The utility sector has experienced some major highs and lows over the past five years. The consequences of deregulation efforts, including the rise and fall of merchant generation and energy trading, have had a major impact on the stock prices of utilities. Likewise, merger and acquisition attempts have negatively affected stock prices. Utilities paid a premium of as much as 50% over value, often funding the purchase with debt. Merged utilities had trouble hanging onto savings from cost cutting and restructuring as regulators typically held the merger process hostage until both parties agreed to return a significant portion of any savings to customers.
“Wall Street in general and investors in power entities (whether you're a stock or bond investor or a bank debt investor) have been really challenged in the last couple of years, but that turned around last year,” says Frank Napolitano, managing director and co-head of the Global Power Investment Banking Group at Lehman Brothers in New York. “Last year, we saw a resurgence in the way the companies were valued and new investors coming on the scene that weren't beholden to the losses of the past. They could put new money to work and could ride a wave into the future, which was generally the high-yield marketplace. Those investors have done extremely well, because they invested in undervalued securities and have basically ridden those back to par value.”
Some industry experts say utilities are going “back to basics” by investing in infrastructure and building out their T&D systems, while they look for gains in operational efficiency, continue to spin off under-performing deregulated assets, buy down debt and refocus on the regulated businesses.
“Utilities that have kept their focus on the regulated businesses have provided the biggest returns on Wall Street,” says Brett Perlman, a principal with Vector Advisors in Houston, Texas. Although the jury is still out on the impact of deregulation on investment in T&D infrastructure across North America, the experience in Texas has been mostly positive. The Texas Public Utility Commission made sure the bulk power grid was upgraded prior to going forward with customer choice. Perlman suggests that states considering deregulation heed the lessons learned in Texas if they are to have a positive restructuring experience. He also recommends developing a robust wholesale market, writing clear non-gameable rules, and providing solutions for credit and clearing.
Merchant Generation in Trouble
Many utilities, encouraged to divest of generation in their service territories, decided to take the cash and invest in merchant generation elsewhere. Perlman reports that the stock market has not been kind to the energy merchant sector, which lost 85% of its value since 2000. This represents a loss of more than US$170 billion in value.
Some companies (including Mirant) with a large position in merchant generation have gone bankrupt, while others (including Calpine and AES) suffered major stock-price declines. Although Perlman sees the demise of speculative energy trading, he expects a form of trading to return, mostly as a tool for generation asset optimization and risk management. While the build-out of generation has not been kind to those who initially invested, it has resulted in a surplus of generation capacity. Today, the New England Power Pool has a capacity margin of 35%, the Southeastern Electric Reliability Council shows 32% and East Central Area Reliability Coordination Agreement (ECAR) comes in at 31%. Most of the West has a capacity margin of 31%. With this excess of generation, equilibrium between generating capacity and load is not expected to be reached until 2011 to 2020, depending on the region of the country.
Napolitano says that executives at public utility companies have likely seen their stock price graph form a “U” pattern. “Five years ago, the stock price was at the top end. Then it swooped all the way down and all the way back up,” he says. “Utilities have repaired themselves from a balance sheet standpoint and are now able to serve all of their stakeholders.
“Prior to last year, companies were strictly serving the liability side of their balance sheets by paying down debt, refinancing debt and selling non-core assets. Now they're actually able to serve their equity stakeholders, and this has been the case for a period of about 12 to 18 months. What's driving that is the steady dividends that utilities pay and their use of free cash flow to buy back stock and increase dividends. They have free cash flow because they're not currently spending it on growth activities.”
Bond Rating Agencies Speak Out
Shareholder value is only half the story. The utility industry is a capital-intensive industry that has traditionally funded capital improvements by issuing bonds. Organizations such as Standard & Poor's and Moody's Investment Service evaluate the ability of utilities to pay back their debt obligations by issuing credit ratings, which then affect the ability of utilities to borrow money at desirable rates.
Analysts look at the bond market in a different light than they do the stock market. Jeffrey Wolinsky, director of corporate and government ratings at Standard & Poor's, states, “While equity analysts look for significant growth, stability is the underpinning of what makes for a strong bond.”
