Business & Money
The utilities industry is in need of more equity.
Regulated utilities, in response to increased risks and bond downratings, have de-leveraged their capital structures. According to preliminary figures from the Edison Electric Institute (EEI), in 2003 utilities cut their short-term debt by more than half compared with 2002. The EEI data also reveal that for 2003, electric utilities issued more than $10 billion of new common equity and repurchased just slightly more than $100 million of common stock. Value Line projects that total capital for electric utilities will increase about 12 percent during the next several years, while common equity will increase nearly 28 percent. Similarly, natural gas distribution company total capital is projected by Value Line to increase about 10 percent, while common equity is projected to increase close to 15 percent. For both industries, the median common equity ratio in the near-term future for companies with investment-grade rated subsidiaries is in the range of 51 to 52 percent.1
Common Equity
For utilities, higher equity ratios are desirable for several reasons.
Higher equity ratios enable utilities to offset some of the increase in business risk by lowering financial risk. Higher equity ratios give utilities flexibility in issuing new debt (or preferred stock) when needed without unbalancing the capital structure. While much attention is paid to the amount of leverage a company employs, utility management must be concerned with the amount of debt not in use. This reserve of unused debt capacity is important because it allows utility management to issue new debt in an orderly manner or to accommodate larger than anticipated issuances of debt.2 Since utilities have an obligation to serve, they cannot sit out adverse market conditions and wait for a more favorable economic environment. Other things being equal, the higher the equity ratio, the higher will be the debt interest coverage. Higher coverage would tend to lead to higher bond ratings and a lower cost of new debt. A thicker equity ratio provides a bigger base over which a decline in earnings can be spread. Other things being equal, a higher common equity ratio would reduce the leverage effect on the capital structure and make a company's common stock earnings performance more predictable, and thus less risky. Other things being equal, the higher the common equity ratio, the lower the risk of ruin (i.e., bankruptcy). While bankruptcy was only a remote possibility for most utilities in the past, it has become a more threatening specter over the past several years. Even in the absence of an immediate threat of bankruptcy, a higher equity ratio can generally help cushion a company if its financial situation deteriorates. A downward change in the common equity ratio will have a much more significant impact on the required rate of return for equity than an equivalent percentage point upward change in the common equity ratio because of a non-linear relationship between the common equity ratio (, common equity as percent of capital) and the cost of common equity.3 For example, let us assume a company that has 50 percent common equity, 50 percent debt, and a beta of 0.70. Using the Hamada decomposition formula presented on page 30, if this company's common equity ratio went from 50 percent to 70 percent, its re-levered beta would decrease to 0.54 from the beginning 0.70 level-a decline of 0.16. In contrast, if this company's common equity ratio were to be lowered to 30 percent-a change in common equity ratio of 20 percentage points-its relevered beta would increase to 1.07-an increase of 0.37 from the beginning 0.70 level. Thus, changes in the cost of equity relating to changes in the common equity ratio are not symmetrical-something that regulators have to consider in evaluating capital structure decisions.
A second factor to be aware of is that many of the common methods used to estimate the cost of equity (e.g., discounted cash flow and capital asset pricing model) use market prices, either directly or indirectly, in their equity costing approaches. Since the price-book ratio for most utilities is well in excess of 1.0, this means that the financial leverage captured by these approaches may be less than the book-value-based leverage applied by regulators for setting rates.4
Preferred Equity
There are two types of preferred stocks employed by utilities-"traditional" preferred stock and "trust" preferred securities. Trust-preferreds are a hybrid security comprised of a preferred stock and a debt security. The great majority of preferred stock outstanding for utilities is now of the trust-preferred type. Recent accounting changes call for deconsolidation of certain trust-preferred securities, but with the debt element being recorded on the balance sheet as part of long-term debt. In addition, what previously had been identified as preferred dividends from trust preferreds is now categorized as interest expense. Rating agencies, such as S&P, now include trust-preferred balances as part of total debt and trust-preferred "dividends" as part of interest expense that must be covered in the coverage ratios calculated. This transformation of most preferred securities into a near-debt equivalent is an additional reason why utilities have to thicken the common equity component of their capital structures.
