deregulation increases cash flow, profitability

Howard Gorman, R.J. Rudden

One of the major hot issues of the last few years has been “Is deregulation working?” Deregulation of the electric utility industry marked a fork in the road for many companies, and in most of the states where it has been implemented, is far enough along to consider the question.

To do so, FERC Form 1 and other sources were analyzed for trends in electric utility profitability and cash flow for years 1990-2003. After eliminating holding companies (which duplicated the data for the operating utilities), and California utilities and other outliers (which would have skewed the results), approximately 65 companies in “deregulation active” states and 70 companies in “deregulation not active” states (including “deregulation delayed”) were in the database. State classifications were taken from the EIA website.

effects are evident

To analyze the effects of deregulation, two ratios were compared for differences between companies in active and not active states. The ratios were electric net income/electric operating revenue, an indicator of profitability; and cash from operations/cap ex plus dividends, an indicator of a company’s ability to finance itself. Revenue excludes purchased power and other power supply. The results are shown in the two following charts.

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For each ratio, companies in active states (solid lines) had greater improvement during the period 1990-2003 than companies in not active states (dashes). The charts show that the gaps have widened since about 1999.

Electric net income/electric operating revenue (bottom left chart) in 1990 was approximately 21 percent for companies in both active states and not active states. In 2003, companies in active states (solid lines) remained at the 1990 level of 21 percent, but companies in not active states (dashes) declined to 17.5 percent. Annual changes were in the same direction for both groups, but companies in active states had more pronounced ups and downs.

Cash from operations/cap ex plus dividends (above chart) in 1990 was 88.1 percent for active and 91.8 percent for not active. In 2003, companies in active states (solid lines) increased to 107 percent, or 18.9 percentage points, while companies in not active states (dashes) increased to 92.8 percent, or just one percentage point. Once again, annual changes were usually in the same direction, with the active group showing much larger annual changes in the last few years.

To assess whether the changes in were comparable across individual companies, the annual standard deviation among the companies in each group was calculated for each ratio. The results are shown in the two following charts.

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The charts show very noticeable increases in the annual dispersion of results for both ratios. For the ratio electric net income/electric operating revenue (top right chart) the increase in dispersion was similar for companies in active states (solid lines) and not active states (dashes). But, for cash from operations/cap ex plus dividends (above chart), there was much wider dispersion among companies in active states (solid lines) than companies in not active states (dashes) for most years.

active deregulation means active management

To gain insight into possible explanations for the results, two things that companies can largely control were examined: capital structure, measured by the ratio of debt/total capital and capital expenditures, measured by the ratio of cap ex/depreciation expense. The results are shown in the next two charts.

Debt/total capital (chart on previous page) of companies in not active (dashes) states was pretty much the same in 1990 as in 2003, at approximately 49 percent, and the ratio stayed within a narrow band. But debt/total capital of companies in active states (solid line) increased significantly, from 51.9 percent in 1990 to 55.5 percent in 2003, with a clear upward trend since 1996.

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Capital expenditures/depreciation expense (above chart) in 1990 was 167 percent for companies in both active and not active states. For companies in not active states (dashes), this ratio was higher in 2003 than in 1990, with increases and decreases during the period, and a 14-year average of 163 percent. The ratio for companies in active states (solid line) was higher than 1990 only in 2002 and 2003, and averaged just 150 percent in the 14 year period. In fact, for most of the period companies in active states had a lower percentage than in 1990.

observations

Using the simple indicators of profitability and cash flow identified above, companies in active states improved relative to those in not active states from 1990 to 2003. These improvements were associated with more active management, including changes in capital structure and capital expenditures. Perhaps these changes have been beneficial, spurring complacent companies to optimize their capital structures and rationalize capital expenditures. Or perhaps the changes have been harmful, driven only by the need to produce financial results in a more challenging regulatory environment. However, it seems clear that active deregulation affects the way companies are managed.

In addition, companies in states with active deregulation have become less homogenous. To paraphrase Yogi Berra, “They came to a fork in the road and they took it.” Decreasing homogeneity makes it much harder to construct peer groups for regulatory purposes and for financial analysis. Therefore, it is ever more important to understand each company’s situation, including the unique risks it faces and management’s strategy for dealing with them.

The increasingly heterogeneous nature of electric utilities is of course at least partly due to the fact that the process of deregulation has differed from state to state. But, it also reflects that once deregulated, companies have the opportunity to react to the marketplace rather than to a regulatory environment. This makes it critical for managements to create and implement strategies that are appropriate to the companies’ unique strengths, weaknesses and opportunities.

Deregulation has exposed companies to the marketplace, and has created opportunities for them to adapt and to innovate, and in this regard it must be called a success.

Gorman is a vice president with R. J. Rudden Associates, Inc. specializing in energy financing and analysis, economic and financial planning, accounting and cost of service. He can be contacted at hgorman@rjrudden.com or 631-348-4090 or 516-829-6855.

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