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The Fortnightly 40

Fortnightly Magazine - September 2008

report similar plans, along the entire length of the energy value chain, in both regulated and unregulated business areas.

“Our current growth plan is focused on exploiting our mineral acreage position in the Appalachian basin,” says David F. Smith, president and CEO of National Fuel Gas Co., ranked number 3 in this year’s F40. “For our pipeline and storage segment, along with the $180 million Empire Connector that we’ll put into service in November 2008, we have more than $1 billion worth of infrastructure additions on the drawing board.”

In addition to focusing companies’ attention on new construction and other capital investments, the Big Build is affecting key financial metrics for companies in the F40.

The most obvious example is free cash flow (see Figure 7) . As a group, the F40’s cap-ex budget exceeded operating cash flow in 2007, resulting in negative free cash flow—the first time that happened in the three-year reporting period. But it won’t be the last time—and as a result, free cash flow is becoming a less important measure of company performance.

Similarly, dividend yields have tightened for many companies—especially those with the largest cap-ex budgets, and those whose unregulated earnings have grown to dominate their balance sheets.

“Our earnings have been roughly 50 percent from merchant sales and 50 percent from the wires business,” Farr says. “It looks like in 2010 and beyond our earnings will be more like 75 percent merchant and 25 percent wires. As that happens, we’ll evaluate our dividends in light of other growth opportunities, and seeking to maintain our solid investment-grade credit rating—which is an extremely important asset.”

PPL isn’t alone. Lower dividends have developed a significant correlation with higher shareholder value as measured by the F40. Excluding the anomalous El Paso Electric—which paid no dividend in 2007—a company’s rank in the F40 shared a 0.4 inverse correlation with its dividend yield compared to other companies in the ranking (See Figur 3) .

“This is explained in part by the fact that when stock prices go up, dividend yields go down,” Azagury says. “But there’s also a negative correlation between dividend yield and return on invested capital, which seems to show two things. First, the market isn’t rewarding higher dividend yield, and second, the companies with higher dividend yield seem to be the ones with fewer opportunities to invest capital in ways that drive returns.”

Of course earnings growth and dividend yield traditionally distinguish one type of stock from another, and utilities historically have been considered dividend investments. That seems to be changing in the current business cycle, and the inverse correlation between dividends and overall returns seems likely to become more pronounced as the Big Build proceeds. “The gap in dividend payouts between top-10 and bottom-10 companies will be exacerbated in a high capital-investment cycle,” Azagury says.

How long unregulated earnings will continue to drive returns—and therefore lower dividends—depends on factors that are difficult to predict. Nevertheless, dividend yield—like free cash flow—is becoming decidedly less reliable as a measure of power and gas company performance, at least