Debt
Because utilities are both capital intensive and have an obligation to serve, it is important that they have investment-grade debt. Debt rated below that level often is regarded as having speculative characteristics and is accorded the sobriquet of "junk bonds."5 While spreads between different ratings of investment-grade bonds are often in the 10-50 basis point range, the spread between the lower levels of investment grade debt and the higher levels of junk bonds are often in the 50-250 basis point range. Once a company is downrated to the junk level, it takes a long time to make its way back into investment-grade category.
There is a possible confounding effect when capital structure theory is applied to a regulated utility. For an unregulated firm, if the debt ratio is increased, the tax savings (flowing from the tax deductibility of interest payments) go to the common stock investors. For a regulated company, in contrast, the tax savings go to ratepayers. Thus, a lowering of the common equity ratio for a utility would mean an increase in risk to utility common stockholders without them being able to enjoy the concomitant tax savings from which the common stockholders of unregulated companies benefit.
In examining capital structure issues, per books capital structures of utilities are not taken at face value by the financial community. For example, rating agencies exclude securitized debt balances and the associated interest payments from leverage and coverage calculations. In addition, bond-rating agencies take into account both capitalized leases and long-term purchased power obligations in their analyses by imputing additional debt for the capital structure ratios and additional interest for coverage calculations.
It is important to note that S&P recently indicated that it regarded purchased-power obligations as riskier than under its former assessment and was establishing new, tougher standards relating to its evaluation of such obligations.6 S&P suggested that to recognize the effects of purchased power upon capital structure, utilities either incorporate more common equity in their capital structure, request higher returns on existing common equity or obtain an incentive return mechanism for economic purchases.7 The implications of debt-equivalence of purchased power contracts is especially important for transmission and distribution companies. Because such companies no longer have the balanced capital structure and cash flow related to their generation assets, but now merely have a debt imputation related to purchased-power contracts, this could have a significant effect on both the leverage and coverage ratios of such companies. As S&P indicated in the statement cited above, utilities have to be proactive and offset the negative impacts of purchased power contracts in such instances.
The Need For More Equity
Given the increase in utility business risk and the other factors discussed above (, the transformation of most preferred equity into a near-debt-like element of the capital structure, the increase in the amount of purchased power, etc.) the need for more equity and lower leverage is apparent. The forecasts for electric utilities and gas distribution companies indicate they are moving their capital structures in a direction of incorporating a thicker amount of common equity. Such increases in the equity ratio are well warranted under the circumstances.
Endnotes
1. Value Line figures are for the parent companies; in many instances individual operating companies have even higher common equity ratios. The Value Line data exclude short-term debt.
2. Examples of factors leading to unanticipated issuances of debt include increases in deferrals due to spikes in fuel costs, increases in bad debt expense and, at the extreme, emergency expenditures in response to a terrorist attack.
3. In contrast, there is a linear relationship between the debt/equity ratio and the cost of equity.
4. Surveys have indicated that textbooks as well as most financial advisers and corporations employ market-based weights in evaluating capital structure decisions.
5. Five-year default rates for investment-grade bonds are generally 1 percent or less, while the parallel default rates for junk bonds are generally in the 5 to 10 percent range.
6. See Standard & Poor's May 8, 2003 report entitled "'Buy Versus Build': Debt Aspects of Purchased Power Agreements."
7. Also see Robert Rosenberg, "Purchased Power: Risk Without Return?," , Feb. 15, 1996, p. 36.
Utility Business Risk:
The business risks of many utilities are increasing. Restructuring uncertainty, fuel price volatility,1 the need for extensive capital expenditures for infrastructure improvement, the incurrence of large deferral amounts during a period of capped rates, potential increases in interest rates,2 the requirement for significant environmental expenditures that raise costs but not output, the threat of terrorist activity, and, in some instances, risky provider-of-last-resort responsibilities all contribute to this heightened risk. The rating agencies, recognizing increased utility risk, have responded with significant bond downratings over the past few years. Standard & Poor's still lists nearly 40 percent of the electric utility industry as having a negative outlook; in sharp contrast, very few electric utilities have a positive outlook.
