Business & Money
Sticking to the Knitting:
A review of three years of post-Enron stock performance by electric utilities.
Immediately following the Enron collapse, investors dumped the stock of any electric power company that appeared to be pursuing non-traditional growth strategies. Any company that emphasized unregulated businesses-investments in overseas assets, merchant power plant development, and energy marketing and trading-was suspect. In response, these companies and the overall industry turned to the back-to-basics strategy, refocusing on core, regulated utility businesses.
But some companies never had to go "back-to-basics" because they never left. Other companies went against the back-to-basics trend and continued to pursue a growth agenda.
As we end the third year of the back-to-basics era, what does the performance track-record for the industry look like? What were the key performance drivers for the most successful players? Do certain nuances of the back-to-basics strategy appear more successful than others, and why?
To answer these questions, we considered the performance of 57 electric companies. To examine the impact of alternative strategies on investor performance, we grouped these companies into three categories:1,2
Recent Converts. In response to a massive sell-off by investors and pressure from rating agencies, companies in the Convert category turned from their growth strategies and adopted a back-to-basics strategy.
Long-Time Traditionalists. Even if they had unregulated businesses, companies in the Traditionalist category always emphasized their utility businesses in terms of capital investment, management attention and focus, and positioning with investors.
The Skeptics. Without exception, companies in the Skeptics group have utility businesses focused on running well. However, these companies have not abandoned more aggressive earnings growth targets and have continued to focus on opportunities associated with investments in non-regulated businesses. For each of these groups, we considered the performance measured in terms of total shareholder return (TSR)-dividends plus change in stock price.
The 2004 Performance Story
After a major slump in 2002, the electric utility industry has largely re-bounded, with much of the value creation coming from the Convert group. Over the past two years, 2003-2004, total shareholder return for the set of 57 companies was 66 percent, whereas the S&P 500 index returned about 10 percent. In 2004, top performers were primarily Converts ().
From Dec. 31, 2001, through Dec. 31, 2004, this set of 57 companies created almost $101 billion in shareholder value in connection with an overall 29 percent return over the three-year period. This compares favorably to the S&P 500 index, which returned only 6 percent during this period. However, as expected, during this period,3 the differences among the three groups' performance were significant.
Although the Convert group as a whole created enough value to more than make up for its precipitous declines in stock prices during the period surrounding the Enron collapse, the statistic is misleading. Overall, the group created enough value to get back to where it started, but this was largely due to the success of three companies (out of 15): Exelon, TXU, and Edison International. Excluding these three companies, the group lost an average of $1.1 billion over that time period. The other companies either posted large losses that have yet to be fully recovered or barely broke even. Of greater interest, the Skeptics group outperformed companies in the Traditionalist group.
Most of the growth in shareholder value for the Skeptics group came from stock price appreciation, while only about 21 percent of the growth came from dividends. For Traditionalists, a larger proportion of growth (33 percent) came from dividends, though most of the value creation came from stock price appreciation. To better understand the relative performance of the groups, we analyze the performance of each group in more detail.
Recent Converts: True Believers or Biding Time?
Recent Converts were companies whose growth strategies (before 2001) were generally viewed as being in the same market sector as Enron. Around the time of Enron's bankruptcy filing, investors rejected these stocks and sought companies with "safer" strategies. We can differentiate among the strategies pursued by the companies in the Convert group, including:
Wholesale trading or unregulated generation operations. Of course, wholesale trading operations were most closely connected with Enron, and "asset light" wholesale marketers such as Dynegy and Aquila were among those companies that were hit the hardest during the 2001-2002 period.
International investments. As losses from international assets continued to drag down utility earnings, the investment community began to realize that utilities had greatly overspent on many of these assets. The share prices of some companies, such as AES and CMS, fell steeply because of losses related to their businesses in the troubled South American markets. TXU suffered when the U.K. wholesale power markets dried up. Overall, investors sold the stock of just about any utility with a significant international portfolio, regardless of the quality of those assets.
Investments/development of merchant power plants. The glut of gas-fired merchant power plants led to the collapse of wholesale power prices. Merchant portfolios were suddenly worthless. Even companies with large, stable core utility businesses were hurt by their exposure to merchant plants-for example, Duke Energy and Exelon.
In general, companies that underperformed the sector were those that invested most in asset-light strategies, such as wholesale trading. Enron's collapse had less of an impact on companies with asset-heavy trading operations, such as Duke. Companies that focused on international investments were seen as risky-though for reasons somewhat unrelated to problems that investors had with Enron's business model.
In response to the market sell-off in the 2001-2002 period, coupled with increased pressure from rating agencies, most of these companies converted. They announced that they would sell their unregulated businesses and assets, exit international ventures, and shut down energy marketing and trading activities. Going forward, their strategy would go back-to-basics by focusing on regulated utility operations. However, for these Converts, the shift to back-to-basics has delivered mixed results to date ().
Certain companies in the Convert group were winners for a range of reasons. Key elements that determined which Converts were able to restore shareholder value may include the following:
The ability to more rapidly restore the balance sheet by selling valued assets (, AEP); The extent to which balance sheets were not unduly leve- raged (, Exelon, Edison International); and The impact of new management in restoring investor expectations (, TXU, Duke Energy).
Perhaps the most significant difference in the performance in this group is the role played by strong regulated electric utilities at the core of the overall revenue engine. Enough bad investments can sink a company (as in the case of TECO Energy), while strong utilities saved companies like Xcel, AEP, Edison International, and Exelon.
Regardless of the impact of these factors, it is unlikely that some of these Convert companies will ever gain back the valuations enjoyed before the back-to-basics era.
