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Business & Money

Sticking to the Knitting:
Fortnightly Magazine - March 2005

expense of growth potential." 4

Will Back-to-Basics Have Legs in 2005?

Some industry observers have disparaged the back-to-basics strategy as a non-strategy or a short-term solution to excess debt. However, our analysis of the performance of the Traditionalist group suggests that these assertions are not correct. Companies that have always emphasized and focused on their regulated utility businesses have created shareholder value and largely have avoided the down-cycle that many other companies experienced during the period of turmoil surrounding Enron.

But surprisingly, this Navigant Consulting analysis also has validated the strategies of Skeptic companies. In rejecting both "gravity" earnings growth associated with a focus on the regulated utility business and the excesses of the Convert group, Skeptic companies have demonstrated an ability to create shareholder value. As the industry now enters the fourth year of the back-to-basics era, the question is, What strategy makes sense in 2005 and beyond? To answer this question, it is helpful to reframe the question and ask it within the context of a tradeoff between risk and return. The focus by Traditionalists on their core utility businesses is not without risk. Yet the risk is less than focusing on an integrated energy value chain (like Dominion) or building a national retail energy business (like Constellation Energy). Next, the concept of return must be linked to earnings growth. Without earnings growth, a company cannot increase its dividend; and without some increase in the dividend (, without some earnings growth) sustainable share price increases will be difficult. In theory, the attraction to investors of the less-risky Traditionalists' strategy is played off against slower earnings growth-yield vs. appreciation in share price.

So for 2005, here is the question: Will investors reward companies that follow less-risky Traditionalist strategies with modest earnings growth, or instead favor those companies in the Skeptics camp that pursue more aggressive strategies linked to achieving strong earnings growth? We may have seen an early answer for 2005. In late December, Exelon announced it was merging with PSEG. While some observers have pointed to industry consolidation as a driving force for the PSEG acquisition, in fact, the primary rationale behind utility M&A is to pursue earnings growth through scale and scope.

With the distinct possibility that we are seeing an improving economy and rising interest rates, utilities will feel pressure to deliver earnings growth beyond the average of 2 to 3 percent. After a decade of cost-cutting, it will be difficult for utilities to achieve significant long-term earnings growth merely through a strategy of increasing efficiency. Also, for most, growing the rate base and a steady diet of rate cases will not provide the answer to the challenge of achieving significant, sustainable earnings growth.

Hybrid Strategy

In a sense, M&A is a hybrid strategy. It reflects the Traditionalist strategy because of its focus on achieving scale and wringing efficiencies out of the regulated utility business. But it also reflects the perspective of the Skeptic strategy. That is, an M&A strategy represents a rejection of "doing nothing" when it comes to growing earnings. The utility industry went through significant