Business Versus Financial Risk
Financial analysts often dichotomize the risk of a firm into business risk and financial risk. Business risk reflects the operating risk of the firm and, in particular the risk that net operating income will not be as expected. Financial risk reflects the additional risk imparted to the firm by the presence of fixed-payment capital (i.e., debt). A firm can control, to some extent, its overall level of risk by adopting a more conservative capital structure (i.e., using more common equity) if its business risk is increased. Other things being equal, the more debt a company has, the greater financial risk for both common stockholders and debt holders. This is simply because debt represents a fixed cost that must be paid under any circumstance, or else a company may, in the extreme instance, be subject to bankruptcy.
It is nearly universally agreed that investors require a higher rate of return for an investment in the common equity of a company than they do in its debt. This is so for two important reasons. First, if an enterprise fails, debt holders have priority over equity holders as to the remaining assets of the company. Second, for an ongoing business, debt holders must be paid their contractual level of interest before equity holders can receive anything. Because of this basic fact of financial life, companies may reduce their dividend payments to equity holders when under some financial strain. The cessation of payments to debt holders is a much more rare occurrence and will usually result in bankruptcy, unless corrected. In summary, debt is thought to be less risky than equity because debt holders have priority over equity holders as to: (1) distribution of assets in the case of dissolution of the company; and (2) distribution of earnings in the case of everyday operations.3 Because equity holders "take second," they require a higher return than do debt holders.
In a more formal academic sense, employing the CAPM model, there are two indications why leverage leads to risk. First, beta is derived by dividing the covariance of market returns and the returns on the stock in question by the variance of the market. The covariance in the numerator, in part, reflects the standard deviation of returns of the stock in question. If a company takes on additional leverage, then its standard deviation of returns is likely to increase, thus leading to an increase in the measured beta as a result of the additional leverage.
The second way to demonstrate the risk-increasing effect of leverage is by using Robert Hamada's well-known decomposition of beta, shown below:
BL = Bu + Bu (1-T) D
The above formula indicates that as the amount of debt (D) increases compared to the amount of equity (E), the levered beta (BL) that we measure in the market will increase. In this formulation, the unlevered beta (Bu) represents the operational risk of the company in the absence of leverage-i.e., it is the pure business risk of the company.
There is evidence that, over time, common stockholders have, in fact, earned a higher rate of return than have bondholders. Ibbotson Associates indicates that over a long period of time, common stocks have earned a market return more than 6 percentage points greater than long-term corporate bonds. Clearly, common stockholders have earned a significant premium as compared with bondholders.-R.G.R.
Endnotes
1. 1. See, for example, Standard & Poor's August 12, 2004 report entitled "Rising Coal Prices May Threaten U.S. Utility Credit Profiles."
2. This is of special concern given that The Value Line Investment Survey of May 14, 2004 indicates that a significant proportion of many utilities' long-term debt is variable rate.
3. Common stockholders absorb all of the earnings variability, even though they provide only some of the capital of a firm. For example, if a write-off is required, it is charged to the retained earnings component of common stockholders' equity. Common stockholder risk is exacerbated due to the effects of leverage. If a company is financed 50 percent with equity and 50 percent with debt, common stockholders would absorb all of the write-off-that related to their proportional share of capital and also that related to the debt share of capital. Using the above hypothetical company as an example, if such a company were required to write off 20 percent of its capital, 40 percent of its common equity would be lost. Thus, leverage magnifies the write-off that common stockholders have to absorb. The presence of leverage causes similar fluctuations in earnings levels flowing from cash flow variability unrelated to write-offs too.
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