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Capacity Value Trap

Are merchant power assets overpriced?

Fortnightly Magazine - December 2011

The concept of the value trap is an old one. Warning against buying assets simply because they have declined steeply in value, Richard Wyckoff, a stock market authority of his day, warned in 1924 that “there are a great many times when a security will decline in market price while its intrinsic value and earnings power are shrinking even more swiftly.” The question arises: have assets declined in price because investors over-reacted and shied away from risk unduly, or because the underlying discounted value of future cash flows has decreased markedly?

The current market for U.S. merchant electricity assets brings this question to life. On some measures, merchant-oriented companies and power plants look like a bargain. This is particularly true when they are compared to regulated utilities. When investors swam collectively toward the relative safety of dividend-paying, regulated utilities, the prices of regulated companies and assets rose relative to their merchant peers. Between late 2008 and mid-2011, regulated utility shares became significantly more expensive; they moved from trading at approximately 11 times their trailing earnings to around 16 times trailing earnings. 1 This paralleled equity investors’ tendency to award heightened valuations to industries that are less sensitive to the vagaries of the North American economy, such as consumer staples, healthcare, and agriculture. Very low-risk fixed income instruments such as investment-grade bonds also did well. And investors did extremely well in such commodities as gold and silver, which provided protection against inflation—much like the cash flow streams of regulated utilities that will, by regulatory formula, rise with along with inflated costs or nominal interest rates. In contrast, valuations of shares in generation companies with merchant-oriented assets, such as GenOn, Dynegy, and Calpine, fared far less well over this period. This trend paralleled declines in riskier and small-cap shares generally. Typically, a wave of negative investor sentiment of the type witnessed in late 2008 and early 2009 will disproportionately affect valuations of young, small, non-dividend paying, distressed companies. 2

The trend of regulated-oriented companies being bid up compared with merchant-oriented companies also played out in the corporate M&A market. Diversified utilities largely adopted regulated-centric strategies in the period between late 2008 and 2010. PPL acquired regulated utilities in Kentucky ($8 billion) and the UK ($6.5 billion) pursuing a “strategic objective of achieving a much heavier weighting of rate regulated earnings and cash flow.” 3 PEPCO divested the Conectiv merchant fleet to “reposition PHI as a fundamentally regulated company.” 4 Dominion announced it was embarking on a “transformation into a more regulated company,” and PSEG sold its Texas merchant assets. 5 NextEra announced it would sell some of its merchant fleet.

And other regulated utilities maintained a steadfast focus on expanding their