Beating the Street (38 page)

The second was that demand for electricity in Michigan was on the rise. It had grown 12 years in a row. Even in the recession of 1991, the region consumed 1 percent more electricity than it did in the prior year. On peak days for electricity use, CMS had only 19.6 percent in extra generating capacity held in reserve, which in utility circles is considered a very thin margin. There were few new plants coming on line in the Midwest to satisfy the growing demand, and it takes 6–12 years to build one from scratch. Even some old ones were being retired. From Economics 101 you learn that when demand grows faster than supply, higher prices result. Higher prices produce more profits.

CMS's balance sheet still had a lot of debt left over from the
nuclear fiasco. It sold $1 billion worth of bonds to finance Midland's conversion to gas. (I noted that bondholders must have had faith in these bonds, because the price had increased since the initial offering.) CMS had also sold $500 million worth of senior notes, which I was glad to see were not callable for 10 years. When a company is deeply indebted, you want it to be a debt that doesn't have to be paid in full anytime soon.

CMS had enough cash flow to pay the interest to its lenders, and then some. I assured myself of that by reading the balance sheet. I took the earnings and added those to the depreciation, then divided by the number of shares and came up with a cash flow of $6 a share. Since most of CMS's generating equipment was new, the company was not forced to spend a lot of money on repairs. What was set aside for depreciation could be used for other purposes. The company could (a) buy back its own stock, (b) make acquisitions, or (c) increase the dividend, all of which would eventually benefit the shareholders. My preference was for (a) and (c).

I asked Fryling about CMS's plans for the cash. He said CMS was going to use it to expand the gas plant and to improve the efficiency of the transmission lines, both of which would add to the company's generating capacity. When a utility adds, say, 10 percent to capacity, it automatically adds 10 percent to its earnings, based on the formula that is applied by the regulators who set the rates. It is a wonderful thing for shareholders when a utility builds a new plant (one that gets a license to operate, at least) or takes other steps to increase capacity. When capacity grows, so does the rate base, and so do the earnings.

Fryling and I also discussed the recent oil discovery in Ecuador, on land that CMS owns jointly with Conoco. Production is scheduled to begin in 1993, and if this goes according to plan, CMS will receive $25 million in annual profits by 1995. This $25 million will add 20 cent a share to earnings. Fryling also informed me that the so-called Power Group, a CMS subsidiary that owns several small cogeneration plants and has been losing money of late, could turn a profit by 1993.

CMS had hoped to go to Long Island and help Long Island Lighting convert its Shoreham nuke plant, idled by politics, to natural gas. This collaboration fell apart in 1991. But the greatest ongoing disappointment was with the regulators.

A utility in the final stages of recovery depends on regulators to treat it gently and pass along the costs of its mistakes, but the Michigan commission was uncooperative. It had handed down three unfavorable
rate decisions in a row and had refused to let CMS charge its customers the full price of the natural gas burned at the Midland plant.

Apparently, the company had reason to believe that a recent appointee to the commission would be more accommodating, i.e., only mildly hostile. Mildly hostile would be an improvement over the commission's traditional attitude. The commission's own staff had produced a study that favored certain concessions to CMS, and the full commission would soon be voting on these concessions.

If CMS got a reasonable decision from the company's point of view, it would be allowed to earn $2 a share in the upcoming year, as opposed to the $1.30 that Wall Street was expecting, and the earnings could grow steadily thereafter. This possibility was much on my mind when I recommended the stock in
Barron's.

I also thought CMS was more than just a gamble on Michigan regulatory politics. In the long run, I expected the company to thrive with or without an accommodative public service commission. Its powerful cash flow would enable it to reenter the ranks of the strong utilities, and when that happened it could once again borrow money at lower interest rates.

If all items were resolved in the company's favor, CMS would be allowed to earn $2.20, and if not, it would earn in the neighborhood of $1.50, but either way it would prosper in the long run. If the regulators restricted its earnings, it could plow the cash back into more generating capacity and grow the business internally. With the stock selling at $18, and below book value, I saw a lot of potential reward without much risk.

If you don't like CMS Energy, you can always look into the hapless Public Service Company of New Mexico or the more hapless Tucson Electric. You can be sure that the investor relations person won't be too busy to talk to you.

Allied Capital II

When Uncle Sam or the Queen of England is having a garage sale, I always try to attend. Not-So-Great Britain is way ahead of us in sponsoring these events, having sold everything from the waterworks to the airlines, but if our own deficit spending continues at the present rate, someday we may have to privatize the national parks, the Kennedy Space Center, and even the White House Rose Garden just to pay the interest on our national debt.

