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Lack Of Earnings Quality And Debt Downgrades Limit S&P 500’s Upside

Four in a row. That’s how many consecutive 3-point baskets Andre Iguodala scored against the Houston Rockets in last night’s playoff game. There has also been a “4 for 4″ in the financial markets. One after another, major banks have lowered their year-end targets for the S&P 500. Most recently, the global equity team at HSBC shaved its year-end target to 2,050 from 2,100. On the surface, HSBC’s cut is less severe than other bank revisions to S&P 500 estimates. That said, J.P Morgan pulled its projection all the way down from 2200 to 2000. Credit Suisse? Down to 2,050 from 2,200. And Morgan Stanley slashed its year-end projection from 2175 to 2050. So what’s going on? We had four influential banks expressing confidence in the popular benchmark a few months earlier. Their analysts originally projected total returns with reinvested dividends between 5%-10% in the present 12-month period. Now, however, with the S&P 500 only expected to finish between 2000-2050, these banks see the index offering a paltry 0%-2%. Another way some have phrased it? Excluding dividends, there is “zero upside.” Here is yet another “4 for 4” that makes a number of analysts uncomfortable. Year-over-year quarterly earnings have fallen four consecutive times. That has not happened since the Great Recession. And revenue? Corporations have put forward year-over-year declines in sales growth for five consecutive quarters. That hasn’t happened since the Great Recession either. The bullish investor case is that the trend is going to start reversing itself in the 2nd half of 2016. However, forward estimates of earnings growth and revenue growth are routinely lowered so that two-thirds or more companies can surpass “expectations.” And it is not unusual for estimates to be lowered by 10%. Take Q1. Shortly before the start of the year, Q1 estimates had been forecast to come in at a mild gain. Today? We’re looking at -9% or worse for Q1. Over the previous five years, Forward P/Es averaged 14.5. They now average 16.5 on earning estimates that will never be realized. In essence, S&P 500 stock prices are sitting a softball’s throw away from an all-time record (2130), while the forward P/E valuations sit at bull market extremes that do not justify additional appreciation in price. And what about earnings quality? Wall Street typically presents two kinds: Generally Accepted Accounting Principles (GAAP) earnings and non-GAAP earnings that excludes special items, non-recurring expenses and a wide variety on “one-time charges.” The foolishness of non-GAAP presentations notwithstanding, one might disregard the manipulation when non-GAAP and GAAP are within the usual 10% range. This was more or less the case between 2009 and 2013. By 2014, however, the gap between the two different earnings per share reports began to widen. By 2015, “manipulated” pro forma ex-items earnings exceeded actual earnings per share by roughly $250 billion, or 32%. Can you spell c-h-i-c-a-n-e-r-y? Of particular interest, there was a similar disconnect between GAAP and non-GAAP in 2007. Non-GAAP in the year when the last bear market began (10/07) was 24% higher than GAAP earnings per share. It follows that the discrepancy today in earnings quality is even wider than it was prior to the stock market collapse. “But Gary,” you protest. “As long as the Federal Reserve and central banks are exceptionally accommodating, stocks should excel.” In truth, however, the long-term relationship between the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the Vanguard Total Bond Market ETF (NYSEARCA: BND ) demonstrate that the bond component of one’s portfolio has been more productive over the last 12 months than the stock component. Bulls can point to the market’s eventual ability to shake off the euro-zone crisis of 2011. That was the last time that the SPY:BND price ratio struggled for an extended length of time. Back then, however, the Federal Reserve offered two aggressive easing policies – “Operation Twist” and “QE 3.” Today? Stocks are not only extremely overvalued on most historical measures, but the Fed has only lowered its tightening guidance from four hikes down to two hikes. Is that really enough ammunition to power stocks to remarkable new heights? “Okay,” you acknowledge. “But rates are so low, they are even lower than they were in 2013. And that means, going forward, there is no alternative to stocks.” Not only does history dispel the myth that there are no alternatives to stocks , but many corporations that have been buying back their stocks at attractive borrowing costs are now at risk of debt downgrades, higher interest expenses and even default. For example, the moving 12-month sum of Moody’s debt downgrades hopped from 32 a year ago to 61 in March of 2016. Meanwhile, the longer-term trend for the widening of credit spreads between investment grade treasuries in the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) and high yield bonds in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) suggest that the corporate debt binge may soon come to an ignominious end. Foreign stocks, emerging market stocks as well as high yield bonds all hit their cyclical tops in mid-2014, when the credit spreads were remarkably narrow. The IEF:HYG price ratio spikes and breakdowns notwithstanding, the general trend for 18-plus months has been less favorable to lower-rated corporate borrowers. The implication? With corporate credit conditions worsening at the fastest pace since the financial crisis , companies may be forced to slow or abandon stock share buybacks. What group of buyers will pick up the slack when valuation extremes meet fewer stock buybacks? Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

