One of my favorite investors to discuss markets with, my father, turns 85 years old today. His approach has always differed somewhat from my own: While I’m usually conservative to a fault, he often sets his eyes on big gains and has done quite well at it over the years.

He and I, however, are always on the same page when it comes to seeking quality. We buy companies that are gaining value as businesses and hold onto them as long as that’s the case. Selling is only for taking profits when gains have come too far too fast or when an underlying business is coming unraveled.

Earnings season is the ideal time for gauging quality, i.e., discerning business health. And with so many challenges facing companies today—a weak US economy, rising raw materials costs and tight credit—the stakes have rarely been higher to post good numbers than during this reporting period.

We’ve only seen a handful of companies report their second quarter earnings so far. There’s still a lot of ground to cover and plenty of room for surprises, both positive and negative. The good news is the numbers we’ve seen for Utility Forecaster holdings have been about as good as we could expect.

As I’ve pointed out repeatedly over the past year, regulated energy utilities are in a far better place now than they were during the last bear market, which took the dow jones Utility Average down nearly 60 percent from its late-2000 peak to its late-2002 bottom. That’s courtesy of half a decade of debt reduction and cutting operating risk.

Unlike the last bear market, there are no Enrons waiting to implode or government investigations of dubious business practices. Even states with notoriously tough regulators have been allowing companies to recover costs expeditiously.

Companies do face future challenges, notably earning a return on the estimated $1.5 trillion in new spending that industry studies estimate is needed for the next 20 years to keep power flowing in the US. But for now, the industry on the whole is as healthy as it’s been in decades, and the credit-rating upgrades and dividend increases are still coming.

As of Thursday afternoon, the only major power company in the Utility Forecaster portfolio to release full numbers is Exelon Corp (nyse: EXC), and they definitely confirm the sector’s positives. The company combines a thriving generation arm in unregulated areas of the Mid-Atlantic and Midwest, with regulated transmission and distribution utilities in the Philadelphia and Chicago metropolitan areas.

Exelon’s headline earnings per share came in at $1.13, well above the $1.03 posted a year ago and even further ahead of Wall Street estimates of $1.02 a share. Revenue rose to $4.6 billion from $4.5 billion, and management reaffirmed full-year guidance of $4 to $4.40 a share for operating earnings.

The key to that showing was strong performance from the company’s fleet of nuclear power plants--the nation’s largest--which averaged 95.8 percent of operating capacity, up from 93.6 percent. Nuclear energy sales also benefited from higher prices in the wholesale market, which were driven by rising natural gas prices. Availability of fossil fuel plants was slightly lower, while hydro plants ran at a somewhat higher rate than last year.

Offsetting the strong wholesale market performance was slightly lower profitability at Illinois-based regulated transmission and distribution operations, largely because of the impact of milder weather on demand in the quarter. Higher bad debt expense—a by-product of the weaker US economy—was another negative. Fuel costs also rose at the fossil fuel plants, though nuclear and hydro costs remained steady.

The key takeaway from these results is that Exelon is weathering this environment. And despite the choppy action in the stock price following the results, that’s a clear sign it’s still becoming a more valuable business, and it, therefore, remains a very worthy holding.
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The nation’s second-largest nuclear company, Entergy Corp (NYSE: ETR), hasn’t yet released final numbers. But it did indicate that its results would also show a substantial jump over 2007 levels. Unlike the Exelon numbers, those figures were below Wall Street projections but nonetheless demonstrate good wholesale market performance. And the company affirmed its full-year forecast of $6.50 to $6.90 a share, as well as progress with the planned spinoff of its nuclear assets in the second half of the year.


Realistically, there are bound to be some shortfalls even in the power sector. Indiana-based Vectren (NYSE: VVC), for example, has already warned that unregulated marketing operations will drag down its otherwise healthy second quarter results. And other companies with hefty unregulated operations are also at risk, particularly if they’re tied closely to the level of economic growth.

At this point, however, only a very small handful of power companies are even remotely vulnerable to dividend cuts based on their second quarter results. PNM Resources (NYSE: PNM) is experiencing a shortfall in earnings because of squeezed margins at its Texas retail power unit. Hawaiian Electric (NYSE: HE), meanwhile, has been hurt by surging oil prices—oil generates virtually all of its electricity—and troubles at its banking unit. Neither, however, are included in the Utility Forecaster Portfolio.

Energy infrastructure stocks and limited partnerships (LP) comprise another group likely to report very solid second quarter results. The only Portfolio major to report thus far is Enterprise Products Partners (NYSE: EPD), and the results make for very good reading.

Headline earnings per share roughly doubled over last year’s levels as revenue rose 51 percent. Those numbers literally blew the doors off Street projections and were particularly impressive in light of the fact that the LP’s Independence Hub was impaired for 66 days during the quarter. The results are further confirmation that Dan Duncan’s flagship is on the right track as the company adds fee-generating assets like clockwork and pushes up cash flows and distributions.

The really good news is, from all indications, other LPs with solid fee-based assets should follow suit. Energy Transfer Partners (NYSE: ETP) won’t announce full numbers until Aug. 11. But this week the LP did announce another solid dividend increase and increased its guidance for both fiscal year 2008 and fiscal year 2009 on the basis of planned additions of assets.

Still Connecting

Since this bear market began a year ago, a cadre of analysts has stubbornly maintained communications companies were no longer recession resistant. Quarter after quarter, they’ve forecasted sizeable earnings shortfalls, supposedly as consumers cut back on communications spending.