Privatization is a strange concept. You take something that's owned by the public and then sell it back to the public, and from then on, it's private. From a practical standpoint, what's useful to know about this is that whenever the Americans or the British have privatized something by selling shares in it, it's usually been a good deal for the buyers.

The reason is not hard to imagine. In the democratic countries, the buyers of privatized industries are also voters, and governments have enough trouble getting reelected without having to contend with a mass of disgruntled investors who've lost money on the telephone company or the gasworks.

The British learned this lesson in 1983, after two of their earliest privatizations, Britoil and Amersham International, came out overpriced,
creating widespread ill will when the prices declined. Since then, the British have structured their offers so it's been unlikely that investors would lose, at least in the early going. British Telecom doubled in price in one day. Three million Brits snapped up the shares. No wonder the Tories are still in office. This leads us to Peter's Principle #21:

Whatever the queen is selling, buy it.

A few years ago, I was introduced to a tempting proposition from a British contingent that showed up in our offices at Fidelity. They introduced each other as Lord So-and-So and Sir So-and-So. They brought along a large bound volume which proved to be a prospectus for a group of British water utilities that were about to be privatized. The prospectus was numbered like the limited edition of a rare print. On the cover were the names and the corporate logos of the new companies—Northumbrian Water, Severn Trent, Yorkshire Water, Welsh Water PLC, etc.

Even though Magellan had already taken part in the bonanzas of British Telecom (the largest public flotation the world had ever seen at the time—$4 billion) and British Airways, I was unprepared for the benefits that were built into these waterworks deals. They were monopolies, just as water utilities everywhere tend to be—it's always nice to own a monopoly. The British government, before setting them free, had absorbed most of the prior debt.

These companies were coming out debt free, with extra capital provided by the government, which had given them a “green dowry” to get them off on the right foot. They agreed to embark on a 10-year program of upgrading the water systems, an effort that would be partially subsidized by the green dowry, with the rest paid for by an increase in water bills.

In our conversation in my office, the water lords told me that water bills in England were so low (100 pounds a year) that even if these prices doubled the customers would not resent it. Even if they did resent it, there was nothing they could do about it except stop using water, which was unlikely. Water demand in England was growing at 1 percent a year.

These new water shares could be bought on the installment plan, just like cars or stereos or rugs. You could put 40 percent down and pay the rest in two easy installments, one due in 12 months and the
other in 20 months. The British had offered the same sort of deal, which they called “partially paid shares,” on British Telecom. When British Telecom came public at $30, all the buyer had to pay was $6 down. Then, when the share price rose to $36, the buyer who paid $6 could sell and double his money.

The implications of this partial-paid concept I failed to appreciate with British Telecom. I thought the stock price was going up too fast, but when I finally understood the benefits of the partial-paid feature, I could see that the buying frenzy was justified. The same sort of deal was offered with the water companies, as follows.

In addition to allowing you to buy shares on the installment plan, the water companies paid an 8 percent dividend, beginning immediately. For at least a year, you got this 8 percent dividend on the full value of shares you acquired at 40 percent down. That gave you a 20 percent return on your investment in the first 12 months—even if the stock price stayed flat.

The British water shares were understandably quite popular. Before the initial public offering, U.S. fund managers and other institutional investors were given an allotment. For Magellan, I took everything I was allotted, and then bought more shares in the aftermarket, as they began to trade on the London Stock Exchange. A portfolio of all five of the water utilities doubled in value in three years.

The other British companies sold to the public have done just as well or better in the six months to one year after the offerings. This brings us to another what-if fund, the Queen's Garage Sale Fund. Any U.S. investor could have put together a portfolio of the stocks shown in
Table 17-1
and gotten the results shown there.

Every time a telephone company has been privatized, in whatever country—the Philippines, Mexico, Spain—the shareholders have reaped once-in-a-lifetime rewards. Politicians around the world are dedicated to improving phone service, and in the developing countries there is such a hunger for phones that these companies are growing at 20–30 percent a year. What you've got here is the growth rate of a small growth company, the size and stability of a blue chip, and the guaranteed success of a monopoly. If you missed AT&T in 1910, you could have made up for it with Spanish and Mexican telephones in the late 1980s.

Table 17-1. QUEEN'S GARAGE SALE FUND

Magellan shareholders made a lot of money on Mexican telephones. You didn't need to visit the Mexican telephone company to see that a bonanza was coming. The country knew it had to improve the phone service before the rest of the economy could expand. Phones were as important as roads. The country also knew that it couldn't have a good phone system without a well-capitalized, well-managed phone company. And it couldn't attract the capital without allowing shareholders to make a decent profit.

Here's another great what-if portfolio, Telephones of the Emerging Nations:

Table 17-2. TELEPHONES OF EMERGING NATIONS