TransCanada – It’s Not The End Of The World, Rather A Buying Opportunity

The president has finally rejected TransCanada’s Keystone XL pipeline. The decision seems more political than economical, but it is bad for TransCanada which has already spent $2.4 billion on the project. Although the market has been focusing on the future of Keystone XL, TransCanada has other projects in its pipeline that could fuel its growth in the coming years. Energy East could be the biggest growth driver in the long term, but the management has laid emphasis on a number of small projects. Earlier this month, the Obama administration finally rejected TransCanada Corp. (NYSE: TRP )’s Keystone XL pipeline on the grounds that the project was not in U.S. national interest and could reflect poorly on the country’s global leadership in protecting the environment. The decision, which was widely anticipated, finally concludes TransCanada’s seven-year efforts in getting an approval for the 830,000 barrels a day pipeline from the current administration. The decision seems more political than economical. It is difficult to imagine how a 1,179-mile pipeline spread over six states which would have mostly carried crude from Canada’s oil sands, but also up to 100,000 barrels a day of North Dakota oil, to Gulf Coast refineries would not lead towards meaningful economic benefits for the U.S. and Canada. Besides, the State Department’s environmental review , released in Jan. 2014, had already stated that the construction of the pipeline will not have any substantial negative impact on the climate. On the contrary, the rejection could increase the Canadian oil sands producers’ reliance on rail for delivering the crude to the U.S., which is far more carbon-intensive than the pipeline. Nonetheless, the decision is bad for TransCanada which has already spent C$2.4 billion on the project. A significant chunk of the expenditure could be written off as non-cash pretax charges in the coming quarters. The investment which related to the physical pipeline and equipment, however, can be utilized on other projects. As I have discussed previously , TransCanada has several options on its table following the rejection. The company can seek remedies under the energy chapter of the North American Free Trade Agreement, construct a rail loop that would connect U.S. and Canadian pipelines, or simply wait until a new U.S. president arrives in 2017 and then file another application. However, it is also important to note that the rejection is not the end of the world for TransCanada. Although the company’s stock declined 5.2% on the day of the rejection and has failed to completely recover completely since, I believe this could be an interesting buying opportunity. Although Mr. Market has been largely focusing on the future of Keystone XL, TransCanada has several other projects in its pipeline that could fuel earnings and cash flow growth in the coming years. This includes the giant Energy East pipeline which is bigger than Keystone XL in terms of investment, capacity and impact on the bottom line. Energy East, which comes with a price tag of more than C$12 billion as opposed to Keystone XL’s C$8 billion, will be able to ship up to 1.1 million barrels of crude per day from Alberta to Eastern Canada. Once Energy East becomes fully operational by 2020, it can lift TransCanada’s annual earnings (EBITDA) by C$1.8 billion. Keystone XL, on the other hand, was supposed to generate annual earnings of C$1 billion. Overall, excluding Energy East and Keystone XL, TransCanada has a backlog of C$15 billion of commercially secured major projects that can lift its annual earnings by more than C$1 billion in the long-term, according to my rough estimate. Energy East pipeline What’s even more interesting is that during the recently held investor day (Nov. 17), TransCanada emphasized that in addition to the major projects, it also has a C$13 billion backlog of eleven smaller projects, none of which require investment of more than C$1.4 billion, which will drive its growth over the next two years. Some of these projects, such as the Houston lateral and terminal, Topolobampo, Mazatlan and Canadian Mainline, will begin to contribute to earnings in 2016 while some of the bigger ones with capital cost of at least C$1 billion each, such as the liquids pipelines Grand Rapids and Northern Courier, will fuel earnings growth beyond 2016. Overall, the small and large projects are forecasted to drive 8% to 14% increase in annual earnings through the end of the decade. This will lead towards an average of 8% to 10% increase in dividends in each year through 2020. That’s higher than the CAGR of around 7% witnessed over the last fifteen years. Thanks to the recent drop following Keystone XL’s rejection, the stock is already offering an attractive yield of around 5%, which is higher than the industry’s average of 3.2%, according to data from Thomson Reuters. I believe the recent weakness could be an opportunity to buy this pipeline stock and earn strong returns in the long-run.

