Can utility executives find happiness in back-to-basics?
We've read the pitch a number of times in these very pages. Top investment bankers have told us that a "back-to-basics" strategy will never produce a high-enough return to please electric utility stockholders; that the only solution to bridge this "earnings gap" would involve a rash of mergers and acquisitions (M&A) between utilities.
What's more, those bankers warned us that if utilities didn't act fast, they would see their investors lured away by the promise of higher-yielding, fixed-income securities.
After the roller-coaster thrills of the past decade, can utilities ever go back to their traditional role as slow-and-steady performers, with equity performing more or less as a bond equivalent? Or, will the analysts' warnings prove prophetic: that fickle investors will turn their backs on companies that remain happy to stick to the straight and narrow path?
So far, this year has proven no different. The financial community continues to question the concept of success without growth, yet some experts still appear willing to defend the traditional utility vision of slow-and-steady.
I can think of no better example than what I saw just two months ago, as the debate played out at Exnet's annual M&A conference, with the adept title, "Can Mergers and Acquisitions Close the Growth Gap?" held at New York City's Plaza hotel in late January.
A Bit of Growth, for Now
The doom and gloom of the growth-gap appeared to be overshadowed by the extraordinary financial performance turned in by electric utilities over the past year. For the first time in decades, the major utility indexes have been outperforming the S&P 500. That was the most oft-quoted statistic at the conference, by bankers and utility executives alike.
A second piece of good news was the structural shift in the valuation of utilities on Wall Street, brought about in large part by the dividend tax repeal. But as the taxman giveth, the bond trader may taketh away, at least according to Credit Suisse First Boston's Jonathan Baliff, who offered a rather off-putting prediction for the coming year.
Baliff gave pause to many in the hotel audience with his prediction that for 2005, "P/E multiples of utilities [would] decline 10 percent as dividends lose the battle with interest rates." He drew his conclusion from his findings that dividend payout ratios alone explained 21 percent of the variation among price-to-earnings (P/E) ratios in 2004, but that Treasury rates explained 34 percent of the P/E ratios. In other words, interest rate hikes from Alan Greenspan's Fed could likely put utility equities under water for 2005.
Yet Baliff's report that ample credit was available to utilities in the booming institutional loan market, and that traditional banks were again lending large amounts, gave reason for others to believe that the industry's best days might still lie ahead. That's why many executives, speaking to me on the condition of anonymity, expressed skepticism that mergers could be a panacea for the industry's future financial concerns.
Sure, interest rates are worrying, they said, but given that the industry has refinanced most of its debt at lower rates, the worry has now receded somewhat.
Last year, in our June issue, AEP CEO Michael Morris argued that the historical tie between utility stock valuations and interest rates should be put to bed.
"I think that tie isn't needed anymore," said Morris.
"That really is a historic tie that had so much to do with the building of a $4 billion power plant in the face of borrowing funds at kind of interest rates."
Furthermore, utility execs were skeptical because a successful merger is anything but easy to carry out. The so-called M&A answer, they said, would be difficult if not impossible to achieve in some cases, given the significant number of regulatory approvals and intense scrutiny associated with such transactions.
Many utility executives believe public policy issues will drive whether a regulator signs off on a merger deal. Even Jeff R. Holzschuh, head of the Global Energy and Utilities investment banking group at Morgan Stanley, predicted that, at best, two mergers greater than $10 billion would be announced in 2005, and perhaps two international acquisitions. So the notion that a wave of mergers is coming could be held by only the most optimistic banker or CEO.
Attorneys from LeBoeuf, Lamb, Greene and MacRae, a sponsor of the Exnet M&A conference, made clear the obstacles to clients:
"The primary motivating force in favor of strategic mergers," the firm says, "will be the pressures to find new sources of earnings growth but, as always, there will be countervailing pressures."
According to the LeBoeuf attorneys, regulatory uncertainty will give pause to potential M&A deal makers: "Where companies are contemplating rate cases in the near future, management may well decide to forgo merger discussions until after rate issues are resolved and valuations are more certain."
Lingering Doubts, for the Long Term
Nevertheless, even as executives at the meeting saw the promise of modest gains for the coming year, it was painfully clear to many that the electric utility industry will see precious few growth options over the long term.
Today, after having lost billions, investors say (and so do the now-risk-averse directors at the utilities themselves), that they will not support unregulated growth initiatives, such as merchant power, energy trading, international ventures, telecom investments, or adventures in retail competition.
Yet the temptation is always present and cannot be dismissed entirely.
Paul J. Bonavia, president - Commercial Enterprises at Xcel Energy, took the Exnet audience through the industry's missteps in insurance and banking during the 1980s, and then through the all too familiar merchant years of the 1990s. In the end, he framed the utility executive's growth dilemma perfectly.
"We are back to our utility executive, who has had a flirtation with banks, insurance, and has gone off to China and got a certificate in [Guangdong] Province to build a coal plant, or bought something exciting in Argentina or Australia.
"Management is still looking for the Holy Grail. What do you do? We're going to be plain-vanilla utilities."
He said utilities would have no choice but to focus on rate-base investment to grow the business, and he took issue with bankers in earlier panels that said back-to-basics growth wouldn't do. Bonavia pointed out that when comparing a utility index to the S&P 500 over a 50-year period, one of the most interesting insights one finds is that the utility index and the S&P 500 are almost congruent (one right on top of the other).
"Over time utilities have performed just as well as the broader index," he says. "In times when the S&P 500 is booming, utilities lag. When it is lagging, utilities lead," he says.
From the standpoint of at least one utility's management, there is no crisis that necessitates a merger. "We are not dealing here with some crying need that has to be filled. It's a pretty healthy business. [If] we stick to our basic game plan, we'll do just fine," he says.
But he acknowledged that some utility executives will become tired of plain vanilla and will look to M&A. "Looking at the 1980s, 1990s and 2000s … eventually, they all got restless and looked in new directions, and I think the industry in this decade will as well."
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