Wolinsky finds that utilities are still issuing significant debt with $60 billion in financings in the first half of 2003, compared to $70 billion in financings in the first half of 2004. He says he's seen utility bond ratings suffer significant downward pressure over the past four years. This downward pressure accelerated when utilities took on a great amount of leverage to finance unregulated business ventures, which, for the most part, failed to generate desired levels of cash flow, causing credit ratings to deteriorate. Similarly, merger and acquisition activity did not provide the returns predicted by utility executives, leaving utilities unable to recoup the premium paid for their acquisitions, again putting downward pressure on bond ratings.
“We have 34% of utility companies on ‘negative outlook,’ with their financial situation expected to deteriorate over the next two- to three-year time frame,” Wolinsky says. “Because of eroding financial profiles in the utility industry, we have listed less than 2% of companies with positive outlooks.”
Standard & Poor's also places ratings for specific companies on credit watch, which warns the bond market of impending problems within three to six months. The number of utilities whose ratings are on credit watch is down from 2003, but the bias is still negative. “Utilities took on too much debt, and they are now in the process of repairing their balance sheets by reducing debt and increasing equity levels,” Wolinsky says.
Recapping the situation that got many utilities into a financial mess, Wolinsky maintains that what utilities do best is operate regulated businesses and manage the regulatory process. What they don't do well is invest in deregulated ventures. Nevertheless, Wolinsky acknowledges that the average rating is still investment-grade, even though bonds have slipped from A- to BBB. Most utility bonds haven't dropped to speculative grade as the regulatory environment helps stabilize the revenue stream.
“Credit rating agencies are extremely wary about diversification outside of regulated operations, and they probably will be for an extended period of time,” Napolitano says. “Their view is ‘prove it.’ Everything they've ever listened to has turned out not to be true in every form of deregulation, whether it be energy-related deregulation or alternative investments that companies made. So I think the rating agencies are going to take the stance that if utilities ‘prove it’ on a consistent basis then they'll believe it. But some time has to go by for that to happen.”
However, he says if you look at equity research reports, such as where stock price targets are and valuations are on a P/E basis and on an EBITDA multiple basis, the investment community has gotten past some pretty monumental challenges and changes that the sectors faced in 2001 and 2002.
The “back to basics” strategy is great for awhile, but expect equity analysts to soon ask, “How are you going to grow, or are you content to generate returns more like a bond type instrument?”
Some utilities are finding growth in the regulated utility industry. For example, Northeast Utilities will be investing $1.2 billion in transmission, which will provide significant earnings growth. We Energies is investing in generation and distribution under its “Power the Future” initiative, which could provide a 13.5% P/E growth and 2.5% dividend growth.
Most utility CEOs don't want to merge, no matter how compelling the argument. Today, utility stocks already have high P/E ratios, and if utilities bought assets, they would be buying at a premium. But Standard & Poor's Wolinsky believes utilities have not entirely given up on mergers and acquisitions. For those utilities that have senior management nearing retirement age, being acquired would typically provide a premium for existing shareholders and a severance package for their executives. “The regulated business remains the best place for utilities to put money to work, as utilities have been good operators and, for the most part, good constructors,” Wolinsky says. He also “sees utilities taking on debt to strengthen their own internal distribution systems through new capital projects.”
What Does the Future Hold?
Perlman expects the great majority of new generating plants will be built under the regulatory umbrella. But most importantly, he predicts “investor-owned utilities seeking growth will find it through traditional sources, but with better execution.”
Napolitano says companies that have repaired their balance sheets more quickly than others are at a unique first-mover advantage to drive where the industry goes.
“Right now we haven't seen a lot of deals yet,” he says. “We've seen a lot of financial sponsors talk about deals and actually buy some companies this year, but they're basically smaller transactions. We haven't seen any new big, defining moves by some of the bigger market cap players, but that may come.”
