Tag Archives: applicationtime

Public Service Enterprise: Facing A Long-Term Decline

Summary Public Service Enterprise is facing many headwinds in the form of an unsustainable business model and an aging infrastructure. The company’s continual infrastructure build out should prove to be counterproductive in the long-run. While societal electricity usage will likely increase dramatically over the next few decades, Public Service Enterprise should still feel downward pressure in the long-term. Public Service Enterprise Group (NYSE: PEG ) is currently one of the nation’s oldest and largest electric utilities. The company dominates the New Jersey electricity landscape, providing millions of individuals with electricity. The company has been one of the top performing electric utilities over the past few years, consistently beating investor expectations on many fronts. Despite all of this, PEG will likely underperform investor expectations moving forward. While PEG may continue to do well in the near-term, the company’s long-term prospects are dimmer. PEG is a diversified electric utility, which means that it incorporates all types of energy sources into its business model. While this business model makes it more competitive against non-diversified electric utilities, the company is still too highly valued at $20.74B . The energy landscape is starting to shift away from a one dominated by centralized generation, and PEG will likely be one of the first companies to feel the effects of this change. Given that PEG’s business model has remained unchanged for countless decades, the company should have a hard time adapting to changing realities. Continual Grid Build-Outs Are A Long-Term Negative PEG makes much of its money by building out grid infrastructure in order to sell more electricity. This only makes sense given that the only way to reach more residences/buildings is to expand its grid system. In fact, PEG expects to spend approximately $1.6B in 2015 on its transmission infrastructure. The company’s transmission investments are expected to continue rising moving forward, which could actually dampen the company’s long-term prospects. Such grid investments incur huge sunk costs, as PEG expects to spend $2.6B in upgrades on its electric/gas distribution and transmission systems. While this would be a great investment under the assumption that centralized methods of generation will remain at similar levels of profitability for the foreseeable future, this is far from certain. Distributed generation methods is becoming more promising by the day, especially with the progress being made in energy storage technologies. As such, these growing grid infrastructure investments could very well end up as billions of dollars in unrecoverable sunk costs. Given the rather slim margins of PEG, these investments would only be recouped if individuals continue buying electricity from the company’s power plants at current rates. With the proliferation of alternative energies, distributed generation has become more viable than ever, and could force PEG to reduce electricity costs in order to remain competitive. This will make it increasingly hard for PEG to recoup investments. Given PEG’s centralized generation model, the company needs to continue expanding and maintaining its infrastructure in order to grow. On the bright side, PEG is implementing many grid efficiency programs, which is actually conducive to distributed generation. The company is planning to spend an additional $95M on increasing energy efficiency over the next three years, although this amount is minimal in the grand scheme of things. Given that distributed generators still requires a grid to function, improving grid efficiency is a win for everyone. Regardless, PEG is still spending enormous amounts of money building out its grid, which may actually end up costing the company in the long-run. Aging Infrastructure With PEG’s aging infrastructures, increasing amounts of investments will be needed just to sustain the company’s current grid. Given that PEG has one of the oldest grid systems in the country, grid maintenance investments will likely ramp up moving forward. Even worse, these grid maintenance costs cannot be avoided, which means that more and more of PEG’s expenditures will go purely towards maintaining its current infrastructure. Such a model of centralized generation reliant on a rapidly decaying grid infrastructure is not sustainable in the long-run, and is one more reason why PEG should increasingly lose revenue to distributed forms of generation. On top of this, many policies restrict PEG from entering into the distributed energy game due to concerns about monopoly power abuse. For instance, regulators rightly fear that utilities will enter the distributed power game for the sole purpose of eliminating the competition to keep the centralized generation model dominant. This scenario is realistic given that such utilities already have countless billions of dollars invested in centralized power plants. The United States has some of the oldest electric grid infrastructures among the developed nations. PEG is no exception in this regard, and is planning to spend billions over the next few years just on upgrading/maintaining its grid. Source: tdworld The Silver Lining Unless PEG finds an alternative business model that is not reliant upon building out an aging infrastructure, the company will find itself in trouble. Unfortunately, the company has no real solution to this problem. In the best case scenario, PEG shifts its business model to become more conducive to distributed generators like rooftop solar by focusing more heavily on grid efficiency. In the worst case scenario, PEG ends up in a utility death spiral as a result of its current business model. The main point is that a business model dependent upon continually building out infrastructure to grow profits is not sustainable in the long-run. The good news for PEG is that the timeline for distributed generations rise is uncertain. While there are many reasons to believe that this model will overtake centralized generation in the future, this could happen much later than expected. Also, the future energy landscape could be a healthy mix between centralized and distributed generation, in which case PEG can still maintain a large portion of its revenues. Not only that, total future electric use could easily grow multifold due to the increasing electrification of the society(i.e. electric transport). The energy used in transportation alone is approximately equivalent to the energy used by households. This essentially means that PEG’s future may not be so pessimistic even if distributed generation starts to play a much larger role in the energy landscape. PEG’s annual revenue( $11.26B for 2014) could grow immensely if electric use were to indeed skyrocket in the long-term. Although PEG may look undervalued in this light, there still seems to be too many headwinds facing the company. With all things considered, PEG will likely still underperform the market over time. Conclusion From a rapidly aging infrastructure to the rise of distributed generation, PEG’s prospects are not looking great. The company has experienced an overall trend of declining profits over the last couple of years, which should only continue moving forward. Although PEG’s net income spiked in 2014 to $1.52B, the company will likely experience declining net incomes moving forward. While PEG’s business model has remained essentially unchanged for countless decades, this will almost certainly change in the future. Even assuming that electricity usage increases significantly over the next few decades, PEG’s P/E ratio of 12 is still much too high given current trends. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

