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Winners and Losers: Utility Strategy and Shareholder Return

Diversified companies lead (and the globals lag) over the past five years.

Fortnightly Magazine - October 2004

has morphed into a group of energy companies with divergent business strategies. Financial performance of the group, in aggregate and across companies, has been volatile over the past several years. Clear winners and losers emerged from this era of restructuring.

Winners

The five-year shareholder return numbers illustrate that companies with strong regulated enterprises, accompanied by upstream investments in oil and gas, have surpassed their peers. Companies focused on the natural gas businesses in general have outperformed their electric peers. Diversification has begun to pay-off for shareholders. Six of the top-quartile companies possessed oil and gas reserves. Only five of the top-quartile companies derived over 75 percent of their revenues from regulated businesses. However, those without stabilizing regulated core franchises have suffered. Of the merchants in the group, only Calpine has managed to show positive shareholder returns during the period.

Losers

Losing companies include those that have been slow to extract themselves from the merchant energy morass, those who gambled and lost in international markets, and those still smarting from over-leveraged balance sheets. Regulatory risk and unresolved litigation also have been detrimental.

A twist in these conclusions is that today's relatively pure-play regulated utility may be a winner only by virtue of not losing in the latest round of alternative step-out strategies. These companies may prove to be tomorrow's losers by not demonstrating significant growth potential. This is because today's energy investors want it both ways: As alternative investments become more attractive, a safe regulated return is welcome, but it may be overshadowed by competitors with well-conceived growth strategies.

Diversification has been a double-edge sword for the industry. Merchant strategies in general have not paid off over the past five years, while investments in the upstream have. Clearly, these results are subject to market cycles. Upstream returns may have neared their peak, while the merchant segment of the business may have hit its near-term trough.

We believe low single-digit returns are unsustainable for the sector in the long run given that the average cost of capital for this group of companies is near 10 percent. We expect three trends to emerge from what we perceive to be an imbalance between risk and reward for shareholders. First, some companies will continue to retrench around core regulated enterprises, stabilizing lower-risk returns. Those in favorable regulatory climates, with underlying service area growth and efficient operations, are likely to outpace their peers. Second, growth-oriented diversified companies will emerge with somewhat more volatile but higher sustained earnings. Lastly, specialized non-diversified companies (such as merchants) will eventually capture substantially higher returns during market cycle upside swings, but it remains to be seen if the risk/reward trade-off will eclipse that of their peers.

Five-year returns of the group will therefore migrate to approach double digits within three years as the 2002 trough becomes a starting point for recovery for the troubled merchants. The group average will, however, continue to reflect strategic choices by individual companies out of sync with market and regulatory forces that frame the winning business formula.

The restructured energy market affords more opportunity for both success and