Libya: What It Means
for Dividend Investors
By Roger S. Conrad
Utility Forecaster
 For 41 years Libyan strongman Moammar Qaddafi was a thorn in the side of the West. In fact President Reagan, on Apr. 15, 1986, sent the US Sixth Fleet on a massive and successful attack that wiped out much of the North African country's military power and nearly claimed the dictator's life.
No friend of Western democracies, Qaddafi waged war deep into the heart of Africa, fomenting violence in neighboring Chad, Mali and Niger. He sponsored terrorist training camps and flaunted warm relations with other notoriously anti-Western, anti-capitalist and anti-democratic leaders. Now to stay in power, he's apparently employed an army of mercenaries to carry out air and ground attacks on Libyan civilians.
It's hard to imagine anyone would mourn Qaddafi's passing, other than family members and cronies who've profited so richly under his rule. Ironically, just as the rebellion to overthrow him has neared success this week, global markets have sold off, apparently on the "uncertainty" of who or what will follow his regime.
The reason, of course, is Libyan oil and gas supplies. Midway through the last decade Qaddafi appeared to have a change of heart regarding foreign investment in the country's energy business, perhaps because development without them was proving problematic. As a result a flood of new capital entered the country, and the industry revived.
Today Italy and Spain depend on Libya for an estimated 22 and 13 percent of their crude oil supplies, respectively. Italy also depends heavily on the country for natural gas (13 percent of 2010 supplies), with a good portion transported via Eni's (NYSE: E) Greenstream pipeline under the Mediterranean Sea to Sicily. Italian companies have an estimated $5.5 billion in total infrastructure investment in Libya, which they would stand to lose in complete unraveling.
It shouldn't surprise anyone that markets always price in the worst-case for global events. And with Qaddafi vowing to fight to his "last drop of blood" - and presumably everyone else's - it's easy to conjure up nightmare scenarios. Loyalist militias today apparently fired on unarmed protesters leaving mosques in the capital Tripoli today, causing an unknown number of deaths.
A permanent loss of gas and oil supplies from Libya could be made up from Russian energy supplies. That would, however, increase the latter's influence immeasurably, particularly in Europe. It would also tighten global supplies considerably by essentially removing 2 percent of output at the same time developing world demand is inexorably ratcheting up and demand in the US has been recovering.
That raises the specter of much higher oil prices, particularly as summer driving season arrives in the Northern Hemisphere. Many worry this will spark global inflation. Others are concerned it will halt the economic recovery just as it's gaining momentum, as consumers are forced to curtail spending in other areas to keep their cars running.
My colleague Elliott Gue has written extensively on these issues. And I urge readers to check out The Energy Letter, www.investingdaily.com, Elliott's free weekly commentary, for more. My concern, however, is how Libya can and will affect income investors. Here's how I see it.
First, whoever wins Libya's civil war, getting the energy flowing again will be a top priority. The country simply depends too much on energy production - 95 percent of total merchandise exports at a recent count. It also depends heavily on European markets, where 90 percent of that output goes. Those ties are further reinforced by such projects as the Greenstream pipeline.
Not being able to do business in Libya would strike a blow at the already weakened economy of Italy. On the other hand, the two countries have had tight ties since the Punic Wars a couple millennia ago. The Italians endured the Qaddafi era; they should be able to weather whatever comes next.
Italian oil giant Eni has been cited frequently since the violence began as a "loser" from the conflict, as it currently draws 14 percent of global output from Libya. The company has cut its production in the country to half normal levels and has at least temporarily shut Greenstream. Yet, it's already clear it could actually wind up a winner, as it rationalizes a transaction to buy 3 billion cubic meters of already "prepaid" gas from Russian giant Gazprom OAO (Other OTC: OGZPY.PK) and benefits from higher oil and gas prices elsewhere.
The stock took a hit in the first few days of the conflict but has since bounced back, as investors have taken note of these prospects. It would also be a major mistake to count out the company's prospects in North Africa. Just days after regime change in neighboring Tunisia, for example, Eni announced a major investment program in that country. It's not hard to envision it will do much better in Libya under a new government.
In contrast to Eni, most dividend-paying energy-producer stocks rallied in the wake of the Libyan news. That's always nice. But history shows that buying oil stocks in the wake of such geopolitical events doesn't always yield the best results for long-term investors. Traders can go in and make big money. But those who buy for income wind up paying more and therefore get less in current yield. And when the tensions cool prices invariably back off.
