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Utility Valuation: Shedding Light on the Black Box

Experts debate how energy companies should be valued in the wake of electric restructuring and Enron.
Fortnightly Magazine - April 15 2002

 

Experts debate how energy companies should be valued in the wake of electric restructuring and Enron.

How should you value a diversified energy holding company with regulated and unregulated subsidiaries? How should you value a pure play merchant generation developer, an electric utility distribution company, or a stand-alone vertically integrated utility? Which is the good investment and what's the ideal energy corporate model?

Furthermore, should energy companies continue to pursue accelerated growth strategies, or avoid it by focusing on the regulated (and some say safe) stable earnings?

Ever since electric restructuring began in the mid-nineties, industry executives, mutual fund managers, Wall Street equities analysts, and ratings agencies have been struggling to find the answers.

Over the last half-decade, the energy industry has experimented with spinning-off its generation, or transmission, or distribution, or an entire subsidiary. Some companies have gone into energy trading, merchant development, or have taken a more retail focus. Others diversified into energy technology development, telecommunications or pursued international holdings. And still others decided to continue having a hand in all these businesses. Finally, some companies decided they were happy being vertically integrated regulated utilities and stayed out of the game altogether ().

Of course, observers say that all this wheeling and dealing has turned once very predictable and transparent companies into black boxes that some energy executives, financial analysts, and investors do not fully understand. This, of course, is not a new problem.

Oddly, the current perceived mess in valuation stems from the previous attempt to qualify and quantify deregulated utility businesses. As early as 2000, Wall Street and others were advising utilities to spin-off or carve-out their unregulated subsidiaries to give financial transparency to analysts covering the sector and potential investors.

Those bankers and analysts, from investment banks J.P. Morgan, Deutsche Bank, Morgan Stanley and CIBC World Markets, told the in March 2000, that it was difficult to evaluate the earnings growth number because it was difficult to evaluate a given energy trading or merchant subsidiary when paired under a holding company structure with a regulated utility.

Furthermore, many bankers complained that energy-trading or merchant operations results were poorly reported by the holding company. They explained that's why the holding company received a modest price-to-earnings (P/E) ratio. The P/E earnings ratio is the price of a stock divided by its earnings per share.

The P/E ratio, also known as a multiple, gives investors an idea of how much they are paying for a company's earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

During the 2000-2002 periods, many of the companies that carved-out their merchant activities did earn higher P/E ratios from investors than diversified utility holding companies.

Then, the California crisis and the Enron debacle happened, introducing new wrinkles to how the market valued these companies. The energy merchants discovered they were captive to investors' impressions of the supply picture. The whole industry was penalized for being involved in the same business as Enron, although their corporate structures and debt situations, in most cases, were

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