CenterPoint Energy: Utility Assets In A Petri Dish

CenterPoint combines electric utility, natural gas utility, and midstream assets. Weakness in natural gas prices and a potential slowdown in Houston’s economy is creating anxiety among investors, and anxiety is the Petri dish of investor opportunity. The current yield of 5.3% makes patience waiting for a turn in CenterPoint’s markets an acceptable investment strategy. CenterPoint Energy (NYSE: CNP ) is an interesting electric and gas utility servicing Houston and Minneapolis as its two biggest markets. Within the overall consolidation trend in the utility sector, combined with the current appetite electric utilities have for gas utility and infrastructure exposure, CNP could become an interesting acquisition. According to its most recent investor presentation , CenterPoint is three regulated companies in one. In 2013, CNP spun-off and currently owns 55% of MLP Enable Midstream (NYSE: ENBL ). CNP is majority owner of the general partner and income from the Midstream Investments segment comprised 25% of 2014 operating income. Electric transmission and distribution segment services the electric needs of the greater Houston area, and accounted for 48% of 2014 operating income. Houston Electric owns no generating facilities and is regulated by the Texas Railroad Commission, the state regulatory body. Natural gas distribution in Texas and surrounding states combined with greater Minneapolis territory accounted for 23% of 2014 operating income. Other Energy Services chipped in 2%. CNP reports quarterly results as Midstream Investments and Utilities. CenterPoint’s service territory is outlined below: (click to enlarge) CenterPoint’s Midstream Investments performance has increased the share price and income volatility. In step with the current downdraft in the energy sector, income attributed to Midstream Investments has fallen significantly. In 2014, Midstream Investments generated $308 of reported equity income. For the second quarter 2015, Midstream Investments generated $43 million of reported equity income, substantially below last year’s $74 million. However, with the most recent quarterly distribution of $73 million, this segment’s cash flow has remained about the same. As with many MLPs, Midstream Investments fortune is tied to natural gas markets, and the midstream segment should improve with higher demand and prices. According to the latest presentation and factoring in its ownership interest, Midstream Investments equity income will move $13 million, or $0.04 a share for every 10% move in natural gas, ethane, and NGL prices. Management has offered guidance of Midstream Investments distribution income growth in the 3% – 7% range over the next two years, based on $3.15-$3.65 Henry Hub and $60-$70 WTI pricing by 2017. The Utility segment offers a balance to the volatility of Midstream Investments, but is not without its own concerns. Houston Electric generated 48% of 2014 income, or $595 million. Some fear a slowdown in the Houston metro area caused by a deepening despair in the oil segment will reduce electricity demand. While management points out that its economic base is more diverse than during the last downturn in the oil sector, a flattening of demand during these stressful times should not be unexpected. Underlying residential customer count growth has been around 2% compounded over the past 25 years, which is high for an electric utility. Houston Electric services 2.3 million customers and has a $4.1 billion rate base. CNP spends around $820 million a year on its electric capital expenditure budget, of which 37% is in transmission and 59% in distribution. Houston Electric’s current allowed return on equity is 10.0%, in line with the industry. The company has been granted a $13 million rate increase as of September with an additional $20 million pending decision. Regulated natural gas utility assets generated 26% of reported operating 2014 income, or $288 million. CNP services 3.3 million natural gas customers in five states, has a rate base of $2.2 billion and a capital expenditure budget of around $525 million. The average allowed return for the natural gas business is 10.3%. Last August, CNP requested $53 million in rate relief from its Minneapolis customers. Morningstar’s analysis recaps the positive and negative investment thesis for CNP: “Bulls Say: Strong utility earnings growth and solid cash distributions from Enable should allow approximately 4% annual dividend growth during the next five years. The formation of Enable will allow CenterPoint to focus capital expenditures on its utilities, resulting in an estimated 9% rate base growth during the next five years. Houston Electric’s service territory is located in one of the