[BETA] Fortnightly

What to Do With All that CASH?Seeing no need to build, utility managers are looking

to invest. Can they be trusted

with stockholder money?With little of the fanfare that surrounds the debate on utility competition, robust cash flows and declining capital outlays have created forces that will reshape the industry no matter how competitive restructuring unfolds. Cash generation already exceeds investment in core utility activities, and the differential will grow sharply over the next several years. Utility managements face two options: 1) they can retire securities and shrink their capitalizations, or 2) they can invest unabsorbed funds outside their core businesses. Their choice will exert a major impact both on the future business activities of utilities and on shareholder values.

Growing Cash Flow,

Shrinking Expenditures

In the last several years, the relationship between electric utility cash generation and the industry's investment opportunities has changed dramatically. Although it enjoys the cash generation capability of a capital-intensive industry, electric utilities have actually become less capital intensive. Current cost-based rates provide utilities with large amounts of capital recovery through depreciation and amortization, yet capital expenditures are shrinking rapidly due to three factors:

s Continuing excess capacity has limited the need to build new generating capacity.

s Utilities are no longer the sole provider of new generating capacity.

s New technology (em especially combined-cycle gas turbines (CCGTs) (em sharply reduces the capital intensity of electric generation. (A CCGT now requires as little as one-third the investment per kilowatt of capacity that a new coal-fired unit did six or eight years ago.)

These forces are shrinking capital expenditures but not cash flow. Corporate capital expenditures for a sample of 77 utilities that account for 95 percent of investor-owned utility (IOU) capitalization peaked at $29.1 billion in 1992 and declined to $26.4 billion in 1995. Managements project a continuing decrease in capital spending, to $24.5 billion in 1996 and $23.5 billion in 1998. By contrast, depreciation rose from $17.6 billion in 1992 to $21.6 billion in

1995, and is projected to reach

$25 billion by 1998. Thus, where capital spending exceeded depreciation by $11.5 billion in 1994, the gap narrowed to only $4.8 billion in 1995, and spending should exceed outlays by $1.5 billion in 1998. After 1996, utilities will be disinvesting in their core businesses.

Total internal cash generation, including retained earnings and deferred income taxes, already exceeds capital expenditures. Cash generation not absorbed by capital spending reached $2 billion in 1995, and is projected to grow to $5 billion in 1996 and $8 billion by 1998. Unabsorbed cash will likely total $40 billion between 1996 and 2000.

Options: Retrench or Diversify

Unabsorbed cash generation of this magnitude can be used to accomplish a variety of objectives. Let us consider two alternative financial strategies. The first applies all unabsorbed funds to retire outstanding securities. The second invests all unabsorbed funds outside the core franchise business.

If the entire $40 billion were used to retire securities while capital structures and dividend payout ratios remained constant, the industry's common equity would shrink 20 percent (em roughly 4 percent per