Most retailers fail to give investors a sound basis for assigning value.
At this years’ annual KEMA conference for retail energy marketers, Vikas Dwivedi, a securities analyst with Prudential Equity Group, stunned many in the audience with his comment that the investment community did not know how to value retail power marketers. He speculated that some of his peers even assign negative values to energy retailers, and went on to complain of poor disclosure practices and investor presentations that fail to differentiate one marketer from another.
Surprised by these comments, I decided to look at the top five marketers to compare how they stack up on disclosure practices, performance metrics, their ability to describe to the investment community what makes them unique, and ways to better communicate the value of the enterprise. Several days of reviewing financial reports and investor presentations gave me a better appreciation for Dwivedi’s comments. The value propositions all sound somewhat similar, and the majority of retailers indeed failed to give investors a sound basis for assigning value to the business. (See chart.)
The Top Five Marketers
Traditional approaches to business valuation focus on examining historical cash flows (earnings before interest, depreciation, taxes and amortization, a metric commonly referred to as “EBITDA”) or valuing tangible assets such as plant, property and equipment. What makes valuing a retail energy marketing business difficult is that its most valuable assets are intangibles, including the experience of its staff, their business relationships with customers and suppliers, its reputation in the marketplace, its contract backlog, and business processes and technology. Moreover, experience in both the wholesale and retail energy business has shown that past earnings may not be indicative of future results.
KEMA lists the top five marketers as Constellation NewEnergy, Reliant Resources, TXU Energy, Suez Energy Resources and Strategic Energy.
Constellation NewEnergy (CNE) touts itself as the No. 1 competitive energy retailer in North America, serving customers in 29 states, Washington, D.C., and two Canadian provinces. CNE proposes to help customers maximize the value of their energy investment by offering scalable products, competitive pricing, and industry-leading resources. By year-end 2005, the company served 15,500 MW of peak electric load and 300,000 mmBTUs of natural gas to its commercial, industrial and governmental customers, and reported annual revenues of $6.9 billion and a 24 percent share of the switched electric market.
Purchased by Constellation Energy Group from AES in 2002, CNE is one of the earliest entrants to the retail power business, having been started as a privately-owned company (f/k/a NewEnergy Ventures) by Michael Peevey, who now heads the California Public Utility Commission. (AES purchased NewEnergy from its founders in 1999 in a transaction reportedly valued at $90 million.)
In 2002, when Constellation purchased NewEnergy for $260 million, it served 4,000 MW of load. Since that time its megawatt sales have nearly quadrupled. Delivered volumes were up 13 percent in the first half of 2006 as compared to the first half of 2005. Margin growth has been equally impressive, with CNE reporting $274 million in margin in 2005, up nearly $100 million from 2003. Margins in the first half of 2006 were $165 million, up 26 percent over 2005.
Built on the proposition that size matters, CNE aims to leverage its low cost business model and its national capability. CNE management attributes much of their success to its decentralized business model, which has allowed it to develop a strong presence in regional markets, stay close to its customers and drive down overhead costs on a per megawatt hour basis.
Reliant Energy ranks as the second largest retail competitor in the United States, serving 1.9 million accounts in Texas, New Jersey, Maryland, Pennsylvania and the District of Columbia. Reliant states its value proposition as taking a participative approach to serving customer needs by applying knowledge, innovation, services and reliability to allow customers to leverage their energy spending and have greater confidence in their purchasing decisions.
Despite ongoing problems in the company’s wholesale business, Reliant’s retail business has been a strong player in the Texas market, particularly in the industrial sector. Prime-time television commercials originally aimed at residential customers outside its native territory also provided a strong boost to the company’s commercial business. During the first three years of competition, Reliant was able to increase awareness of its brand from 35 percent to 85 percent throughout Texas. Its commercial sales efforts were the strongest among all competitors and it took the most market share from all players because of these efforts. Delivered volumes actually grew by 7 million megawatt hours, or nearly 12 percent, between 2002 and 2004, before leveling off in 2005. Reliant delivered 61.1 million megawatt hours of electricity to Texas customers in 2005, making it the largest deregulated marketer in the state.
