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Power Failure: Sorting out the Investment Winners and Losers
New York: August 21, 2003
By John R. Stephenson

Last week we saw something remarkable. The biggest power failure in the nation’s history. A blackout so massive that some fifty million people were left without power, some for days, while governments, utilities and politicians pointed fingers. While the cause is unknown, the solution is obvious - greater investment in the electric grid that serves us as consumers. From an investment perspective who are the likely winners and losers and what is the best course of action for investors to follow?

The makings of this disaster go back over a hundred years to the time when electricity was first invented. Because generating plants and the associated transmission and distribution lines (the wires that get the power from the plant to your home) were so expensive to build and operate, it made little sense for competing plants to be built. The solution - grant the utilities monopoly service territories that a local public utilities commission would oversee to ensure that there were no abuses of monopoly power. The problem today, is a complex system straining to meet the demands of a growing nation. This system is being overseen by overlapping levels of both governmental and non-governmental agencies with little physical redundancy whatsoever in the system. As well, we have the deregulation of the nation’s electricity system occurring on a piecemeal basis. Confused? Even the experts are confused as to who was responsible for this massive blackout that crippled some fifty million people and stalled the economy of the crucial Northeastern region of the country. Sorting out the mess is going to take years, not weeks, and given the highly political nature of the industry today, you can bet that politics will play a heavy role in the solution to this problem in the years that lie ahead.

So where do we stand? We can all agree that the energy delivery system in this country is crucial to our economic development as a nation and that disruptions of this type pose not only a danger to our economy but also to our national security. It is also clear that at least at the present time there exists tremendous political will, not only in the United States but also in Canada, to clean up this mess and get a system that works. Recent studies have shown that to bring the transmission grid into the twenty-first century will require an investment of some $56 billion. But where is that money going to flow and how are you to benefit? Perhaps you should buy the stock of some of the utilities in the affected areas? Perhaps an investment in Detroit Edison (DTE) or First Energy (FE) would make sense? Think again. After it was discovered that four out of five suspect transmission lines that seemed to be at the heart of the crisis belonged to First Energy, the stock sold off hard. Investors worried about the possible liabilities that First Energy might have if it were found that their portion of the system was at fault for the blackout. Under the law, utilities have an obligation to serve, which cuts both ways. They have a ready customer base, but they also can be left holding the bag if a major problem occurs that dramatically affects their customers.

Not only are utilities responsible to the end users of their product, you and I, but they also have to answer to a wide variety of agencies and governmental organizations. If they sell power wholesale to other utilities, their actions are governed by the Federal Energy Regulatory Authority (FERC). If they sell their power to retail customers, then the local public utilities commission (PUC) is the arbiter of their policies. Should a major disaster occur that affects hundreds of generation plants and another country, then the feds will get involved and the utilities will have to cow tow to the Secretary of Energy. Figuring out the dynamics of the political machinations of the various levels of government is just too hard for an investor to do, largely because the politicians do things for political rather than economic reasons. Trying to bet the farm on the direction of a political outcome is just too difficult.

But surely there must be some safer bets? Money is going to be spent and someone is going to benefit, the only question is who? If utilities themselves are too difficult for investors to sort out, then the most likely call is to find a company that manufactures the critical transmission equipment that the grid relies upon. In the same way that fortunes were made by those that sold the picks and shovels for the California gold rush rather than those actually panning for gold, the original equipment manufacturers should be the biggest beneficiaries of all of this new capital investment.

The largest manufacturer of high voltage transmission equipment is ABB Ltd. a Swedish company. Manufacturers of backup generation equipment such as diesel generators should also fare well as this crisis has made it obvious that the contingency plans that most individuals and businesses have in place is woefully inadequate. The largest manufacturer of diesel electric generators in the world is Caterpillar Inc. (CAT). Others have thought that the solution to the problem is to have small generators, or microturbines serving single offices in a distributed generation model. The manufacturers of microturbines all tend to be small and largely unprofitable, but one company that might benefit in the short run is Capstone Turbine Corporation (CPST), a manufacturer of small microturbines. Of course, pure play transmission companies might be an attractive area of opportunity for investors, but the leading company in the industry, Trans-Elect, Inc., which has been gobbling up transmission assets from some of the behemoths in the industry (companies such as Dynegy and TransAlta) is a privately held concern.

With money to spend and political will in their corner, the nation’s electricity grid is in for a much needed facelift. The likely beneficiaries in the short term are the manufacturers of transmission equipment and backup generation equipment. When the political chips have fallen where they may, the utilities with large transmission systems should be the beneficiaries of the increased cash flows in the longer term.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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