The bullish news is these events show once again that the balance of market power is in the hands of energy producers, perhaps more than ever. Simply, it affirms that supplies are tight relative to demand that continues to go higher. That's a formula for higher energy prices long term - and fatter profits for producers.
On the other hand, every bull market in natural resources has plenty of ups and downs along the way. The massive price spike we saw in mid-2008 for oil and gas was the last straw for a weakening economy and financial system--not inflationary but intensely contractionary, at least in the US. The time to buy energy stocks was not in mid-2008, when prices were soaring, but later that year, when they were trading at a fraction of peak levels.
If you own energy stocks now I don't see any reason to sell, other than to re-balance your portfolio. But if you're a buyer, remember that patience is essential for income-investing success. Readers will want to continue adhering to the buy targets set.
What income investments would be hurt by an energy price spike that could result from a worst-case complete sidelining of Libya? For one, any companies operating in industries for which fuel costs are a major influence on profits.
Back in the 1970s many electric utility companies used crude oil to generate a hefty share of their electricity, including several operating in tough regulatory environments. Today, however, oil has been almost entirely replaced by natural gas, which is a purely North American market and completely immune from pressures in Libya.
The only exception is Hawaiian Electric Industries (NYSE: HE), which is rapidly moving away from oil toward use of renewables and conservation with regulators' support. The company is allowed to recover its fuel costs directly from customers, limiting financial exposure. As long as that's the case, there's little direct risk, though investors should use caution with the stock.
The possibility of a fuel price spike is also a risk to transports, particularly airlines. The latter, however, are generally not suitable for income investors anyway, owing to volatile earnings and cash flow.
What about interest rates? Could a fuel price spike send them careening higher, wreaking havoc among income investments? That's a possibility at least some advisors were talking about at the Orlando MoneyShow earlier this month, and I'll no doubt hear the same concerns at other speaking engagements this spring, including my publisher's own show in Las Vegas Apr. 1-2, the second annual KCI Wealth Summit.
My comments are these. First, dividend paying stocks from MLPs to utilities have been decoupled from interest rates since early 2008. Instead, they've followed prospects for the economy, rising when the news has been good and falling when it's soured. There's nothing to suggest they've started following interest rates again.
Second, rising interest rates proved contractionary in 2003, 2004, 2005, 2006, 2007, and again in 2008, rather than inflationary. Consumers paid more, so they spent less and the faster growing pushing rates higher cooled. That's likely to remain the case for one reason: There's absolutely no wage-push inflation in the US, and without a return to '70s-style inflation is simply impossible.
Higher interest rates and oil prices will take money out of people's pockets, so they won't be able to spend it elsewhere. Rather than fomenting higher prices across the board, they'll slow things down. Inflation is likely to rage in the developing world as commodity prices rise. But until unemployment drops a lot more and wages start rising, it can't happen here.
My approach remains to stick with individual companies that are growing as businesses and therefore lifting dividends over time. I don't want to pay more than prices that are justified by the growth of these businesses and dividends.
This approach requires those who follow it to stick with positions over time, even as the markets move up and down. That means the value of holdings rises and falls throughout the various cycles. But we can steady the value of our overall portfolios by holding a mix of investments that perform well under varying conditions.
If an income investor is worried about a meltdown - either resulting from a Libyan implosion or something else - they need to hold positions in dividend-paying stocks that would do well under those conditions. That could be Canadian or Australian stocks, which are priced in currencies that rise in value when natural resource prices do. If we're worried about another 2008, hold some low-duration, high-quality bonds - nothing will protect your wealth better.
Above all, hold stocks of high-quality companies, preferably those that are growing dividends as well. That's the key to building wealth in any environment, no matter what happens in Libya, Russia, China or anywhere else.
The vast majority of Utility Forecaster Portfolio has now reported fourth-quarter and full-year 2010 numbers. The good news is this week's batch of results were generally favorable for the long-term health of the reporting companies, just as was the case for the others who've reported thus far during this earnings season.
Solid numbers have helped more than a few picks push on to even higher prices the past few weeks. That's even despite the general turmoil in the market triggered by Arab world unrest and its potential implications for energy prices and, by extension, global growth and inflation.
The notable exception this week was Frontier Communications (NYSE: FTR), which plunged nearly two full points in a matter of minutes after announcing results on Wednesday. Selling appeared to be initially sparked by higher costs than many expected for the company's integration of recently acquired Verizon Communications' (NYSE: VZ) lines.