No. 3, TXU Energy, lays claim to serving the most customers in the state of Texas, 2.3 million meters. Its goal is to put the customer’s mind at ease and offers easy, on-line services for residential customers and customized products for businesses. TXU Energy’s current focus is on providing superior service and options to customers while achieving long-term sustainable residential net margins of 5 percent to 10 percent. To accomplish these objectives, the company has launched a number of new offerings for customers in its native market, to meet the needs of customers and increase retention. The various plans have features including price certainty, prices indexed to natural gas, renewable energy, and time-of-use options. The objective is to offer plans that more directly meet the needs of customers, as the price-to-beat is set to expire on Dec. 31, 2006.
In areas outside its native market, TXU Energy is pursuing customers through a multi-channel approach using both savings and dependability messaging to achieve acquisition goals and a targeted 5 percent to 10 percent net margin.
Despite starting out in early 2001 with a highly favorable customer perception, billing and customer service problems at the start of deregulation along with fierce price competition caused TXU to lose significant market share. Delivered volumes fell more than 35 percent from 2002 to 2005, and first-half 2006 volumes were off 12.5 percent year over year. Much of this loss is attributable to the large industrial segment where competitors have come in with lower prices along with more aggressive sales and marketing efforts. TXU has reportedly lost more than 50 percent of its industrial customers since the market opening.
SUEZ Energy Resources NA is now ranked by KEMA as the fourth largest electric retailer in North America. Started in January 2003, it also claims to be the fastest growing, serving more than 12,000 customers in eight states. Its mission is to provide risk managed electric supply to help its customers effectively manage the uncertainty in today’s deregulated energy market. As a wholly-owned subsidiary of SUEZ Energy North America Inc., its revenues are included in the consolidated results of its parent, which provides other services including electric generation, natural gas and LNG supplies and wholesale energy marketing and trading. SUEZ Energy North America Inc. is a business unit of the publicly-traded French company, SUEZ Energy International, which owns and operates electric generation, water utilities and waste treatment facilities globally. SUEZ does not provide separate operating results for its retail subsidiary and its fourth place rankings are based on non-public data.
Strategic Energy’s (SE) value proposition is that it is an independent advocate for its customers, able to provide a deep understanding of the energy markets and a comprehensive energy strategy to help customers meet their business and financial objectives. Started in the mid-’80s by Pittsburgh attorney-entrepreneur Rick Zomnir as a consulting firm advising large industrial customers on the purchase of natural gas, the company began focusing on power in the late 1990s. Recognizing the need for large scale financial support to grow its electric supply business, Zomnir turned to Great Plains Energy (GPE), the parent of Kansas City Power & Light, for funding, in return for the sale of approximately 82.5 percent of the company stock. GPE purchased another 6 percent in November 2002, and then purchased the final 11.45 percent in May 2004. This final purchase from Zomnir and his management team valued the company at $786 million, nearly 20 times 2003 earnings.
SE grew rapidly under Zomnir’s leadership in the early years by going into new markets as they were opening to competition. SE currently serves 16,300 customers in nine states. As a separate reporting unit of its publicly-held parent, its disclosures are the most comprehensive of the five retailers and provide insight to the spectacular growth in the early days of retail marketing. The company’s delivered megawatts grew tenfold between 2000 and 2004, going from 2 million to 20 million megawatt hours. Net income growth was just as impressive, increasing from $5.9 to $42.5 million during the same period.
With GPE’s buyout of the remaining equity in 2004, Zomnir and key members of his management team left SE. While sales declined throughout most of 2004 and 2005, they’ve improved significantly over the past three quarters. The company’s backlog is up 40 percent from year-end 2005. Delivered volumes are estimated to range between 16 and 18 million megawatt hours in 2006, down 11 percent to 21 percent from their 2004 highs. Corresponding 2006 net income is projected to range between $19.7 and $24.3 million. The company has recently focused on serving smaller customers in an effort to improve margins. Over the past two years, the number of customers served has more than doubled while the average customer size has dropped from approximately 500 to under 200 KW.
