the current technology rally. Relative strength (a measure of Yahoo!'s price performance versus that of all other shares on the market) has jumped to 94 in the last three months from 52 in the last six months. Our StockScouter rating for the shares has moved up to a current 8 out of a possible 10 from 6 just 90 days ago. Wall Street analysts raised their estimates for 2005 earnings per share to 57 cents from 52 cents 60 days ago. Yahoo! is set to report second-quarter earnings on July 19 and the shares are likely to follow their historical pattern of running up into the earnings report. As of June 3, I'm leaving my target price at $45 by July 2005. (Full disclosure: I own shares of Yahoo!.)
5 stocks that could soar if rates stay low
Sometimes Wall Street gets more than a little ahead of itself. That's exactly what happened to shares of Engineered Support System (EASI, news, msgs) on June 1. The stock dropped more than $3 a share after the company lowered earnings guidance for 2005 by 9 cents a share or about 4.5%. (The company actually raised revenue guidance for the year by about $50 million.) The punishment was so severe because going into the earnings announcement, several Wall Street analysts had projected that Engineered Support Systems would actually raise guidance. The problem seems to be with production delays and performance issues in a single military program, the deployable power generation and distribution system. Fixing the problems has pushed out full production and added costs that took about 7 cents a share -- accounting for most of the decrease in earnings guidance for 2005 -- out of earnings for the quarter that ended in April 2005. I think the recent quarterly miss is a one-time problem well within the power of management to fix on the schedule that the company has outlined. As of June 2, I'm keeping my target price at $45 a share but moving the timeline to October 2005 from September. (Full disclosure: I own shares of Engineered Support Systems.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American Electric Power, Engineered Support System and Yahoo!. He doesn't own short positions in any stock mentioned in this column.
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