Power generators need suppliers to survive and prosper

Scott Budoff and Tobey Winters, Saw Mill Capital LLC

What once was considered a “sleepy” industry that offered secure investments to conservative investors is now viewed as a high-risk bet on the future of the U.S. power market. The aftershocks of deregulation, the Enron debacle, the California meltdown, the sluggish economy, 9/11 and the collapse of the merchant development boom are fundamentally transforming U.S. power generators and the supply chain that supports them.

In the past, access to “cheap” capital drove largely unsuccessful investments by utilities and independent power producers (IPPs) in geographic expansion, power trading operations, merchant power projects, and non-core businesses. Now, with $90 billion of debt coming due for repayment over the next four years, profits diminished and financial risk elevated, capital has become difficult and costly to raise. Power generators and energy merchants have responded to difficult capital markets and declining profits by restructuring their balance sheets and focusing on improving cash flow. To do this, they are exiting volatile merchant generation and trading operations, selling non-core businesses, reducing capital spending and downsizing existing core operations. So draconian have the cuts been, that even the operations and maintenance budgets for core generation operations have been drastically cut, opting to defer prudent expenses today in exchange for the risk of lower reliability and higher O&M expenses in the future.

While the troubles of utilities, IPPs, energy merchants and large OEMs have been widely publicized by the media, another story has gone untold. As this $1.1 trillion industry continues to restructure, the suppliers of equipment, services and technology to the power industry have been buffeted by one of the most unpredictable and volatile business cycles experienced in U.S. history.

Ultimately, power generators’ cash flow will increase, debt will be paid down or restructured and those companies with strong balance sheets will survive, while those with flawed business models and weak balance sheets will be sold off to the highest bidder. Financial restructuring, however, is not the only requirement for success. We believe that a strategic realignment between power generators and their supply chain is critical to the long-term success and profitability of the power industry. Fortunately, early signs indicate that just such a strategic realignment has begun.

If it doesn’t kill you, will it make you stronger?

As a private equity firm that invests exclusively in power industry suppliers, we have witnessed first hand the impact of the most recent business cycle and the dramatic changes in market conditions that have impacted power industry suppliers over the last five years.

Many suppliers to the power industry have been whipsawed by the market’s wild ride. In the late 1990s, suppliers were required to meet increasing demands by power companies investing capital in new plants and environmental control systems at an unprecedented pace, while these same customers were downsizing and outsourcing many O&M functions. When the party was over, the trend reversed itself very quickly and suppliers were left with excess capacity and diminished market opportunities.

Most of these issues have gone unnoticed by utilities. They generally do not pay much attention to the consequences of their actions on the suppliers who build and maintain their assets. The assumption has always been “the supplier will always be there” and “they can take care of themselves.”

How difficult has it been for power industry suppliers? First, there is the list of suppliers that have declared bankruptcy: Babcock Borsig, Babcock & Wilcox, The Washington Group, and Stone & Webster. Additionally, there are companies like ABB and Foster Wheeler that are reported to be narrowly avoiding bankruptcy by substantially restructuring their operations.

As a result of financial troubles, weakened suppliers find it difficult to finance operations, retain experienced workers and secure bonding. This in turn leads to diminished capabilities, shrinking backlog and underutilization of manufacturing and engineering capacity. Struggling for survival, suppliers in financial distress are forced to “buy” projects by bidding for them on an incremental contribution basis to increase overhead “absorption,” instead of at pricing levels that can sustain profitable operations.

This may be good for generating companies in the short run, as it provides for lower prices and better terms and conditions as weakened suppliers are forced to take unprofitable projects to survive. Financially weak suppliers, however, significantly increase project risk. As many have learned the hard way, “cheap” may actually be “expensive.”

But all is not doom and gloom for power industry suppliers

Fortunately, all suppliers are clearly not equal when capabilities are compared and a thorough risk assessment is conducted. Smart companies recognize that by selecting suppliers based on cost alone, they are significantly discounting important factors that may dramatically increase overall project risk.

For example, an experienced supplier has knowledge of the customer and its organization, as well as a historical perspective on the assets being supported. This generally reduces project risk for the supplier and the customer and increases the opportunity for a knowledgeable supplier to find ways to add unanticipated value to the project. Conversely, by simply selecting a supplier based on cost, little strategic value is created and project risk is increased, as new suppliers are required to move up the learning curve to understand the customer’s organization and assets.

Today, most suppliers are more than willing to develop and/or customize their products and services for large customers, if justified by the profit potential of the relationship. The traditional auction approach (or the modern e-auction approach) to procurement is appropriate for the purchasing of commodities, but should not be applied to suppliers of highly engineered, value added products and services. Instead, smart customers are starting to identify key suppliers and require that they compete for long-term strategic alliances on the basis of “value creation” instead of “lowest cost of procurement.”

This approach not only increases customer profitability, but generating companies that proactively work with key suppliers to encourage new products and services are strategically positioned to benefit from their suppliers’ knowledge with minimal cost and risk. Interestingly, to some extent this strategy has been adopted on the nuclear side of the business. Because risk management is pervasive in the nuclear plant culture, there is more willingness to recognize the strategic value offered by their “trusted” suppliers.

A strategic reassessment is underway

Historically, utilities have been shaped by public policies dictated by regulation, as opposed to by market forces. Fortunately, smart generating companies have started to recognize the importance of the health and stability of their supply chain as a critical strategic requirement to increased profitability, cash flow and return on capital.

Making key suppliers part of the value creation team (as opposed to an adversary in the procurement process) can significantly improve profitability and cash flow. Strategic suppliers are uniquely positioned to identify opportunities to improve asset utilization and efficiency, extend the time between scheduled outages and reduce emissions by focusing their products and services on new customized solutions targeting specific goals set out by plant management. In fact, in many instances, suppliers are willing to survey plant operations to develop and prioritize value added projects in partnership with plant management as opposed to waiting for time-pressed plant personnel to identify opportunities.

In terms of potential for value add to the power industry, we believe that certain key suppliers to the power industry are (and will continue to be) the engines of productivity enhancement and profitability growth over the next decade. There are many companies in the power market today with better products and proven technologies, but these companies lack capital or have difficulty finding customers whose corporate culture and plant management share the common goal of profitability improvement. Gaining senior management attention and sponsorship for improvement opportunities in plant operations is difficult and time consuming. To be successful, however, power generators must make this a strategic priority in the same way that downsizing, outsourcing and modernization have been adopted in the past.

The bottom line is that power generators have a vested interest in making sure that their key suppliers survive and prosper. Rather than beating up on them for the lowest price, generating companies must develop mutually beneficial, innovative, and yes, even creative long-term strategic relationships with their key suppliers to optimize the supply chain and maximize long-term cash flow, profitability and enterprise value.

Based on early successes, we remain optimistic that over time the power industry will successfully restructure its supply chain, ultimately benefiting all market participants. If we are right, this strategic realignment will not kill the power industry, but will make it stronger.

Saw Mill Capital is a private equity investment firm that invests exclusively in manufacturing and service providers to the global power industry. Saw Mill Capital is actively looking for investment opportunities in partnership with strong management teams seeking capital to divest from a corporate parent, to take advantage of growth opportunities or to provide for shareholder transition. For more information please contact Budoff, partner, at 914-741-9091 (sbudoff@sawmillcapital.com) or Winters, VP Research, at 914-741-9098 (twinters@sawmillcapital.com).

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