The magnitude and suddenness of the stock's decline smacks of ill-placed stop-losses getting executed at the same time. So does the equally violent recovery of half of those losses minutes later. The bad news is a there a no doubt a number of investors who've been flushed out of the stock at an abysmal price. The fear that's left in the aftermath is likely to keep Frontier on the weak side for a while.
The important thing, however, isn't whether stocks disappointed Wall Street projections for a given quarter. Rather, it's if the numbers indicate companies are still healthy and growing. As I point out below, that's the case for Frontier, which has become a much better bargain for those who don't already own it.
It's also true of the rest of these companies, most of which have gotten at least slightly cheaper this week due to fears about the Middle East. Here's the roundup of their numbers, as well as Frontier's.
Aqua America (NYSE: WTR) posted an 11th straight year of net income growth, with a 19 percent boost over last year's tally. As was the case for last year's then-record results, the keys were capital spending on the company's water systems and rate increases to pay for them.
The company completed 23 acquisitions, boosting its customer base by 1 percent despite the slow economy. That growth rate should pick up in 2011, as many of the areas acquired are slated for growth. The company also has $26.6 million in rate-hike requests pending, which will boost results later in the year. Maintenance expense-to-revenue fell to 38.6 percent from 40.3 percent a year before, a clear sign of efficiencies.
The stock fell slightly after announcing the numbers but that appears more related to overall market conditions. Buy Aqua America up to 25 if you haven't yet.
CLP Holdings (OTC: CLPHY) enjoyed a 26 percent boost in 2010 profits on a 15.3 percent increase in revenue. The key was strong results in the home Hong Kong market, which saw a 5.8 percent increase in revenue, supplemented by growth at the company's investments in Australia and China.
The former, fortunately, doesn't appear to be affected significantly by that country's flooding, as new acquisitions have paid off. Chinese renewable energy investments are also growing rapidly and CLP benefitted from a stable coal supply as well.
The stock is basically flat on the news, which was very much in line with management and analyst expectations. CLP Holdings remains a buy up to USD9.
CMS Energy (NYSE: CMS) slipped a few cents after announcing its fourth-quarter and full-year 2010 earnings this week but appears to have stabilized shortly thereafter. The reason seems to be a slightly lower 2011 guidance estimate by management than what the Street has expected. That seems to be the result of a slightly scaled back capital spending plan, which has been the primary driver of growth in recent years.
For 2010 the company earned $1.36 per share (payout ratio 61.8 percent) for the year and 21 cents for the seasonally weak fourth quarter, excluding one-time items. That was in line with guidance and produced growth in the mid-range of CMS' long-term goal of 5 to 7 percent annual profit growth. This goal is based on previously announced capital spending plans for the next five years, which remain largely intact with regulatory support.
CMS has come a long way back over the past eight years. These numbers indicate, however, that it's still on the come. My buy target remains 20 for those who don't already own CMS Energy.
El Paso Corp (NYSE: EP) also continued its road back last month, which benefitted Income Portfolio Holding El Paso Corp 4.75 Percent Convertible Preferred C (NYSE: EP C). The key was continued growth of the company's infrastructure side, which included the completion of three pipeline projects in the fourth quarter an incredible 25 percent under budget. Oil and gas production was up 7 percent, pushing cash flow from operations up to $1.8 billion for the year.
As is the case with CMS, these solid results are light years away from the near bankrupt state El Paso found itself in eight years ago. The good news is we're likely to see a lot of this, even if natural gas stays weak, as the company brings five major pipeline projects into service in 2011. El Paso Corp is now a buy up to 18. El Paso Corp 4.75 Percent Convertible Preferred C has run a bit here but would be on a pullback to 40.
Frontier Communications (NYSE: FTR) is thus far the only Utility Forecaster Portfolio company to report anything approaching disappointing earnings. The market's mighty reaction to them, however, is much more the result of misunderstanding them and poorly placed stops than anything fundamental.
The key challenge remains integrating the 4.8 million phone lines acquired from Verizon Communications (NYSE: FTR) in the deal that closed last July. This is a time-consuming and expensive process, and the financial impact shows up clearly on the fourth quarter payout ratio of 88 percent of free cash flow. That's a much higher percentage than in previous quarters. But again, it's due to one-time factors, mainly upgrades to the system and the elimination of redundancies.
Management continues to expect higher than normal costs until the second half of 2011, which will likely keep the payout ratio on the high side. The important thing, however, is the investment appears to be working to bring the Verizon lines up to the quality level of the legacy business. I was most impressed by the company's ability to increase returns from this side of the business, including solid gains in revenue per customer. Doing that to the Verizon lines is no sure thing. But access-line losses and broadband gains both showed improvement.
