Utilities light up investment horizon

John Stephenson

Sterling Consulting Group

As the slow pace of a protected market gives way to the breakneck speed of competition, utilities must cut costs and quickly adapt to a wide range of issues. In meeting these new market requirements, today`s utilities represent leaner and more aggressive investments.

Traditionally, utility capital structures consisted of large amounts of long-term, continuously rolling debt. And because utilities were assured of earning a return above their borrowing costs, things couldn`t have been better. However, this model no longer applies in a competitive environment. Instead of using an arbitrary benchmark, analysts and executives rate a company`s performance against lean, hungry, and efficient competitors lured by the market`s enormous potential. Faced with this scenario, some utilities are drastically altering their capital structures to quickly respond to today`s opportunities and threats.

Changing their capital structures requires utilities to finance their operations differently, changing the proportion of assets financed with debt and the type of debt used. Until now, utilities moved more with the bond market than the stock market and were considered to be long duration interest plays with returns similar to bonds.

As companies aggressively switch to short-term debt and reduce the amount financed with debt altogether, their risk/return profiles change dramatically. More equity type financing, shorter term debt, and larger returns bring increased volatility. Utilities now need higher returns to compensate for equity costs that have become a much larger proportion of their overall costs and are significantly higher than the costs of debt.

Lowering their equity costs becomes an important issue for utilities because their capital costs directly affect profitability and the bottom line. To lower capital costs, utilities must make their stock so appealing that it commands a premium price. This allows them to finance activities with less stock, which avoids excessive dilution and helps keep the stock price high and equity capital cost low.

By adopting sound risk management practices, reducing earnings volatility, embracing a long-term strategic approach to their business, and actively participating in a new competitive market, utilities can make themselves attractive to savvy investors.

Realization of their changing roles and market perceptions, can and should lead responsible utility executives to be pro-active both with respect to the types of changes they make and to how quickly they implement those changes. In a climate where everyone in the industry repositions sooner or later, those who do it sooner not only benefit from their own efforts, but piggyback on the success of others.

These developments mean three things for the money management community:

– Those asset managers now holding utility stocks need to re-evaluate the risk, return, and time horizon of these investments. Utility stocks will need to be removed from a conservative investor`s portfolio. A large number of other portfolios need significant rebalancing as well to bring their risk/return profiles back in line with those specified by the policy statements.

– As more money managers realize this and begin to take action, some interesting and attractive opportunities arise. They can now accomplish two investment objectives with a single trade: (1) they acquire an asset with good appreciation potential, fairly high returns and relatively low correlation with other assets; and (2) they acquire this asset at a bargain price.

– Since utilities are now aggressively entering short-term capital markets, there`s significantly greater demand for short-term funds and a good chance that this will drive short-term interest rates up.

This can result in a gradual downward trend for yields on short-term instruments. If a large number of utilities refinance at the same time or within a short time span, a large drop of 100-150 basis points can occur.

If the simultaneous entry scenario seems likely, taking a long position in short-term bonds may prove a profitable market timing trade. In other words, a fixed income fund manager armed with this type of analysis should considerably shorten the duration of his portfolio to take advantage of this opportunity.

For the equity players, another type of analysis may be relevant. Because of the deregulated utility industry`s extreme volatility, a well-diversified portfolio constructed solely of utility stocks should provide an attractive return.

The power market, a $300 billion behemoth, has enough room for some very big deals, and the incredible complexity of the business allows small but creative players to reap extraordinary gains. However, with volatility, special attention must be paid to the risk management capabilities of utilities and their ongoing commitment to maintaining them.

And because of the industry`s increasing complexity and sophistication of market participants, derivatives are an important tool for utilities. A properly constructed and managed derivative portfolio allows them to concentrate on their core business and keep up with major market movements. Also, an option-based approach to valuing generating assets allows them to maximize the value of their asset bases and increase returns.

With all this in mind, the utility employee profile has been changing as drastically as the rest of the business, and the quality of human capital has undoubtedly become a major consideration in valuing utility stocks.

A brief look at the importance of electricity to virtually every facet of life in an industrialized nation, gives a glimpse of potential future markets and assures steady growth for years to come. The ever-increasing demands for power within the emerging markets provide yet another major impetus for explosive growth.

Environmental issues also make the industry a more aggressive investment. As social investing becomes a more accepted strategy, utilities can capture that segment of the investing public by stressing and demonstrating their commitment to cleaner and more efficient generating technologies.

Utilities seem to be on the right track, and although they still have a long way to go, a framework for success is being put into place. Both as short- to medium-term profitable investments and as long-term growth stocks, domestic and international utilities are definitely gathering momentum. The industry`s potential boggles the mind, with only one question remaining: Just how bright can this industry shine?

John R. Stephenson is vice president of utility and related services for the Sterling Consulting Group, a Houston-based management-consulting firm. Stephenson has a mechanical engineering degree, an MBA from INSEAD in Fontainebleau, France, and is a chartered financial analyst. Michael Fox-Rabinovitz assisted in the preparation of this article.

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