Bargain-hunting would seem to be the game of the moment in a stock market that's weakened considerably in the past month. Even in an industry that hasn't been very popular so far this year, Virginia-based power producer AES Corp. (AES) has taken a beating, down nearly 26 percent since the start of 2010.
Common sense would suggest that utilities—typically a defensive sector—would have become more popular since a broad stock market correction began in late April. But that's not the case. The 36-member Standard & Poor's Utilities index is down 7.6 percent since its recent peak on Apr. 23—also the near-term high for the S&P 500 index—compared with a loss of roughly 2.4 percent from the start of the year through Apr. 22.
The market's wariness of the industry in general stems from fear that the trouble in Europe could scuttle a global economic recovery, reducing energy consumption, says Lasan Johong, an analyst at RBC Capital Markets. That would be a problem for power companies that aren't allowed by regulators to maintain a fixed level of revenue despite lower consumption levels, he says. Another concern is that if European countries have to spend their way out of an economic tailspin, it will trigger inflation and force central banks to raise interest rates. Higher interest rates would make the yields on utility dividends less compelling than they've been in the zero-interest-rate environment, and would also boost the cost of capital, making it harder for utilities to build additional generation capacity, he adds.
"Utilities have built into their valuations expectations for strong growth," he says. "Whether now or later, people are worried investments in expanded capacity won't happen and that will have a negative impact on earnings."
Another factor dissuading investors from utilities is uncertainty about how high the tax rate on stock dividends will be once the Bush Administration's tax cuts expire at the end of 2010, says Tim O'Brien, manager of the Evergreen Utility & Telecom Fund (EVUAX). The tax rate could jump as high as the 39.5 percent rate on ordinary income, although the Obama Administration has proposed a 20 percent rate, vs. the current 15 percent.
O'Brien sees AES as a well-managed company with high-quality assets, but he doesn't own the stock because his investors are income-oriented and AES doesn't pay a dividend. One reason he thinks AES shares have been slammed so far this year is the company's exposure to emerging markets, which "were the darlings of the market until the end of March" but were sold down in April and May.
Unlike the rate-based utilities, unregulated independent power producers have a lot of exposure to fluctuating commodity prices. (AES has both regulated and nonregulated power operations.) Shares of power companies have fallen in tandem with the price of natural gas and won't recover until natural gas prices go up, says O'Brien. Since natural gas prices set all electricity prices at the margin, power producers' profits have been squeezed by depressed natural gas prices over the past two years. Consensus estimates for earnings among analysts are being lowered and those estimates typically take into account a natural gas price of $5.50 to $6.50 per thousand cubic feet, higher than the current spot price of gas around $4.70.
While investor appetite for assets exposed to emerging markets appears to have wavered, AES's increasing footprint in markets such as Brazil, India, and China should allow its core power-generation business to grow more quickly than those of domestically oriented utilities, Ladenburg Thalmann (LTS) said in a May 12 research note. AES has relatively modest commodity price sensitivity by virtue of its global diversification, long-term contracts for the power it generates, and regulated utilities, compared with other U.S.-based utilities and power producers, the note said. Ladenburg Thalmann raised its rating on the stock to buy from neutral on May 12, based on a revised 12-month price target that implies potential appreciation of 30 percent in the shares and on some recent announcements of sales of smaller utility operations at attractive prices.
The Reaves Utility Income Fund (UTG), a closed-end fund with $640 million in assets, has also shied away from AES because it doesn't pay a dividend. But the "value of a dividend strategy beyond the cash flow it gives you is it imposes an internal discipline with regard to capital allocation on the part of management," says Ronald Sorenson, chief executive officer of W.H. Reaves & Co. and lead portfolio manager of the closed-end fund. His doubts about the stock are based on AES's aggressive capital investment strategy, he adds.
The pressure on the stock may also be the result of a strengthening U.S. dollar. AES is one of the most globally diversified power companies, with just 21 percent of its total revenue in 2009 coming from North America, according to a Standard & Poor's report on May 29. That may lead investors to believe the company is more vulnerable to negative currency translation effects when revenue generated in local currencies is converted to U.S. dollars.
While that's true, what much of the market misses, says Johong at RBC, is that weaker local currencies make developing countries' economies more competitive and boost their commodity exports, whether iron ore and coffee from Brazil or copper from Chile. The adverse currency translation impact is being partly offset by greater power consumption in those economies needed to produce higher volumes of commodities to meet increased export demand, he adds.
Johong believes most investors mistakenly dismiss AES as overleveraged, looking at an inflated net debt-to-capitalization ratio, a key metric for assessing the strength of a company's balance sheet. That ratio—in the low 70 percent range—looks higher than it really is because U.S. accounting rules require that 100 percent of a Brazilian subsidiary's debt be consolidated onto AES's balance sheet even though it owns only a 40 percent interest in the subsidiary. If the Brazilian unit's debt were not consolidated, the ratio would be in the low 60 percent range, he says. The Brazilian Development Bank, which took a 60 percent equity stake in the subsidiary in 2003 in exchange for forgiving more than $2 billion in debt, has said it will sell its interest back to AES, but that isn't expected to happen until after a new presidential administration takes power in Brazil in early 2011.
Another aspect of AES's debt that the market largely fails to understand is that the majority of it isn't holding company debt, but project-level debt, much of which is backed by collateral, which protects the parent company from being held responsible if the subsidiary were to default, says O'Brien at Evergreen Investments.
In a May 26 research note, Barclays Capital reaffirmed its overweight rating for AES, citing asset sales expected to close in the second quarter that will raise about $2.7 billion in cash, which can be used toward a significant backlog of opportunities. Analyst Gregg Orrill said in the note that he expects AES to be able to stick to its 2010 earnings forecast of 90 to 95 cents a share after its wind-generation joint venture is completed. Potential longer-term uses of the $3.3 billion in cash that AES holds on its balance sheet from asset sales include recently announced wind and solar projects, as well as a $400 million, 532-megawatt hydroelectric plant in Chile and a $200 million coal plant in India, the note said. The wind and solar plants could begin production by 2012, while the coal and hydro plants wouldn't start operating until 2014 or 2015.
Orrill said he expects the $1.58 billion that the China Investment Corp. paid for a 15 percent equity stake in AES in March to add 20 to 25 cents a share to AES's 2010 earnings vs. currently modeled assumptions.
Perhaps most important, the most formidable competitors for the kind of international projects that AES is pursuing have been knocked out by the recessions of 2001-2002 and 2008-2009, says RBC's Johong. Despite favorable economic conditions, European and U.S. competitors aren't likely to reemerge over the next five years, which leaves lots of room for AES to grow, he said in a May 10 research note.