Most important, management is sticking with the guidance it gave when it first announced this deal in summer 2009. As long as that's the case, the dividend is safe and the company is going to emerge from this transition in better shape than ever. Again, we're going to have to take this quarter by quarter. But Street opinion is about evenly split between bulls and bears. And if the company does continue to perform, bears will eventually warm up to it and the stock will resume its upward trajectory.
In retrospect, it was probably premature of me to raise Frontier's buy target to 10. But my view is it will definitely be worth that and a lot more. I do not, however, advise anyone to load up on Frontier or any one stock.
Integrys Energy Group (NYSE: TEG) turned in a solid fourth-quarter and full-year 2010 report, its first since I added it to the Portfolio this year. Importantly, management stuck to its guidance for the coming year, which should see further earnings gains and a dramatic lowering of its payout ratio - pointing the way to dividend growth.
Earnings excluding items were 82 cents a share for the quarter, up from 51 cents the year before. After the asset divestitures of recent years, these are rock solid numbers that rely on infrastructure and reliable cash flows. And Wisconsin regulators in particular are among the most cooperative anywhere. The stock has moved little since the news but remains a solid buy up to 52 for those who don't already own it.
ONEOK (NYSE: OKE) had a lower headline fourth-quarter profit number, but 2010 results were again strong at $3.06 per share not including a one-time gain for an asset sale. The payout ratio of 68 percent is firm backing for the relentless dividend growth of the past year (up 18.1 percent).
The company is more than anything else a solid infrastructure play on the continued increase in natural gas flow in North America. And it has plenty of growth projects on tap, both at the corporate level and through its ONEOK Partners LP (NYSE: OKS) unit. The latter has $1.8 billion to $2.1 billion in new projects on tap, profits from which will flow tax efficiently to the parent via its limited partnership structure. That means earnings and dividend growth for the parent. ONEOK is a buy up to 60.
Sempra Energy (NYSE: SRE) beat Street estimates for 2010 earnings and affirmed its guidance for 2011 profits as well. Fourth-quarter net was 26.7 percent above Street projections. Not surprisingly, the stock has performed well since the announcement, despite the turmoil in the broad market.
The challenge at Sempra for the past couple years has been to exit the commodity trading business and deploy sufficient funds to energy infrastructure to make up the difference. These results are a good sign it's succeeding a lot faster than many had anticipated. There are still some potential hurdles, such as a likely toughening of the California regulatory environment under Governor Jerry Brown. But the company's plan to steadily invest in its electric and gas business in California and elsewhere is set to drive earnings a lot higher.
Best of all, Sempra is sharing that with investors, pushing up its dividend by 23 percent effective with the Apr. 15 payment to 48 cents a share. Buy Sempra Energy up to 55.
Here are the remaining Utility Forecaster companies that have yet to report their fourth-quarter and full-year 2010 results. Those indicated as "estimated" (an "e" in parentheses) have yet to state actual dates, and so could vary.
• AES Corp (NYSE: AES)/AES Corp 6.75 Percent Preferred C (NYSE: AES C) - Feb. 25 (e)
• Atlantic Power Corp (TSX: ATP, NYSE: AT) - Mar. 29 (e)
• Connecticut Water (Nasdaq: CTWS) - Mar. 15 (e)
• Consolidated Communications (Nasdaq: CNSL) - Mar. 3
• Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) - Mar. (e)
• Piedmont Natural Gas (NYSE: PNY) - Mar. (e)
• Telefonica (NYSE: TEF) - Feb. 25
Editor's Note: Roger S. Conrad is editor of Utility Forecaster, 7600A Leesburg Pike, West Bldg., Ste. 300, Falls Church, VA 22043, 1 year, 12 issues, $149, the nation's leading advisory on essential services stocks, bonds and preferred stocks. His proprietary safety rating system evaluates the prospects of every significant electric, natural gas, telecommunications and water company, including utility-based mutual funds and foreign utilities.
He is also editor of Roger Conrad's Canadian Edge, an Internet-based publication devoted to uncovering lucrative investment opportunities in Canadian royalty trusts. Roger has earned him a reputation as one of the leading authorities on Canadian trusts.
Roger is also editor of Big Yield Hunting, associate editor of Personal Finance and co-editor of MLP Profits, an online newsletter that takes the guesswork out of identifying high-growth, high-yield partnerships through studied advice and sound market intelligence.
For more information visit www.utilityforecaster.com.
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