Timothy P. Adams, assistant associate editor & online editor
Recently, I spoke with two financial analysts regarding the current state, trends and forecast of the utility investment market. First was Leonard S. Hyman, a senior consultant associate for R.J. Rudden Associates. (Prior to R.J. Rudden Associates, Leonard was employed by Merrill Lynch, where he managed the utility research department.) Secondly, was Craig Shere, a utility analyst for Standard & Poor’s Equity Research Services.
TA: What is your overview of the utility investment market?
CS: Following the collapse of the energy merchants, more regulated utilities began a “back–to–basics” mantra that de–emphasized unregulated investments. We see these slower growth, higher yielding names performing in line with the bond market—so interest rates will be an important factor in total investment results.
The more volatile unregulated energy market is in a “waiting for the good times” period. Asset sales, debt refinancings, regulatory settlements and cutbacks in capital intensive trading and marketing activities have helped repair the broken industry. We have counted over $20 billion of individual asset sales divested by energy merchants over the last couple years—contributed to both debt reduction and improved cash liquidity. As a result, we believe energy merchants have time (ranging from 2–5 years) to wait for improved wholesale power prices and more favorable weather patterns.
TA: What is the ultimate benefit of the back–to–basics approach?
LH: In the 1990s, investors thought that they should earn 20 to 30 percent per year in the markets, which utilities could not do. If you look at history, though, you see that investors have earned about 6.5 percent per year plus inflation on stock investments. That is nowhere like the exaggerated expectations of the 1990s. Furthermore, most of the return came from the dividend&ndah;and that is for all stocks, not just utilities. Nowadays, that would indicate that investors should expect 6.5 percent plus 2.5 percent inflation, or 9 percent per year. A back–to–basics utility already yielding 5 percent only has to squeeze out 4 percent per year of growth to reach 9 percent, without taking big risks. Investors should be pleased by that expectation.
CS: The upgrade we had on the utility sector, in terms of its market weighting, assumed that the above–average dividend yields and the increased stability of the “back–to–basics” mantra (in what was once a staid industry), will be very attractive to investors over the short term. Now, whether this back–to–basics approach will continue to be attractive in the 3rd and 4th quarter of 2005—if indeed the economy continues to grow and interest rates go up—is a different story.
TA: Since the blackout, has there been a trend to invest more into the T&D side of the industry?
CS: In general, I would say that there is a gridlock. Not enough is being done to promote change within the system concerning T&D and all other aspects of reliability and integration. The blackout meant entirely different things to different people. The people in the Northwest and Southeast, with their low–cost hydro and coal, are saying, “See, this didnà¯¿½t happen to us.” While the Northeast, which is a poster–child for the FERC–envisioned markets is saying, “Our problem was communication. If we had more integration—between utilities and across state boundaries—then the blackouts wouldnà¯¿½t occur.” Everyone is sticking to their guns, and they all feel their guns were reinforced with the blackout.
TA: What can be done to improve this approach toward resolving T&D?
LH: There has to be a financial responsibility. When the lights go out, what happens to an electric company? They lose three hours of sales or so, but that is it. What incentive does an operator have to be good versus sloppy? None. And on the other side, if an operator exceeds performance levels, what reward is given? None. There is simply no incentive to improve efficiency and reliability. We cannot effectively guarantee reliability by saying, “You better follow the rules.” It is impossible to come up with rules that cover everything.
TA: What problems might we face with utility investments?
LH: Interest rates and regulation. First, utility stocks tend to move inversely with interest rates, so if interest rates go up, that will tend to push down the stocks. As for regulation, it is a new ball game. Regulators haven’t had to try rate cases for years. Now utilities have to upgrade their plant and meet new demands, and the only way to pay for this will be by raising prices. There are many regulators out there that have never seen a rate case, and there are many utilities that have retired their rate experts. They’ll both be in for a learning experience.
TA: Do you believe criminal proceedings have affected the average investor’s outlook on utility stocks?
LH: Many average investors might be deterred after reading headlines about cooked books and indictments, but I think that most of the real disasters came about when honest executives made bad business decisions. That’s why going back–to–basics makes many investors more comfortable. There’s less likelihood of disasters when you stick to your knitting.
CS: I see the criminal proceedings relating to the unregulated energy markets slowly dissipating. Settlements that have already occurred with various energy merchants and the FERC, SEC and the CFTC have generally been much less onerous than some investors had feared. We believe this trend will continue as we see final resolution of remaining FERC mandated California refund disputes. As the true extent of these liabilities are clarified, investors should become more focused on drivers (such as margins for wholesale power) that will have more of a long–term impact on energy merchant operations.
TA: What advice would you give to the utility regarding investors?
LH: You will satisfy investors by running your ordinary business well. If you could get changes in the regulatory system that offers rewards for innovation and greater efficiency it might make investors even happier.
CS: Utilities have to get out of the dog–chasing–its–tail evolution, where you repeatedly “diworsify,” go back–to–basics, “diworsify” and go back–to–basics. We have to get to a point where there is sustained long–term unregulated investment that is profitable, rational and appropriately managed in terms of risk. Of course, some companies are now trumpeting the “back–to–basics” mantra out of necessity. However, it is unclear what managements will decide to do once their balance sheets are repaired and their stocks have performed well for a year or two. I believe investors will be seriously skeptical of about future “diworsification” efforts that are not built on proven competencies, sound fundamentals and a long–term vision.
TA: What advice would you give to investors about utility investments?
LH: Look at historical evidence and ignore the hype. There is nothing wrong with a 5 percent dividend and a few percent a year in growth. I attend many meetings with big money managers and they do not object to those modest returns. They object to rash decisions that produce big losses. Utilities can be safe and steady investments.
CS: I don’t believe you can just chase yield. Just because someone has a 0.5 percent higher dividend yield does not mean they are the better investment. You want a company that has consistent growth. And, if they really have consistent growth, they’re not going to have a 60 to 80 percent dividend payout ratio. They’re going to keep more of their earnings to invest into these growth businesses rather than paying it all out to shareholders. It would be wise to focus on companies with histories of both consistent and meaningful dividend growth. If a stock has a $2 dividend and raises it a penny a year, it isn’t meaningful.