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Storm Clouds Forming

The coming cash flow and dividend stress at America’s electric utilities.

Fortnightly Magazine - May 2012

Awareness is growing that the U.S. government’s fiscal, tax, and monetary policies over the past decade have significantly affected the underlying health of numerous industries, most notably in the mortgage banking, housing, and health care sectors. Policy missteps have often created perverse incentives to make specific investments that obscured an industry’s economic well-being or swamped its future financial performance. There’s now a growing concern that similar patterns might be at work in the electricity industry and might portend negative impacts on dividends and cash flows in the coming decade.

At issue is the quality of earnings and cash flows. While there’s no strict definition of earnings quality, its fundamental principle is sustainability. More specifically, are the utility’s earnings and cash flows repeatable? Are they controllable? Are they bankable?

Repeatability is the first test. Do the earnings and cash flows result from permanent increases in revenue or improved expense patterns, or are they the result of special circumstances— e.g., one-time asset sales, special or temporary tax benefits, temporary shifts in expenses across periods, etc.? Controllability is the second test; it assesses management’s role in realizing financial results. Were improvements the result of management action, or simply the benefit of uncontrollable factors— e.g., interest rate or currency exchange changes—that are beyond management’s control. Bankability is, of course, the ultimate test. Do the improvements result in real cash flows the companies can “take to the bank” and pay shareholders.

Earnings Paradox

For the U.S. electric utility industry, assessing the quality of cash flows begins with a straightforward analysis of the primary sources and uses of funds. As a mature, asset intensive business, the vast majority of the industry’s investments— i.e., the predominant uses of funds—are made from its cash flow from operations (see Figure 1) . As expected, during the period 1997 through 2010, the nation’s investor-owned electric utilities (IOU) made cumulative investments equal to 102 percent of their cash flow from operations. The small differences in the industry’s net new cash requirements were realized from financing activities such as new debt and equity obligations.

Like all capital intensive industries, the U.S. electric power sector has enjoyed the benefits of declining interest rates. The total annual interest expense for the industry’s 66 IOUs has remained substantially unchanged over the past decade at about $22 billion, despite a 25 percent increase in the total indebtedness since 2005 (see Figure 2). The industry’s great debt refinancing wave of the past few years helped lower the industry’s effective interest rate by more than 19 percent from its peak in the past decade in 2005. These reduced costs have benefited electric systems and consumers alike. Not unlike the nation’s homeowners who found themselves able to buy much larger homes through falling interest costs during the heyday of low mortgage rates and easy terms, the nation’s utilities and their customers gained more modern, valuable assets at lower overall cost.