Off Peak

November 15, 2000

Rx for IOUs: Slim Down

 

To an industry whose mantra of late has been "diversify and conquer," a prominent utilities consultant has some startling advice: Slim down and focus on your core strengths.

According to Etienne Deffarges, global managing partner for utility strategy at Andersen Consulting, a utility's survival in the deregulated U.S. market will depend on narrowing its business focus and achieving scale. That's because the industry is migrating to one comprised of three tightly focused segments of companies-energy merchants, retailers, and transmission and distribution companies. Deffarges describes this emerging utility business model in his new report, "CEO Challenges in a Competitive Power Industry." New Tactics for Creating Value.

"Today what we have is a very fragmented industry, companies that are very small in absolute terms compared to other industrial concerns, and also compared to their peers in Europe for example," explains Deffarges. "If you're small and you're in multiple businesses, you're never going to have the critical mass that allows you to learn and allows you to develop scale economics and allows you to be at the forefront-it's just not going to happen."

New Tactics for Creating Value. The trend away from the traditional model of creating value through regulatory-mandated returns already is being seen in recent initial public offerings and spinoffs in the industry. For example, Northern States Power and Southern Co. both recently floated IPOs of stock in their unregulated generation businesses, garnering significant earnings immediately.

"This is showing that this is the best way to enlarge a lot of pent-up value in valuation of these investor-owned utilities that today, as they [exist] in their integrated structure within narrow regional or state boundaries, are languishing at PEs [price-to-earnings ratios] that are about half their stock market [value]," says Deffarges. Stocks of traditional IOUs are trading at 40 percent to 50 percent of the S&P 500 index on average.

Once much of the undervalued business is spun off, creating new value, energy companies will forge new alliances to achieve economies of scale, he predicts. "Once many of these [IPOs and spinoffs occur], you're going to see some of them merging with each other so that eventually instead of having, I don't know, 50 or 100 companies with generation capacity in this country, we might have six or seven dominant players."

Before long, he predicts, just a half-dozen large power generating companies will serve the entire U.S. market, with 85 percent of total capacity traded over the Internet. Ten major distributors and a brigade of online energy retailers will offer an endless array of energy services tailored to the specific needs and desires of customers. Eventually the pipes and wires segment will follow the consolidation trend, with several large operators emerging during the next decade.

"It's already started, and as people see benefit from the instant valuation boost it gives us on the market, I think it's going to start happening a lot faster, so I'd say [we'll see consolidation in the generation and retail segments] in two to five years-which is light speed