most economically vibrant metro areas in the country with annual customer growth averaging 2%, driving strong energy usage growth.” “Bears Say: The Transmission and Distribution segment’s operating earnings have recently benefited from abnormally high transmission right-of-way revenues. These revenues likely peaked in 2013 and likely will drop sharply over the next several years. Profitability in the competitive natural gas sales and service business remains challenging, with low basis differentials and severe competition. Low commodity prices and reduced gathering activity continue to pressure earnings from the pipelines and field services infrastructure serving dry gas regions. This will be a headwind for Enable.” Earnings per share have been under pressure from weakness in the Midstream Investments segment. Last year, CNP earned $1.20 a share, but current guidance is for $1.00 to $1.10 in 2015. The Utility segment is expected to contribute $0.71 to $0.75 a share with the balance $0.25 to $0.35 from Midstream Investments. These compare to 2014 adjusted earnings of $0.77 and $0.44, respectively. Based on a turn in its midstream business, management forecasts annual EPS and dividend growth at 4% to 6%, in line with other regulated utilities. Investors should take the time to review CNP’s free cash flow numbers. Over the past three years, CNP has generated higher operating cash flow than its capital expenditure budgets, accumulating $1.585 billion in free cash flow from 2011 to 2014, and $328 million for the trailing 12 months as of June 2015. CNP has produced positive free cash flow in five out of the previous 10 years. There are few utilities consistently generating positive free cash flow. Return on invested capital (ROIC) has historically been higher than utility industry averages at between 6.3% and 8.5% over the previous 10 years. The current weakness of its Midstream Investment business and the cautiousness investors are taking to the company is evident in the current valuation matrix. Based on previous 5-year averages, CNP offers value investors a reason to take notice. Below is a table of current valuation ratios, 5-year averages of the same, and an equivalent share price based on these averages: Ratio Current 5-year Avg Equivalent Price Price/Earnings 15.2 20.2 $ 24.58 Price/Book 1.8 2.2 $ 22.61 Price/Cash Flow 4.4 5.7 $ 23.96 Dividend Yield 5.3% 4.1% $ 24.39 Source: Morningstar.com, Guiding Mast Investments According to Morningstar, the current sum-of-the-parts valuation is in the $23 range. Estimates by segment would be $7 a share for Midstream Investments, $10 for Houston Electric and $6 for the natural gas distribution business. With a current price of $18.50, the spread is around $5, or 27%. Analysts are all over the board with their recommendation. According to finviz.com, the most recent analysis from Morningstar is 4 Stars, S&P Capital IQ is 2 Stars, Goldman reduced CNP to Sell, Credit Suisse recently upgraded CNP to Neutral from Underperform, Deutsche Bank is at Hold, Argus is at Buy, RBC Capital Markets lists CNP at Outperform, and Barclays’s is at Equal weight. Investors can take their pick: Buy, Hold, or Sell. CenterPoint’s diversified asset base could be of interest to larger utilities. The recent trend of electric utilities expanding by adding natural gas regulated utilities and by purchasing natural gas infrastructure to support expanding natural gas power generating facilities may favor CNP’s business profile. Midstream Investments focus has a strong Anadarko basin footprint covering a number of key active plays, including the SCOOP, STACK, Cana Woodford, Cleveland Sands, Tonkawa, Marmaton and Mississippi Lime plays. Other important midstream fields include Haynesville, Ark-La-Tex and Arkoma, and the Bakken. Electric utilities looking for long-term natural gas supply from these mid-continent areas could be interested in securing the infrastructure, hence CNP’s ownership of midstream assets could be of interest, along with CNP’s regulated natural gas customers. While there are no rumors of pending interest, the current consolidation trend is very powerful in the utility segment and at an enterprise value of $9.6 billion in equity ($23 times 425 million shares) and assumption of $8.6 billion in debt, a deal could be very financeable. With a current dividend yield of 5.3%, long-term utility and income investors are being paid to wait for a turn in the midstream business or for CNP to be active in the utility consolidation trend. CNP is a good example of stock valuations where investor anxiety is offering a Petri dish of opportunities. If CenterPoint is not on your radar screen to buy on further dips, it should be. Author’s Note: Please review disclosure in Author’s profile.