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Turning Capital to Wealth: A Ranking of U. S. Utilities

Fortnightly Magazine - December 1999

not wealthier.

Paying dividends can rob a company of the capacity to borrow money and buy back stock, which is a more tax-efficient way to return capital to the shareholder. Stern Stewart clients such as FPL Group and IPALCO Enterprises have followed some variant of our firm's advice to curtail dividends, and instead, borrow and buy back stock. Both of these firms have benefited from significant increases in shareholder wealth as a result.

Florida Power & Light was the first healthy utility ever to cut dividends in anticipation of long-term regulatory changes. In the two years following the dividend cut, FP&L shares outperformed the Standard & Poor's utility index by 15 percentage points. IPALCO went one step further, and combined a dividend cut with a leveraged re-capitalization (borrow and buy back stock). Even after significantly increasing its debt-to-capital ratio, IPALCO maintained its bond rating. The reduced dividends more than paid for the increased after-tax interest costs. In 1997, the year of the recapitalization, IPALCO had a total return of 58.5 percent, the third-highest among utilities. Montana Power Co., a Stern Stewart EVA client, recently exited the generation business, a move that was applauded by the market. Montana Power won the EEI Index Award for the industry's best financial return between Jan. 1, 1994, and Dec. 31, 1998.

Such innovative financial and business strategies are born of a focus on shareholder wealth rather than on accounting measures of success.

Behind the Numbers: Is Bigger Better?

The table on page 44 shows Stern Stewart's ranking of 88 investor-owned electric utilities by their MVA at the end of 1998.

America's most able wealth-creating electric utility is Duke Energy, with an MVA of $15 billion, followed by Southern Co. ($10 billion) and Con Edison ($ 6.3 billion). The table also provides information on how MVA creation has varied historically. Duke and Southern have consistently led the MVA ranking since 1991, whereas Con Ed only recently rejoined the top echelon.

The table also provides the market value (MV) size rank for the utilities (with a lower rank indicating more market value). Duke and Southern have the third-largest and largest MV, respectively. Nine of the top 10 MVA companies also rank among the top 15 in MV. At first glance, it appears that wealth-creation strongly is influenced by size. The reality, however, is more complicated.

One way to look at capital efficiency is to divide MVA by the amount of capital employed. Such a "standardized" MVA indicates the rate at which wealth is being created per unit of capital. A caveat is in order: The objective of management is to maximize MVA, not standardized MVA.

Any project that produces positive MVA adds to shareholders' wealth, and should be undertaken, even if it brings down the ratio of MVA to capital. Standardized MVA is useful as an indicator of capital efficiency, but maximizing it should not be viewed as a goal unto itself. Wealth-creation depends not only on capital efficiency, but the size of the capital base to which this efficiency is applied.

IPALCO demonstrates the highest ratio of