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Interest Rates Strike Back

The old paradigm—a strong inverse correlation of high interest rates and lower utility valuations—once again takes hold.

Fortnightly Magazine - June 2006

and dividend yields correspondingly declined, notwithstanding that since January 2003 the 10-Year Treasury yield has increased from less than 4 percent to, until very recently, approximately 4.5 percent (creating the anomalous positive power and utility industry P/E-to-10-Year Treasury yield correlation of 0.33 noted above) (s ee Figure 1 ).

However, this period of “elasticity” between the 10-Year Treasury yield and the power and utility industry’s dividend yield theoretically should persist only until the point where these respective yields re-base at the adjusted yield ratio of approximately 0.76x, at which point they should again fluctuate in-line and negative industry value correlations should re-emerge. This point appeared to be reached in late January 2006, as the 10-Year Treasury yield increased sharply to approximately 4.6 percent. 3 With the power and utility industry average dividend yield then at approximately 3.5 percent, the yield ratio for the first time since January 2003 approached the implied adjusted yield ratio of 0.76x. Since then, as historical metrics adjusted for the effects of the dividend tax cut would suggest, the power and utility industry average dividend yield and the 10-Year Treasury yield have sustained at approximately the adjusted yield ratio ( see Figure 3 ).

Just as important, the corresponding negative correlation between the 10-Year Treasury yield and power and utility industry valuations re-emerged and has been 0.81 since late January, in line with pre-Dividend Tax Cut correlations (with the negative correlation increasing to 0.91 since April 1). By comparison, during the previous several-month period, there was no such meaningful correlation. As a result, with the 10-Year Treasury yield increasing to approximately 5 percent, the industry’s average 2006E P/E ratio has compressed from above 14.5x to below 14.0x currently ( see Figure 4 ).

Implications for Utility Valuation

This re-correlation of interest rates and industry valuations has several important implications for the power and utility industry. First, industry valuations likely will be challenged to expand significantly above current levels absent a decline in interest rates or some other value catalyzing event. If interest rates continue to rise, power and utility valuations may experience incremental compression. As a result, notwithstanding a particular utility’s success in executing on its plan and delivering projected earnings growth, it may nonetheless realize declining shareholder value over the short term unless it is able credibly to deliver earnings growth sufficient to outstrip the negative value effects of potential multiple compression.

Second, with the dividend-yield component of many utilities’ total return propositions no longer having an after-tax advantage relative to Treasury yields, investors may focus increasingly on a utility’s earnings growth proposition as a value differentiator, both on an absolute and relative basis. Utilities therefore may pursue potential growth-enhancing opportunities more aggressively to sustain shareholder value, including unregulated investment initiatives, merger transactions, or a combination of both.

Third, this new interest-rate environment has important implications for capital structure and capital-return considerations. Utilities should revisit their total return propositions to make sure that their dividend policies are calibrated properly for this likely higher, and value-correlated, interest-rate environment. For those utilities pursuing equity issuance or repurchase initiatives, a