Nukes in Distress: How CMS Energy Became a Bargain

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

Utility stocks were the great growth stocks of the 1950s. By the time Lynch wrote this book, they’d become income plays. You bought them for the dividend, not the excitement. But Lynch made his best utility gains not from the steady ones. He made them from the troubled ones.

At Fidelity, Lynch and his colleagues made bundles on General Public Utilities after Three Mile Island. They made money on Public Service of New Hampshire bonds. On Long Island Lighting. On Gulf States Utilities. On Middle South Utilities, which changed its name to Entergy. And that name change, by the way, led Lynch to one of his favorite principles: corporations change their names for one of two reasons. Either they got married, or they’ve been involved in some disaster they hope the public will forget.

Why Troubled Utilities Are Different

Here’s what makes a troubled utility different from a troubled company in some other industry. Utilities are regulated by the government. A utility might cut its dividend. It might even declare bankruptcy. But as long as people need electricity, the government has to find a way to keep it running.

The state government sets the prices a utility can charge. It decides how much profit the utility is allowed to make. And it determines whether the costs of mistakes can be passed along to customers. Since the government needs the utility to survive, the odds are overwhelming that a troubled utility will eventually get the help it needs.

That safety net doesn’t exist for troubled retailers or airlines or tech companies. That’s why Lynch’s record with distressed utilities was better than his record with distressed companies in general.

The Four Stages of a Troubled Utility

Analysts at NatWest Investment Banking identified a pattern that repeats every time a utility gets into serious trouble. Lynch found it compelling.

Stage one: disaster strikes. A huge cost can’t be passed to customers, or a nuclear plant gets shut down and removed from the rate base. The stock loses 40 to 80 percent of its value. Consolidated Edison dropped from $6 to $1.50 in 1974. General Public Utilities fell from $9 to $3.88 after Three Mile Island.

Stage two: crisis management. The utility cuts spending and goes on an austerity budget. The dividend is reduced or eliminated. Survival starts to look possible, but the stock price doesn’t reflect it yet.

Stage three: financial stabilization. The utility can operate on the cash it receives from customers. It’s still not earning anything for shareholders, but it’s no longer in danger of going under. The stock has recovered to around 60 to 70 percent of book value. Early buyers have doubled their money.

Stage four: recovery. The utility starts earning money for shareholders again. Wall Street expects improved earnings. The dividend gets reinstated. The shares rise to book value and beyond.

The key insight: you didn’t have to rush in during stage one to make great returns. You could wait until stage two or three, after the worst fear had passed, and still double, triple, or quadruple your money.

Lynch boils it down to a simple strategy. Buy when the dividend is cut. Hold until the dividend is restored. That approach had a terrific success rate.

CMS Energy: From Nuclear Disaster to Bargain

CMS Energy used to be called Consumers Power of Michigan. It changed its name after the nuclear plant mess, hoping shareholders would forget.

The stock had been cruising in the $20s. Then it built the Midland nuclear plant. State regulators approved the project throughout its development. Then, at the last minute, they refused to let it operate. Lucy pulling the football away from Charlie Brown.

CMS was forced to write off $4 billion. The stock plunged to $4.50. Wall Street thought bankruptcy was right around the corner.

But CMS didn’t go bankrupt. Instead, it converted the useless nuclear plant to natural gas. The conversion, done with help from Dow Chemical, was expensive but far better than writing off the entire $4 billion. The converted plant opened in March 1990. It actually came in under budget. And it worked.

The stock climbed all the way back to $36. A ninefold gain in five years. But then the Michigan Public Service Commission handed down three unfavorable rate decisions in a row. The stock dropped back to $17.

That’s where Lynch found it.

Why Lynch Bought at $17

Lynch spoke to CMS’s new president, Victor Fryling, on January 6, 1992. Two things stood out.

First, the converted Midland plant was producing electricity at 6 cents per kilowatt. A new coal plant costs 9.2 cents. A nuclear plant costs 13.3 cents. CMS had become a low-cost producer.

Second, electricity demand in Michigan was growing. It had grown 12 years in a row, even during the 1991 recession. On peak days, CMS had only 19.6 percent extra capacity in reserve, a very thin margin. Few new plants were being built in the Midwest, and it takes 6 to 12 years to build one from scratch. Growing demand plus limited supply equals higher prices. That’s basic economics.

The balance sheet still had heavy debt from the nuclear mess, including $1 billion in bonds to finance the gas conversion. But CMS had enough cash flow to cover its interest payments. Most of its equipment was new, so it didn’t need to spend much on repairs. That freed up cash to expand capacity, buy back stock, or increase the dividend.

The wildcard was the Michigan regulators. Three bad decisions in a row had spooked investors. But there was reason to believe a recent appointee to the commission would be more accommodating. The commission’s own staff had produced a study favoring certain concessions to CMS.

If CMS got a reasonable ruling, it could earn $2 a share, well above the $1.30 Wall Street expected. If it didn’t, it could still earn about $1.50. Either way, the company would prosper over time. Its cash flow would let it grow the business internally regardless of what the regulators decided.

With the stock at $18 and trading below book value, Lynch saw a lot of upside without much downside. And the company had an oil discovery in Ecuador with Conoco that could add 20 cents a share to earnings by 1995.

The Lesson from Distressed Utilities

The pattern is clear. Wall Street overreacts to bad news in utilities. The stock crashes. Everyone assumes the worst. But the government has too much at stake to let a major utility fail. The recovery takes time, sometimes years. But patient investors who buy during the fear and hold through the recovery get paid handsomely.

You don’t need to catch the bottom. You just need to recognize when the worst is over and the recovery is underway. That’s where the real money is made.

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