Metrics to Ascertain Value
In addition to the metrics currently disclosed, what could help the investor ascertain value? For starters, a quarter-end mark-to-market valuation of all contracts, retail and wholesale, would be the one metric that would convey a better understanding of future value.
Similar to a wholesale business, much of the value of an energy retailer is derived during the contracting process, which involves the matching of sales contracts with the underlying power supply or financial hedges. It is during this process that the company’s future margin is hopefully locked-in. While few would advocate a return to the days of mark-to-market accounting, it’s interesting to note that many wholesale firms used mark-to-market valuations for management purposes long before they ever adopted it for financial reporting. The reason was it provided great insight into growth in value of the business, allowing one to see the growth (or decline) in value from one period to the next. (Adopting mark-to-market practices across their entire contract portfolio would not only provide retailers with a clear metric to measure the profitability of forward sales, but the discipline of reporting a mark-to-market portfolio value would also provide an early warning mechanism to management of mispriced contracts, hedge slippage, and post-contracting changes in retail adders.)
Other metrics, including contract backlog, contract length and estimated margin, all attempt to portray the value in contracts that have been signed for future delivery. Why not go one step further and actually provide a valuation figure so investors no longer have to guess about the value of forward contracts?
Additionally, the customer renewal/retention figures are important and are metrics that all retailers should provide. They provide insight as to the strength of the customer relationship. The disclosure should clearly state whether month-to-month customers are included. As a point of clarification, it should be noted that a month-to-month customer has not actually renewed its contract. Retail electric contracts typically provide “hold over” provisions similar to leases for rental properties. These provisions simply change the pricing terms of the contract, usually from a fixed price to a market-based price that is determined monthly. Once the fixed price term ends, the contracts continue on a month-to-month basis until either party decides to terminate them. Having a high percentage of customers on month-to-month contracts is one of those good news/bad news items. It’s good news, because the month-to-month rates tend to be somewhat punitive for the customer (i.e., high margin for the retailer), in order to encourage the customer to make a decision about the supply contract, hopefully securing a longer term agreement. It’s also bad news, because while margins may look great for a short time, a large percentage of customers are at risk to suddenly leave. A churn rate should also be provided for customers that are not under long-term contracts, as it provides insight to the stability of the customer base. This statistic is particularly important for retailers serving residential customers.
Finally, a disclosure of commissions paid to independent third party agents, aggregators, brokers and consultants, along with the percentage of sales through channel partners, would provide insight to the strength of the retailer’s customer relationships. Perhaps little known outside the business, many energy retailers have grown by paying significant sums of money to third parties to bring them customers. It is often the third party, not the retailer, who serves as the trusted advisor to the end-use customer, and that third party can typically choose to place the customer’s business with a number of retailers. High payments to third-party channel partners not only erode retailer margins but may also mean that future business will go to the highest bidder. While using outside channel partners benefits the retailer by making selling expenses a variable rather than fixed cost, selling through a non-exclusive third party also means the retailer has lost the primary customer relationship and may not be able to keep its customers coming back.
Click here to enlarge image
* Constellation NewEnergy’s operating results are consolidated within Constellation Energy Group’s merchant segment. Certain items are broken-out within investor presentations.
* TXU Energy’s operating results are consolidated within the TXU Energy holdings segment.
* Operating results for SUEZ Energy Resources NA, Inc., the U.S. retail arm of SUEZ, are consolidated within SUEZ Energy North America and are not separately disclosed.
1. While Reliant does not provide contract backlog, they do forecast delivered volumes and adjusted gross margins for the 2006 to 2008 period.
2. TXU does not provide contracted backlog, but the company’s most recent investor presentation did include a three-year estimate of its retail short position in megawatt-hours.
3. Shown in aggregate across all markets.
4. Does not differentiate between contract renewals and month-to-month customers.
5. While TXU is only active in ERCOT, the company discloses load in its native market versus non-native territories.
Carolyn Pengidore is president/CEO of Ceomperio Energy Inc., an energy consulting firm. She has worked in a variety of leadership roles involving the supply and marketing of power to wholesale and retail customers, and formerly served as a lead partner in Arthur Andersen’s energy trading and risk management practice. Carolyn can be contacted at firstname.lastname@example.org.