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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

cash flow and credit support to the company," Bilicic adds.

Overall, bankers still favor the holding company model, with regulated and unregulated arms operating as subsidiaries. But Wall Street cautions that utilities must keep the two sides in balance. Bankers say both regulated and unregulated companies like Southern Company, TXU, Dominion, FPL, and Entergy performed relatively well under the circumstances. But some believe that Duke Energy's unregulated operations are much too large in relation to the regulated side.

Beyond that, McGinnis cites efforts to reduce short-term borrowing.

"There has been a move," he notes, "to extend the duration of their liability curve by going into the capital markets and raising longer-term debt to reduce reliance on commercial paper and its attendant rollover risk. One of our larger clients will be in the market shortly doing $1 billion in long-term debt financing, which is part of that trend. They are seeking 10, 15, even 30-year maturities, and will get attractive all-in rates."

Turning Sour on Growth

In the wake of Enron, accounting scandals, and earnings restatements, many investors are no longer interested in hearing about utility growth. Investors have just lost confidence, bankers say.

"The cloud hanging over the entire market is that the investors are just unsure that the numbers are telling them what the numbers are telling them," Schreiber adds.

In fact, the way utilities discuss growth will have to change.

"An investor today will typically discount a story that includes growth as the primary objective. If true return on invested capital is actually used as a key measuring criteria for a corporation's investment activity, then the investor will reward that corporation," McGinnis says. Today, what investors want is financial strength and steady earnings. Gone are the days where investors are expecting, or willing to believe, projections of 20 percent annual returns, he notes.

Caren Byrd, executive director at Morgan Stanley, says that a more realistic total return target is about eight to 10 percent, which incorporates yield plus growth. But a 10 percent return will only be achieved by a combination of regulated and unregulated operations, and asset acquisitions that make sense.

"They have to have the in-house capabilities to manage the assets that they are taking on," adds McGinnis.

He offers some advice: "Buy a pipeline, but only if you know how to run a pipeline. Buy a merchant power portfolio in the Pacific Northwest, but only of you get it at the right price and you know where you are going to sell the power.

"The market will not tolerate adventurism by integrated utilities in a large way in the energy-trading sphere," he adds.

Instead, says McGinnis, the investor interest is now coming from the value players.

"There is an implicit valuation hurdle that companies will have to go through to attract new money to their name. That new money will need to come from other funds. It will probably be value-plus growth. The return of the growth guys would be ideal, but it is going to be some time because they have been roundly disappointed."

But this