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Reign of the Bond Kings

S&P, Moody's, and Fitch tell why credit issues now rule the energy sector.
Fortnightly Magazine - October 15 2002

with using a debt-to-capital ratio [to set an ideal capital structure for energy merchants] is because we have a low degree of confidence in the earnings that are being reported, which translates to a low degree of confidence in the equity the companies ultimately reports," Diaz says. "So using debt-to-capital becomes almost meaningless.

"The other part of the equation is that the debt the companies are showing on the balance sheet is not the entire picture, because there are a lot of off-balance sheet vehicles that have been used to acquire assets. The closest picture [to understand a company's capital structure] that we can generate is cash flow to debt," adds Diaz. But even that number would depend on how risky the business profile is, he says.

Barone concurs. He sees no ideal capital structure that ratings agencies are looking at; it all depends on the risks the company is taking. "There is nothing ideal from a credit rating perspective. You could be 80 percent leveraged and still have an A-rated company if the cash flow that was being brought in was sufficiently strong enough to cover the debt that you have."

In fact, as he explains, the credit rating agencies don't focus primarily on capitalization and debt leverage ratios. Instead, it is cash flow coverage of interest and cash flow coverage of total debt that plays a key role. The agencies look also at business risk, financing flexibility, and internal funding, he adds.

Regulated utilities also carry risk, Barone says.

"There are some regulated companies that face challenges because the regulated environment that they find themselves in is not as forgiving as it once was. Sierra Pacific and Nevada Power found themselves buying power at high prices and they didn't get recovery." But those companies are the exception, he says.

"Most utilities collect from one million ratepayers whose credit is pretty good on a whole. Uncollectibles usually count for one and one half percent of total revenue, if that. That is stable cash."

Growth Engine: Has It Sputtered?

The growth engine in the utility industry will probably be a more regulated business, says Barone. "You will probably see continued consolidation of both the merchant sector and the regulated sector, depending on the outcome of the repeal of the Public Utility Holding Company Act."

Barone believes that there will be fewer players tomorrow than there are today. "Everybody talks about the oil and gas companies, the banks, the Europeans. Who knows who is going to come in and sweep these firms up?"

Notwithstanding all this, Hunter contends that utilities will always be in trading-whether it is seen as trading or not.

"Utilities will have to have a trading function. Utilities have had a trading function for decades. Then there is a debate of whether you want one that looks after the native load and trades around that and then does a few trades for price discovery, or do you want to make a material business out of it," he says.

Look at some companies that have substantial generation capacity under contract like