Business & Money

An analysis of the strategic implications of the re-basing of power and utility industry valuations.

Over the past several months, traditional valuation levels have re-emerged in the power and utility industry, with recent premium valuation metrics compressing significantly. This re-basing of industry valuations at levels more supportable by historical benchmarks and fundamental considerations of long-term growth and total return follows a two-year period of significant dislocation in the power and utility industry (and broader financial markets), during which dividend yield emerged as the primary value driver.

As considerations of growth begin to re-emerge in power and utility valuations, the industry again is confronting its historical dilemma: how to achieve long-term earnings growth that outstrips the intrinsic regulated utility growth profile of 1 to 3 percent. Following the collapse of the myriad of non-regulated growth platforms that precipitated recent industry-wide dislocations-most notably merchant energy-many utilities are again focusing on perhaps the most viable, broad-based and credible growth strategy: mergers and acquisitions.

Value-Dislocating Factors

Over the past two years, historical valuation parameters and metrics were dislocated by a unique confluence of economic, market, and industry-specific factors. The recession beginning in 2001, the post-bubble market collapse, and the overhangs of post-9/11 terrorism and war materially affected the general economy and equity markets. These factors triggered a classic "flight-to-safety" phenomenon in the capital markets, with utility securities and their perceived bond-substitute characteristics serving as a specific and traditional beneficiary.

This bond-substitute dynamic was enhanced by several other unique circumstances, further fueling industry valuations. First, the return proposition of utility equities relative to government securities became exceptionally compelling following the decline in interest rates to historic lows, with power and utility industry dividend yields outstripping the benchmark 10-year Treasury yield on an absolute basis over much of the period (see Figure 1). The 2003 dividend tax cut further improved the relative yield proposition of utility dividends to government securities on an after-tax basis. Second, at least initially, the financial difficulties affecting much of the power and utility industry constricted the universe of utilities that had the fundamental "safety" attributes to qualify as viable "bond substitutes." Investment, as a result, was concentrated still further, driving a limited set of high yielding, "safe" utilities to exceptional premium valuation levels.

During this period, utility valuations trended to historical premium levels, with the Lazard Core Utility Index trading between 14x to 15x on a one-year forward P/E basis, markedly in excess of historical trading levels of only 11.5-12.5x and only marginally below the 15.2x P/E median of historical utility acquisitions, which traditionally reflect a 20 to 30 percent premium to public market trading levels (see Figure 2). Select high-yielding, "safe" utilities (i.e., utilities with highly regulated earnings streams and unregulated exposure) commanded even superior valuations, with such utilities as Ameren, Cinergy, and Southern trading at highs over the period of 16.5x, 16.6x and 17.8x, respectively.

Emergent Valuation Re-basing Factors

Recently, however, traditional economic factors, stabilizing market dynamics, and industry valuation orthodoxies appear to be re-emerging, re-basing the industry's valuations on more fundamental and sustainable principles of long-term growth,