July 1, 2001
L.A. Loves a Loophole
There's no getting around it...
Letting Go of Electric Generation
The year-long decline in the electric utility stock market has caught most market observers off guard. Picking the winners among electrics has become more difficult. Says Ed Tirello, long-time market savant and utility equity analyst at NatWest Securities, "Competition and retail wheeling have made the selection process nearly impossible short term."
To identify tomorrow's best industry performers, electric utility analysts have focused on generation. They believe low-cost producers with low industrial sales will do better than high-cost producers with large industrial sales within a region. Difficult to argue. Nevertheless, that's only half the story; the other half involves cost of capital and expected returns on functional assets. That's the half we address here. Looking at generation, transmission, and distribution as separate elements of corporate finance, we find that most electric utilities should quit the generating business.
Any article that puts the word "beta" on the first page will likely, and appropriately, be discarded. Stay with this one. The pain is short. The theoretical after-tax cost of equity (COE) capital for the electric utility industry currently runs at 11.1 percent, if you use the Capital Asset Pricing Model and, by inference, equity betas. So what? Well, theory holds that a stock price can only advance when a company's return on equity (ROE) exceeds its COE. Thus, if beta and COE are still relevant to stock price performance and worthy of our attention, we should be able to construct a predictive model. Graph 1 does just that. Market/ book ratios have been regressed against the quotient of ROE/COE. The graph looks good. Or, in less understandable parlance, the correlation coefficient is 63 percent and the R2 is 40 percent, which suggests that a company's ability to exceed its theoretical COE will determine, in large part, whether its stock price will rise or drop. So for now, let's stick with betas and COE.
The relevant question is this: Do generating assets carry a higher COE than distribution or transmission assets? If so, does the COE associated with generating assets exceed the allowed ROE, or can a utility with an allowed equity return of 11 percent focus on a business with a higher COE and hope for stock price advancement? Probably not. And yet that is just what a growing segment of the industry is doing (em focusing on the higher potential returns generated in the generation business. But how high do those returns have to be in order to lift a utility's stock price? Certainly higher than the theoretical COE, which we will now attempt to measure.
Measuring Functional Risk
We have divided the industry into three segments with high, medium, and low concentrations of generating assets (percentage of utility assets devoted to generating sector). Intuition might suggest that the segment with the highest concentration would post the highest COE. We have analyzed the utilities in each of the three segments and have removed leverage from their equity betas to establish asset betas (since we are focusing on asset classes). Then we calculated medians for each group (see Table 1).
The asset betas