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After Stranding Recovery, What?

Fortnightly Magazine - June 1 1996

Best?

Like most other people, I will probably spend a cash windfall less productively than I will the proceeds of a loan. I obtain the loan only after showing

lenders that my project is better than others that they might finance. Economists may disagree about a lot, but most agree that the capital markets perform well in allocating savings to valuable uses. Capital markets offer investors an entire planet on which to go comparison shopping for the best returns. They promise wealth to those who make good judgments about profitability and risk, and ruin to those who do not.

In theory, management may invest free funds well because its specialization provides a deeper knowledge of good investments than is available to capital markets. In practice, however, managements do poorly for their investors. Managements that spend free cash flows on new lines of business usually create less shareholder wealth than those that return the funds to investors. The greater a firm's diversification, other things equal, the lower the return to shareholders.1

Even the expectation of diversification matters. A utility's announcement that it will reorganize as a holding company generally lowers its market value, possibly because analysts perceive an intent to diversify. Prices of shares in utility holding companies also usually fall when they make diversifying acquisitions.2

Apparently, very few managers know more about diversification than the capital markets. Investors see greater gains when management stays focused. However, managements's incentives may not match the desires of shareholders. Executives whose pay and social status depend on the size of their companies will be loath to downsize even when doing so creates the most value for stockholders. Unwarranted corporate growth becomes an even greater problem if management can spend retained earnings without taking its plans to the capital markets.

The temptation of poor investments is real. Economists have found that firms receiving windfalls are quite likely to invest them in unrelated ventures that ultimately fail or are sold at a loss. Instead of reducing debt, recipients of windfalls are likely to issue more to finance questionable activities.3 The experience of utilities is consistent with these findings. As construction programs topped out in the mid-1980s, some utilities put their newly freed cash into businesses distant from their core activities. The financial results for a sample of diversifications proved "horrendous in the aggregate," with a return on equity of -1.1 percent.4

In most markets, takeovers and other shareholder actions can stop uneconomic spending of free cash. The post-takeover management usually divests unprofitable assets and restructures a firm's finances to create greater value.5 Utility investors, however, probably cannot count on changes in corporate control to help them out. Laws like the Public Utility Holding Company Act and state regulatory

institutions stand in the way of takeovers, and bond indentures make utilities hard to reshape. Mergers offer no panacea (em especially the "friendly" kind that may save some expenses, but cannot deliver the shock treatment of a takeover.

What's There to Buy?

In one vision, today's utilities will expand into related businesses like power marketing and independent power production. Others