Debt up, dividends down
Michael T. Burr
Use the correct tool for the job-that`s one of the first rules learned by any apprentice lineman or field technician. A side-cutter might resemble a wire stripper, but using it thusly often yields disappointing results.
The same is true of utility finance. As market conditions change, companies are using different tools to leverage their growth.
“Deregulated markets and competition are changing utility financing,” said Neal Schmale, executive vice president and CFO of Sempra Energy. “Companies are getting into different businesses, and they`re choosing from a broad array of financial instruments to finance that business.”
Sempra provides a good example of utilities` evolving capital structures. Two years ago, Sempra did not exist. Its predecessors, Enova Corp. and Pacific Enterprises-the respective parents of San Diego Gas & Electric and SoCal Gas-merged in June 1998 to form the $5.5 billion (revenues) Sempra Energy. The new company`s growth strategy is quite different from either Enova or Pacific Enterprises, and so are its financing tactics. “Now we`re big in Mexico and Latin America. We`re involved in retail performance contracting and energy trading,” Schmale said. “As we transition to a competitive market, and continue working toward meeting our earnings growth targets, we`ll be investing more in the unregulated side of the business. That includes doing project financing and general corporate financing. We`re looking at less first-mortgage debt.”
This has become a clear trend among IOUs, according to Rob Hornick, a senior director with credit rating agency Fitch IBCA Inc. in New York. “Utility companies are separating their transmission and distribution (T&D) entities from other areas, and the capital requirements of these entities is different,” he said.
With a regulated rate of return, and thus a stable cash flow, T&D businesses can service a higher percentage of debt in their overall capital structures. For example, T&D companies are commonly carrying debt loads totaling 55 percent or more of their total capitalization, compared to roughly 45 percent for traditional integrated utilities.
Also, the repayment term-or tenor- of utilities` debt is getting shorter. Instead of relying on first-mortgage bonds, which are traditionally secured against such long-term assets as a utility`s rate-base generating plants, companies are issuing senior unsecured debentures.
“When a company wants to move assets around and sell assets, secured debt is more restrictive because of liens on the property,” Hornick said. “Unsecured bonds are being issued at the parent-company level to fund diversified or unregulated activities.” Such bonds typically carry a shorter tenor-10 to 15 years, compared to 20 to 30 years for first-mortgage bonds.
“A shorter duration of debt better matches utilities` balance sheets today, particularly when their investments are less capital intensive,” said Bob Marshall, director of investor relations for Conectiv of Wilmington, Del. “The typical utility balance sheet is long-lived because it`s secured largely by 40-year generation assets.”
The same forces driving utilities toward unsecured, shorter-term debt are also pushing dividend payouts downward. “If you`re going to be spending large amounts of money to acquire new businesses, for example, it`s difficult to pay out dividends to shareholders,” said Fitch`s Hornick. “Utilities increasingly are seeing themselves as different kinds of companies.”
Conectiv-the merged Atlantic Energy and Delmarva Power-is certainly one of those utilities. It announced plans in May to sell off half of its generating assets (EL&P June 1999, page 1). Conectiv hopes to raise $1 billion by auctioning interests in some 2,200 MW of nuclear and fossil power plants, mostly baseload units. The remaining, intermediate and peaking load plants, are to be removed from the rate base and managed by an unregulated subsidiary. Within three to five years, Conectiv expects fully half of its revenues to be generated in unregulated business areas-namely telecommunications and energy services. Conectiv is reducing its dividend payout substantially, from past levels reaching 80 percent of earnings, to between 40 percent and 60 percent.
“This is more consistent with companies operating in a competitive environment,” said John van Roden, Conectiv`s CFO. To provide an exit option for shareholders who might be relying on high dividend payouts, Conectiv held a Dutch auction in which it repurchased 13 percent of its outstanding shares. “We`re seeing a fair number of common stock repurchases going on. Some are in advance of sale of assets,” Marshall said. “The market is expecting the capital structures of utilities to be adjusted and debt to be redeemed, particularly for first mortgage bonds and secured debt.”
While the utility business environment might be changing, utility stocks remain stable investments, according to Sempra`s Schmale. “In general, shareholders are aware of how utility companies are changing. On the broad spectrum of investments that are available, energy stocks like Sempra are still solid and conservative.”
This changing business environment, however, is affecting the way rating agencies see utility credits. “Going forward, we`re rating a different animal,” Hornick said. We expect discos will remain in the investment-grade category, and gencos will fall below investment grade.”
Holding company ratings, how- ever, are not likely to drop substantially soon. “For the near term, the lion`s share of utilities` cash flow will come from the regulated, T&D side,” Hornick explained. “As they develop new business and different cash flows, however, volatility may increase for holding companies.”
At the same time, however, these companies are positioning themselves to offer higher returns to shareholders. “Greater volatility and higher returns go hand in hand,” Schmale said.
The degree to which this volatility translates into earnings growth remains to be seen.