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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

In fact, no one should necessarily be blamed for failing to predict this current cycle. However, I do believe that advisors to the sector share some responsibility for pushing the 'flavor of the month' to such an extent as they did over the past few years in the industry. This is particularly the case when one takes into account the unproven nature of the unregulated marketplace at the time these structures were developed."

Culling Excess Debt

The credit crisis has forced utility executives to revisit capital structure. The financial community is now discussing what model is holding up best.

At Morgan Stanley, McGinnis believes that merchant players should have less than a 50 percent debt-to-capital ratio, and that utilities ought to be around 50 percent to conform to the current credit environment. Most bankers privately concede that ratings agencies and lenders are pushing for a 50 percent ratio. Of course, the 50 percent debt-to capital ratio is not new to utilities. It's a step back to the past.

During the 1960s and 1970s, Schreiber recalls the ideal cap structure was thought to be 50 percent debt, 15 percent preferred stock, and 35 percent common stock.

"I would argue today that 50 percent is probably still a good number, but the preferred component is way too high. If you have any preferred at all it should more appropriately be in the range of five percent of total capitalization.

"The circumstances during those decades were that you could not sell all the common stock that was needed to support capital expenditures. That was the primary reason why preferred ratios reached such heights," Schreiber says.

Moreover, to reduce their debt to 50 percent debt-to-capital, Schreiber says utilities are still going out and selling stock to shore up the balance sheet, even if it may dilute other shares.

"If you need to raise common-and most of these companies do-just do it. It's best to figure that you will dollar average over a period of time, because this is not going to be the last common stock offering that you will ever do," he says.

He recalls the 1970s, when utilities were forced to issue massive amounts of common stock to support credit ratings in the face of large capital expenditure programs. Internal sources of funds were woefully inadequate and companies, in some cases, experienced up to 20 percent dilution as a result of such equity sales.

But at Lazard, Bilicic warns that utilities shouldn't obsess on preserving credit ratings-especially when it comes to the sale of core assets, and the ratings agencies themselves have trouble giving an accurate assessment of credit risk in the merchant sector.

"Executives could be making business decisions in response to reactions from ratings agencies that are not necessarily rational," he points out.

Bilicic also advises utilities not to risk the company's long-term health to boost short-term liquidity.

"Avoiding the pressure to divest core assets is a big challenge for companies that are looking to solve liquidity problems, because some of the most saleable assets are those assets that provide the greatest