Every quarter, they’ve been proven dead wrong as communications companies have continued to put up strong numbers. But three months later, they’ve come back with the same bearish forecast, only to be shot down again by reality.

In the market place, it’s basically played out like this. Each time these widely broadcasted predictions have been made, sector stocks sold off sharply. They then rebounded after the numbers were released, though settling at a lower level than before. The result is that communications stocks are now trading roughly 20 percent below where they began the year, despite continuing to weather well the economic downturn and, increasingly, the long-term value of their businesses.

This earnings season has opened no differently than the several preceding it. And it’s proceeding in much the same way. As was the case in prior quarters this year, the first major to report is the biggest of the bunch, AT&T (NYSE: T).

Before its announcement, speculation was rife that wireless margins and customer growth were about to take a dive. Bears also forecast a big shortfall at the wireline operation, as consumers would supposedly cut the cord in record numbers to reduce expenses.

As it turned out, none of that happened. In fact, Ma Bell’s headline earnings per share rose an explosive 30 percent, as both revenues and operating margins topped expectations. Wireless data sales rose 52 percent as the company added customers, cut churn to a company record 1.1 percent and added 1.3 million new wireless customers.

On the wireline front, the company lost basic copper connections at an 8.1 percent annual rate, and the rate of broadband customers additions dropped sharply. But it remained on target for 1 million-plus customers by year-end for its premium broadband wireline communications service U-verse. That’s a far higher margin business than conventional wireline service, and customers tend to be far stickier as well, with industry surveys indicating only 2 percent of broadband users nationwide would even consider cutting the service in response to the weak economy.

There are still a lot of companies to report in this business. In my view, small rural wireline companies should be watched the most closely, as the loss of basic local phone lines seems to be the part of the sector most at risk. Managements of larger rural wireline operations such as Windstream Communications (NYSE: WIN) have indicated they’re holding firm, just as they have in prior quarters this year.

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Earnings at Verizon Communications (NYSE: VZ), slated to be released Monday, will be the next big industry test. Here again the company has reported solid results every quarter since the bear market/economic slowdown began. But analysts have nonetheless continued to project a doomsday every three months.


We’ll see what the numbers say. But based on the preliminary numbers the company released this week for its wireless business, all indications are the doomsayers will be proven dead wrong yet again. Verizon Wireless—which the company owns 55 percent of in partnership with Vodafone (NYSE: VOD)—added 1.5 million customers in the second quarter. Growth of the company’s FiOS broadband service may also provide a positive surprise as it enters new markets and acquires new customers at a robust rate.

Verizon’s big challenge is completing the planned acquisition of Alltel Communications from the group that took it private last year. The company has planned a series of divestitures to ensure approval from the Federal Communications Commission. That still looks on track to take place before the Bush administration leaves office to avoid the uncertainty of winning approval from appointees of a new president.

On the other hand, Vodafone has now warned investors that it expects revenue growth to slow sharply, thanks to a slowdown in sales in several developed, as well as developing, markets. On the plus side, it continues to add customers, and wireless data look promising. As a result, it’s becoming a more valuable business, and the company is cash rich, evidenced by a large, planned stock buyback.

If any sector would seem certain to turn in robust second quarter results, it’s energy production. The situation, however, has already emerged as considerably more complicated. Chevron Corp (NYSE: CVX), for example, was able to post solid earnings gains, despite a drop in output and weak results at its refining business.

On the other hand, Energen Corp (NYSE: EGN) turned in second quarter earnings that were clearly disappointing, as utility costs rose faster than rates. On the plus side, the oil and gas production side of the business did benefit from higher energy prices and increased output. But that wasn’t enough to prevent the shares from dropping sharply.

Energen’s utility business was disappointing also because of the impact of customer conservation on sales. That’s a problem other gas distributors may have unless they enjoy rate structures that automatically pass through the impact of conservation. One of these is Piedmont Natural Gas (NYSE: PNY). Atmos Energy (NYSE: ATO) enjoys weather normalized rates in most of the states in which it operates as well.

In contrast, the more companies rely on energy production, the better numbers they should put up. ARC Energy Trust (TSX: AET-U, OTC: AETUF) sold oil and gas in the first quarter at 30 to 40 percent below the prevailing spot and futures curve prices in the second quarter. That guarantees a huge boost in cash flow, which management presaged by a 40 percent distribution increase over the past two months.

The Bottom Line

In my estimation, these four sectors have the best chance of beating the tough conditions that burdened corporate America in the second quarter of 2008. And they have the best chance of continuing to do so the rest of the year.

That hasn’t saved them from extreme volatility this year. In the current climate of fear, a growing number of investors of all stripes has been unwilling to hold anything in the face of adversity. Selling waves routinely accelerate into tidal force in sectors that have been strong as well as the weak.

Over the past couple weeks, we saw major drops in the energy and raw materials markets. Investors took profits for fear of losing them. Others who bought in late in the uptrend thinking they couldn’t lose have also bailed out. The result is many of these stocks are as cheap, or cheaper, than they were when the price of the materials they produce was well below current levels.

Utilities, long a refuge in this market, have also taken a hit in recent months, and the major averages are now down on the order of 20 percent. Even the reporting of strong results—indicating little or no impact from the weaker US economy—hasn’t been enough to halt their slide. That was certainly the case with Exelon this week, despite the fact that it topped Wall Street expectations by a hefty margin.

In the near term, emotion does rule the market. In the long run, however, it’s the numbers that call the tune for stocks. That’s why it’s so important to focus on them in the coming weeks. Everything else is ephemeral.

Speaking Engagements

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