The unbundling of services and companies in the electricity and natural gas industries have created unprecedented opportunities to reinvent the traditional integrated utility model, with a broader array of attendant risks and rewards. But this past year was clearly one of retrenchment and strategic soul searching, allowing an opportunity to re-examine the sector for winning business formulas.
Our prior research over the restructuring period of 1998-2002 showed that the modest yet steady profits of companies with a high degree of rate regulation easily won out over flash-in-the-pan step-out strategies. Companies like Exelon and Southern Co. reigned, while companies like Aquila and Dynegy faltered. A return to regulated roots ensued.
This year, relying upon the same financial metrics we used in this earlier investigation, the current study focuses on the shareholder returns for 66 companies in the energy value chain that are listed in the Fortune 1000.
Figure 1 illustrates annual shareholder returns from 1999-2003. This time frame is long enough to capture the impacts of strategic decisions and investment cycles that take years to unfold. The companies are arrayed according to five-year performance, grouped by quartiles. Based on shareholder return and an examination of the basic differences in the business models of these companies, several observations emerge.
During the five-year period, the median annualized shareholder return for the entire group of companies was 4.7 percent, a notable increase over last year's 2.6 percent five-year return, reflecting both improvements in the stock market in general and fewer significant losses announced in the 2003 fiscal year compared to 2002. As much as energy and utility companies have been maligned in the industry and financial press, the group of 66 companies has actually outperformed the broader market. Over the five-year period, the mean group return of 1.8 percent has outpaced the Standard and Poor's average annual return of (0.6) percent. The reality is that many of these companies have provided favorable returns during a period of turmoil in the broader market, particularly over the negative market years of 2000-2002. The surprise has been the business failures from this previously trustworthy sector.
There were six companies that scored in the top quartile for each of the five-year, three-year, and one-year periods ending Dec. 31, 2002, but none achieved that triple-play in 2003. Indeed, the vast majority of this year's top-quartile one-year performers are last year's laggards, a group composed primarily of energy merchants. Three of the top five in annual returns included The Williams Companies, Dynegy, and AES. This shift in performance is evident in the ranking of top-quartile returns, shown below in Table 1.
Last year's results listed Exelon Corp., Western Gas Resources, and UGI Corp. as the leaders of the five-year, three-year and one-year shareholder return categories, respectively. This year's winners in those categories are Western Gas Resources (5-Year: 53.7 percent), UGI Corp. (3-Year: 32.4 percent) and The Williams Cos. (1-Year: 265.7 percent). Exelon fell off the top of the leader's list primarily because its five-year performance no longer includes 1998-a stellar year for its shareholders-when the company successfully positioned itself for deregulation. The Williams Companies took over from UGI Corp. as the leader in the one-year return category because of Williams' meteoric recovery from near disaster in 2002.
Portfolio management theory dictates that greater risks should yield greater returns. The portfolio combinations of risks and returns that optimize these trade-offs are on the "efficient frontier." The same analysis can be applied to corporate business models. Figure 2 illustrates the risk and reward profiles represented by the universe of 66 companies in our study. The chart compares average shareholder returns for the group against the volatility (or risk) of those returns. Moving from left to right on the chart implies greater risk and, therefore, the expectation of higher earnings. In fact, however, many of the higher risk companies have provided significantly lower returns.
The overall shareholder return winner for the period, Western Resources, achieved a 54 percent average annual return with a 16 percent level of risk (standard deviation in monthly shareholder return). Calpine returned 9 percent to its shareholders over this period, but that was coupled with a 28 percent risk quotient. Moving to lower levels of risk, an investor could have achieved 10 percent to 23 percent average returns at 7 percent to 10 percent levels of risk with the group of companies centered in the northwest quadrant.
Of these, an investor might prefer UGI's 23 percent return and 7.4 percent risk, or New Jersey Resources' 12 percent return and only 4.3 percent risk. Companies with lower returns or higher risks are simply less attractive-unless, of course, their business prospects are not reflected by their past performance.
The group of companies that delivered top-quartile five-year annualized shareholder returns is dominated by diversified energy companies. Last year's report highlighted the enduring contributions from regulated returns. This year, only five of the 17 top-quartile companies derived more than 75 percent of their revenue from regulated operations (Entergy Corp., Southern Co., PNM Resources Inc., Keyspan Corp., and Piedmont Natural Gas Co.). Diversification is paying off, or at least it is not overwhelming solid results from regulated operations.
This year, companies with significant natural gas operations were clear leaders in the 5-year average annual return category. This group includes companies with natural gas exploration and production, and distribution businesses. Clearly, those companies with upstream investments have benefited from the sustained increases in natural gas prices. Western Gas Resources, a company with operations concentrated in natural gas exploration and production, led the five-year shareholder return category with a 53.7 percent annualized performance, as shown in Table 2. Overall, companies deriving 50 percent or more of their revenue from natural gas operations earned a median return of 5.9 percent, compared with the 4.7 percent group median. Table 2 also shows that many companies with proved oil and gas reserves were among the top performers in 2003, averaging a 6.7 percent five-year average annual return (8.7 percent if The Williams Cos. and El Paso Corp. are removed).