5 Buy-Ranked Financial Mutual Funds

Most of the recently released economic data, including encouraging job numbers, a flurry of positive housing market data and improving consumer sentiment, suggested that the economy is gradually gaining strength. This raised the possibility of a rate hike in the near future. It is speculated that the Fed will raise interest rates by the end of this year. The rate increase will expand margins for brokerage firms, insurance companies, banks, and money managers. Further, the increased interest rates would enable banks to earn more on the spread between interest rates for savings accounts and certificates of deposit. Meanwhile, the financial sector witnessed an encouraging first quarter earnings season. In this favorable environment, investors may find it profitable to invest in financial mutual funds that are poised to benefit from a possible rate hike. Below we will share with you 5 financial mutual funds . Each has earned either a Zacks #1 Rank (Strong Buy) or a Zacks #2 Rank (Buy) as we expect these mutual funds to outperform their peers in the future. Franklin Mutual Financial Services Fund A (MUTF: TFSIX ) seeks capital growth. TFSIX invests a lion’s share of its assets in undervalued companies that are involved in the financial services domain. TFSIX may also invest in merger arbitrage securities and securities of distressed companies. TFSIX may invest a significant portion of its assets in non-US securities. The Franklin Mutual Financial Services Fund A fund returned 15.4% in the last one year. As of March 2015, TFSIX held 88 issues with 3% of its assets invested in American International Group Inc. (NYSE: AIG ) Schwab Financial Services Fund (MUTF: SWFFX ) generally invests in equities of financial services companies. These companies may include asset management firms, brokerage companies, commercial banks, insurance companies and real estate investment trusts (REITs). The Schwab Financial Services Fund returned 12.6% in the last one year. SWFFX has an expense ratio of 0.90% as compared to the category average of 1.52%. Fidelity Select Insurance Portfolio (MUTF: FSPCX ) seeks capital growth over the long run. FSPCX invests a large chunk of its assets in companies that are involved in operations including underwriting, selling, distribution of insurances related to property, casualty, life, or health. FSPCX focuses on acquiring common stocks of companies throughout the globe. FSPCX considers factors including financial strength and economic conditions before investing in securities of a company. The Fidelity Select Insurance Portfolio fund is non-diversified and returned 10.8% in the last one year. Peter Deutsch is the fund manager and has managed FSPCX since 2013. T. Rowe Price Financial Services Fund (MUTF: PRISX ) invests a major portion of its assets in common stocks of companies from the financial services sector. PRISX may also invest in other companies that earn a minimum of half of its revenues from finance sector. PRISX uses bottom-up analysis to invest in companies that are believed to have an impressive growth potential. The T. Rowe Price Financial Services Fund returned 17.5% in the last one year. PRISX has an expense ratio of 0.87% as compared to the category average of 1.52%. Davis Financial Fund A (MUTF: RPFGX ) seeks long-term capital appreciation. The Davis Investment Discipline is utilized to invest a majority of RPFGX’s assets in companies involved in the financial services industry. Companies that have the majority of their assets related to financial services or derive a minimum of half of their revenues from the financial services domain are selected by RPFGX’s advisors for investment. Davis Financial Fund A returned 13.8% in the last one year. Christopher Cullom Davis is the fund manager and has managed RPFGX since 2014. Original Post

REM Offers A Dividend Yield Of 13.23%, But Is It Safe?