Market Rewards Regulated Utilities
Share Price Sept. 30 2003, over 2004 earnings
|Share price over earnings||Premium to IOU Group Average (percent)|
|Southern Co.||15.1||22.7 Mostly regulated|
|Consolidated Edison Inc.||14.1||14.3 Mostly regulated|
|American Electric Power||13.1||6.2 Relatively stable|
|Duke Energy Corp.||13.0||5.4 Relatively stable|
|Entergy Corp.||12.9||4.8 Relatively stable|
|AES Corp. (The)||12.4||0.3 Relatively stable|
|FPL Group||12.3||0.1 Relatively stable|
|Dominion Resources Inc.||12.3||0.6 Relatively stable|
|Edison International||12.1||0.7 Relatively stable|
|Constellation Energy Group Inc.||12.1||2.0 Relatively stable|
|Exelon Corp.||12.0||2.7 Relatively stable|
|Progress Energy Inc.||11.6||5.9 Generally bigger issues|
|PPL Corp.||11.0||11.2 Generally bigger issues|
|FirstEnergy Corp.||10.7||12.9 Generally bigger issues|
|DTE Energy||10.2||17.4 Generally bigger issues|
|Simple IUO average||12.3|
|Source: Stock statistics as of the fourth quarter of 2004, provided by Vector Advisors.|
A Tale of Two Mergers (As reported by Jeff Wolinsky)
FirstEnergy Merger — FirstEnergy merged with GPU companies in September 2001. After the merger, GPU's bond ratings came down and FirstEnergy's bond ratings went up. Now the ratings of all the merger parties have come down again. Unless a bond investor owned bonds of the FirstEnergy subsidiaries prior to merger, they did not see any benefit from this initiative. Why? Several reasons: First, an additional US$2.2 billion of debt was incurred. The merged company sold international assets but received $650 million less than expected. Also, regulators dropped the allowable return on equity (ROE) for FirstEnergy subsidiary Jersey Central Power & Light to 9.5% instead of the 11.5% that had been allowed in the previous rate filing. FirstEnergy inherited GPU's problems and lost the ability to pass on some fuel costs in Pennsylvania, as regulators determined GPU had not prudently managed the price risk in purchasing power and disallowed $60 million in fuel costs.
|Ohio Edison||BB+/Positive||BB+/CW Pos/—||BBB/Stable/—||BBB/Negative/—||BBB-/Stable/—|
|Penn Power||BB+/Positive||BB+/CW Pos/—||BBB/Stable/—||BBB/Negative/—||BBB-/Stable/—|
|Toledo Edison||BB+/Positive||BB+/CW Pos/—||BBB/Stable/—||BBB/Negative/—||BBB-/Stable/—|
|Met Edison||A/Stable/A-1||A/CW Neg/A-1||BBB/Stable/A-2||BBB/Negative/NR||BBB-/Stable/NR|
PEPCO Holdings Merger — PEPCO merged with Conectiv Inc. in August 2002. The participating companies were rated in the “A” category going into the merger. These companies' ratings were subsequently downgraded to BBB+ (and now carry a negative outlook). PEPCO took on an additional $700 million in incremental debt to affect the merger paying about a 10% premium to acquire the stock of the merger partners. To get the regulators to agree to the merger, rate freezes already in place were extended for an additional two years. In addition, PEPCO's ongoing litigation with bankrupt Mirant Corp. over existing power purchase agreements exposes PEPCO to future increased power costs and puts pressure on its current ratings.
|PEPCO||A/Stable/A-1||A/CW Pos/A-1||A/CW Neg/A-1||BBB+/Stable/—||BBB+/Stable/A-2||BBB+/Negative/A-2|
|Tables courtesy of Standard & Poor's.|
Energy Trading and Merchant Generation Businesses
Financial firms are looking to move into the energy trading business. With the collapse of Enron and the closing of trading arms of utility companies including Aquila, big investment banks, which have been trading commodities for 100 years, see opportunity. They understand risk and have stellar credit profiles. Expect to see these new entrants sign agreements to deliver electricity as far out as three to five years.
On the merchant generation side, expect private equity sponsors to purchase generation assets with debt and structure contracts to deliver power to customers. These equity sponsors intend to convert near-term, high-cost debt to longer-term, low-proposition debt with the intention that these structured deals might prove to be financially lucrative on down the road.