Companies with substantial foreign investments continue to be plagued by those choices. Of the top six companies in terms of revenues from international operations, four have been bottom quartile, providing negative shareholder returns. Responding to these challenges, many companies have reduced their international exposure over the past year. Some recent international withdrawals include TXU Corp.'s exit from its retail electric and gas businesses in the UK and Australia, El Paso's withdrawal from its Czech generation business, and Duke's sale of its Asia-Pacific assets. Nevertheless, PPL Corp. and Sempra continue to perform well even with their international investments, perhaps owing in part to each company's solid base of domestic regulated utility operations. Table 3 (p. 32) shows some reduction in international exposure but belies the fact that most of the recent sales of international operations are still included as discontinued operations in the 2003 financial statements.
This past year was one of de-leveraging for U.S. energy companies, following the debt binge that accompanied diversification and expansion in the 1999-2002 period. Figure 3 illustrates the total cycle.
Last year, we saw a strong correlation between overleveraging and negative five-year shareholder returns. That correlation holds for this year as well, as shown in Table 4.
However, we note the significant progress made by Allegheny Energy Inc., AES Corp., Centerpoint Energy Inc., and Edison International to improve their balance sheets over the past year. Most of this progress was accomplished through asset sales, with Allegheny selling generation and other non-regulated businesses, and AES raising over $700 million through the sale of CILCORP and several international generating facilities, for example.
Return on Invested Capital (ROIC) continues to be an excellent indicator of a company's ability to provide sustained long-term returns to shareholders. ROIC is a more stable measure of financial performance than shareholder returns since it depends on earnings and not on volatile stock prices. Table 5 () shows that the consistent ROIC performers primarily have been the natural-gas-oriented companies. This may be attributed to three factors: the avoidance of the troubled merchant investments of their electric peers, the relative stability of their regulated gas distribution businesses, and the upside from investments in upstream natural gas operations.
FPL Group is the only company without substantial natural-gas operations to make the list of companies returning top-tier ROIC. FPL has benefited from the state of Florida's consistent stance of not deregulating its electric markets, which perhaps, combined with a performance-based rate plan put in place in 2002, has provided returns at a premium to peers. Also, FPL's merchant energy strategy has been relatively conservative, representing less than 10 percent of 2003 total revenue.
The utility sector, once characterized by a homogeneous group of vertically integrated companies, has morphed into a group of energy companies with divergent business strategies. Financial performance of the group, in aggregate and across companies, has been volatile over the past several years. Clear winners and losers emerged from this era of restructuring.
The five-year shareholder return numbers illustrate that companies with strong regulated enterprises, accompanied by upstream investments in oil and gas, have surpassed their peers. Companies focused on the natural gas businesses in general have outperformed their electric peers. Diversification has begun to pay-off for shareholders. Six of the top-quartile companies possessed oil and gas reserves. Only five of the top-quartile companies derived over 75 percent of their revenues from regulated businesses. However, those without stabilizing regulated core franchises have suffered. Of the merchants in the group, only Calpine has managed to show positive shareholder returns during the period.
Losing companies include those that have been slow to extract themselves from the merchant energy morass, those who gambled and lost in international markets, and those still smarting from over-leveraged balance sheets. Regulatory risk and unresolved litigation also have been detrimental.
A twist in these conclusions is that today's relatively pure-play regulated utility may be a winner only by virtue of not losing in the latest round of alternative step-out strategies. These companies may prove to be tomorrow's losers by not demonstrating significant growth potential. This is because today's energy investors want it both ways: As alternative investments become more attractive, a safe regulated return is welcome, but it may be overshadowed by competitors with well-conceived growth strategies.
Diversification has been a double-edge sword for the industry. Merchant strategies in general have not paid off over the past five years, while investments in the upstream have. Clearly, these results are subject to market cycles. Upstream returns may have neared their peak, while the merchant segment of the business may have hit its near-term trough.
We believe low single-digit returns are unsustainable for the sector in the long run given that the average cost of capital for this group of companies is near 10 percent. We expect three trends to emerge from what we perceive to be an imbalance between risk and reward for shareholders. First, some companies will continue to retrench around core regulated enterprises, stabilizing lower-risk returns. Those in favorable regulatory climates, with underlying service area growth and efficient operations, are likely to outpace their peers. Second, growth-oriented diversified companies will emerge with somewhat more volatile but higher sustained earnings. Lastly, specialized non-diversified companies (such as merchants) will eventually capture substantially higher returns during market cycle upside swings, but it remains to be seen if the risk/reward trade-off will eclipse that of their peers.
Five-year returns of the group will therefore migrate to approach double digits within three years as the 2002 trough becomes a starting point for recovery for the troubled merchants. The group average will, however, continue to reflect strategic choices by individual companies out of sync with market and regulatory forces that frame the winning business formula.
The restructured energy market affords more opportunity for both success and failure on a going- forward basis.
1. Includes companies listed in the "Energy," "Pipelines" and "Utilities: Gas and Electric" industries of the 1000 index as compiled on April 5, 2004, excluding Adams Resources & Energy, Hawaiian Electric Industries, Kinder Morgan Energy, TransMontaign, Plains All America Pipeline, Ferrell Gas Partners, Enbridge Energy Partners, USEC, and Oglethorpe Power (not comparable business models); and Mirant (insufficient stock price history).