Traditionalists: Safe and Not Sorry?
During the late 1990s, investor and media attention focused on aggressive earnings growth strategies tied to merchant power plant development, wholesale power marketing, and international expansion. However, most electric utilities continued to emphasize a traditional regulated business despite (or because of) its low-growth, low-risk business model. For these companies, there was no "back" in back-to-basics because they had never abandoned a "basics" strategy.
Traditionalists did create a fair amount of total shareholder value for the 2001-2004 period-with the average company registering a 22 percent return. A few companies stand out among Traditionalists, but most performed within the range of 20-40 percent.
Most of the best performers enjoy favorable regulatory conditions and protected markets, and primarily low-cost coal or nuclear generation portfolios. Transmission and distribution-focused companies, such as Energy East, also have performed well, helped by high allowed rates of return and new customer growth.
One of the best performers was Southern Co., which created almost $10 billion in value during this period and has emerged as one of the top U.S. utilities in terms of market capitalization. Southern has benefited from its good relations with state regulators and a large low-cost baseload portfolio. More important, having previously spun off its unregulated wholesale generation and trading business (Mirant), Southern avoided merchant business exposure.
Skeptics: Often Wrong, Never in Doubt
Companies in the Skeptics group have continued to execute growth strategies based on expansion of non-regulated businesses. Although these companies have strong utility operations, the overall message made by management to investors has not focused on the utility business. The Skeptics' message centers on a soup-to-nuts natural positioning throughout the entire natural gas value chain that emphasizes oil and gas exploration and production (in the case of Dominion Resources), or the creation of a critical mass of retail energy customers in competitive markets throughout the United States (in the case of Constellation Energy), or the continuation of a broad base of energy and non-energy commodity marketing and trading activities (in the case of Sempra). Skeptic companies generally have adopted the message contained in remarks by Mayo Shattuck, the chairman, president and CEO of Constellation Energy, who said, "In order to realize our growth objectives, Constellation departed from the conventional strategies prevalent in our sector … while some of our peers are restructuring their operations to recreate the old utility model. While 'back-to-basics' is viewed as a strategy of safety, earnings certainty is achieved at the expense of growth potential."4
Will Back-to-Basics Have Legs in 2005?
Some industry observers have disparaged the back-to-basics strategy as a non-strategy or a short-term solution to excess debt. However, our analysis of the performance of the Traditionalist group suggests that these assertions are not correct. Companies that have always emphasized and focused on their regulated utility businesses have created shareholder value and largely have avoided the down-cycle that many other companies experienced during the period of turmoil surrounding Enron.
But surprisingly, this Navigant Consulting analysis also has validated the strategies of Skeptic companies. In rejecting both "gravity" earnings growth associated with a focus on the regulated utility business and the excesses of the Convert group, Skeptic companies have demonstrated an ability to create shareholder value. As the industry now enters the fourth year of the back-to-basics era, the question is, What strategy makes sense in 2005 and beyond? To answer this question, it is helpful to reframe the question and ask it within the context of a tradeoff between risk and return. The focus by Traditionalists on their core utility businesses is not without risk. Yet the risk is less than focusing on an integrated energy value chain (like Dominion) or building a national retail energy business (like Constellation Energy). Next, the concept of return must be linked to earnings growth. Without earnings growth, a company cannot increase its dividend; and without some increase in the dividend (, without some earnings growth) sustainable share price increases will be difficult. In theory, the attraction to investors of the less-risky Traditionalists' strategy is played off against slower earnings growth-yield vs. appreciation in share price.
So for 2005, here is the question: Will investors reward companies that follow less-risky Traditionalist strategies with modest earnings growth, or instead favor those companies in the Skeptics camp that pursue more aggressive strategies linked to achieving strong earnings growth? We may have seen an early answer for 2005. In late December, Exelon announced it was merging with PSEG. While some observers have pointed to industry consolidation as a driving force for the PSEG acquisition, in fact, the primary rationale behind utility M&A is to pursue earnings growth through scale and scope.
With the distinct possibility that we are seeing an improving economy and rising interest rates, utilities will feel pressure to deliver earnings growth beyond the average of 2 to 3 percent. After a decade of cost-cutting, it will be difficult for utilities to achieve significant long-term earnings growth merely through a strategy of increasing efficiency. Also, for most, growing the rate base and a steady diet of rate cases will not provide the answer to the challenge of achieving significant, sustainable earnings growth.
In a sense, M&A is a hybrid strategy. It reflects the Traditionalist strategy because of its focus on achieving scale and wringing efficiencies out of the regulated utility business. But it also reflects the perspective of the Skeptic strategy. That is, an M&A strategy represents a rejection of "doing nothing" when it comes to growing earnings. The utility industry went through significant consolidation during the 1990s. Numerous old-line utility names like Central & Southwest, Northern States Power, Philadelphia Electric, GPU, and NYSEG are no longer around. Entering 2005, maybe that's what a back-to-basics strategy will be-a return to M&A and industry consolidation.
2. To be included in this analysis, a company had to provide electric power services to regulated energy end-use customers. We excluded those companies that had an equity market capitalization of under $500 million, as well as companies in the midst of bankruptcy proceedings. Also not included are companies that have not been publicly traded for this observation period of 2002-2004.
3. A 10-year view provides a context for these returns: For the period 1995-2004, the S&P 500 returned a total of 212 percent versus the electric power industry return of 173 percent.
4. Jan. 30, 2004, Q4 2003, Constellation Energy Earnings Conference Call, Mayo Shattuck, chairman, president and CEO, Constellation Energy Group, Inc.
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