Summary Increasing rates on MBS will result in book value losses for the underlying mREITs. Increasing rates on the LIBOR curve will create gains to book value, but the LIBOR rate curve is increasing too much relative to the rates on MBS. Since REM is holding most of the mREIT industry, investors in REM could benefit substantially if interest spreads widened by MBS rates increasing by more than swap rates. One way that could happen for REM would be for the individual mREITs to repurchase their shares at a discount to book value rather than reinvesting in new MBS. A decline in buyers for new MBS would (at least in theory) result in new MBS being issued with higher rates or mREITs paying a smaller premium to face value. The iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) is offering a beastly dividend yield, but the fund is delivering that massive yield through heavy investments in mREITs. Investors that aren’t familiar with mREIT industry need to learn the risk factors that are influencing REM. The biggest risk for investors in REM is that the value of the underlying holdings, the mREITs, could change quite substantially. The ETF holds a reasonably diversified batch of mREITs, though I wouldn’t mind seeing the ETF reduce the weight it puts on Annaly Capital Management (NYSE: NLY ), which is 14.44% of the assets of the ETF. The thing most mREITs have in common is that the RMBS (residential mortgage backed securities) is the primary investment tool. Some of them use other derivative investments, but the main exposure is the RMBS. Some mREITs are using larger positions on ARMS (adjustable rate mortgages), some focus on the 15-year RMBS or the 30-year RMBS, and some go into smaller segments of the market such as lending on jumbo mortgages or non-agency securities. When we boil it down, everything comes back to the rates on MBS and the spreads between short-term rates and long-term rates. Mortgage rates I grabbed the following chart to look for the latest rates across MBS: For 15-year and 30-year securities Interest rates have increased significantly since the end of the first quarter, but they ended the first quarter down from the start of the year. For ARMs The interest rate on new ARMs decreased during the first quarter and has been relatively flat during the second quarter. You might wonder why ARMs have seen interest rates getting soft while they are increasing on other securities. The simple reason is that mREITs are finding adjustable rate mortgages to be more attractive due to expected increases in the interest rates offered by the Federal Reserve. If the Federal Reserve is going to increase interest rates, then mREITs holding adjustable rate mortgages would theoretically be preferable in the short term since the rates they receive will increase. Share price declines Despite the mREIT sector taking a pretty bad beating on share price over the last year, investors in REM are actually flat on their investment because the dividends covered the decline in price. (click to enlarge) When investors hear the dividends are just covering the decline in share price, it may sound like a return of capital. That isn’t the case though. The underlying securities for the ETF are the shares in mREITs and many mREITs are trading at substantial discounts to their own book value. If investors could picture REM as an enormous mREIT with incredibly diversified holdings of the securities that the mREITs are holding, then REM would be trading at a substantial discount to book value. Since REM’s NAV is established by the share price of the mREITs, investors don’t see the huge discount when looking at REM. The mREITs hedge their exposure to rising interest rates through swaps, swaptions, and Eurodollar Futures. The chart below uses the latest publicly available data to establish the interest rates in the LIBOR market: (click to enlarge) The increasing LIBOR rates indicate that most mREITs will have substantial unrealized gains on their interest rate swaps. The gains on swaps should partially offset the losses they will report on MBS. The favorable development for mREITs is that the yield curve is becoming substantially steeper. The one-year rate has increased by about 11 basis points, but the rate on other years is increasing substantially more. An increase of 11 basis points is small relative to the increase in the rates on 15-year and 30-year MBS. On the other hand, the increase in interest rates during the quarter on maturities around 5 years is substantially less attractive. While the mREITs will see substantial gains on their interest rate swaps during the second quarter, initiating new swap positions will require paying these higher rates which in some cases are increasing by closer to 60 basis points. In my opinion, this is one of the biggest challenges to REM. A large portion of the holdings are mREITs that need positions in swaps with durations of 3 to 10 years and the interest rate due on those swaps has increased by more than the yield on MBS securities. Three possible favorable developments for REM REM would have enormous upside if three things happened. The first is that long-term MBS rates inch upwards and the second is that LIBOR rate increases for the first five years of the curve become substantially smaller. The gains on interest rate swaps are nice, but over the next few years, mREITs don’t want to find themselves paying higher rates on new swaps. The third option would be a way to cause the first two things to happen. If the mREIT industry saw substantially more repurchasing shares and less issuing shares, there would be a net outflow of money from the mREIT industry. That would be very beneficial to investors holding the entire industry, because the mREITs would have less capital available to bid for new MBS. A decrease in mREITs bidding on new MBS would mean less competition in that part of the market. Either MBS would be acquired at lower premium to face value or the originators of MBS would increase the interest rates they were charging borrowers to make the MBS more attractive to mREITs to encourage them to a pay a large premium to face value. Either paying a smaller premium to face value or having higher interest rates on the MBS would be extremely favorable developments for mREITs even though it would result in a loss on book value. The loss of book value would be material, but the increase in net interest margins would make dividends substantially more sustainable and encourage investors to buy the underlying mREITs to receive dividend yields that were both large and sustainable. In that case, an investor in REM would expect to see increases in share prices and in dividends. On the other hand, if LIBOR rates rise across the curve and MBS rates increase by less than the LIBOR rates, then the cost of financing for mREITs may increase by more than their yield on assets. Conclusion I’m bullish on the mREIT industry and expect positive returns to shareholders of REM over the next few years. I can’t provide an endorsement of the ETF because I believe the expense ratio is too high. There are a few competing ETF options, but none of them meet my threshold for attractive expense ratios and all of them have at least somewhat unfavorable weightings for the different mREITs in the ETF. Despite those concerns, it may be a good fit for the investor that wants exposure to the mREIT industry, but does not have a large enough portfolio to buy several positions in individual mREITs for diversification. For investors interested in my personal favorites, I like CYS Investments (NYSE: CYS ) and Dynex Capital (NYSE: DX ). I believe at the current discount to book value, American Capital Agency Corp. (NASDAQ: AGNC ) is also very attractive. I find Bimini Capital Management ( OTCQB:BMNM ) to be the most undervalued company in the space, but it is highly illiquid, and I like it for the external manager fees it receives rather than the composition of the portfolio. Disclosure: I am/we are long DX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.