What next? That seems to be the question on every utility executive's mind. After two years of stomach-wrenching ratings downgrades, agonizing downward valuations, embarrassing accounting scandals, skyrocketing gas prices, and positively stubborn mild weather, or the "perfect storm," as many have called it, many believe the worst is now over.
But will the the recovery be worth the wait?
On the plus side, the Northeast blackout of two months ago failed to slow the recent recovery. It came on the heels of a booming stock market, lower interest rates, and a strong winter heating season that helped utilities stabilize credit ratings and turn in a fairly strong second quarter. The dividend tax repeal added still more good news, helping to drive up the Dow Jones Utility Index by double-digit percentages.
If anything, the Blackout may give cover for power executives seeking to invest in infrastructure as part of a back-to-basics strategy.
Yet many executives still urge caution. Just ask Northwestern, which filed for bankruptcy in mid-September, or PG&E Corp., who at press time was dealing with the bankruptcy of its wholesale merchant unit, even as its regulated utility begins to emerge from insolvency, pending regulators' approval of the company's reorganization plan in December. Allegheny Energy, another investor-owned utility, was still flirting with bankrupty at last look. Analysts say the company has much to do to improve its balance sheet and restore investor confidence.
And others look deeper into the future to ask a basic question: What kind of growth will investors expect from a move back to basics? With interest rates now rising, utility stock dividends will face stiff competition from higher returns on fixed-income securities. Simply put, will a back-to-basics growth rate prove sufficient to keep investors interested in utility equities?
To find the answer, offers exclusive interviews with the chief financial officers (CFOs) from Southern (ticker: SO), FPL (ticker: FPL), TXU (ticker:TXU), and Northeast Utilities (ticker: NU), and with the chief executive officer of Aquila (ticker: ILA).
In those intereviews, Southern and FPL explain how they plan to grow earnings through unregulated wholesale operations, while NU, Aquila, and TXU, sobered by unregulated strategies that went sour, talk about their recovery and beyond.
From all of us at the , we hope you enjoy this year's finance forum.
Knit One, Purl Two:
Southern Sticks to the Business It Knows
Thomas Fanning, executive vice president and CFO, Southern Co.
When it comes to the issue of strategy, Southern Co. does not mince words; it's going to remain in the same stick-to-its-knitting, traditional, vertically integrated, low-risk business that it has always been in and has always known. Yet as the economy improves and new opportunities emerge many ask how does Southern know that stick-to-your knitting is going to be successful this next time around. Thomas Fanning, executive vice president and chief financial officer of Southern Co., offers an explanation as to Southern's strategic philosophy. "Do you know the old Sun Tzu saying, 'know yourself, know your enemy?'" he asks, quoting from the oldest and most prestigious texts on strategy and combat, Sun Tzu's, .
Fanning says that Southern's corporate philosophy spearheaded by the company's CEO, "is to know ourselves. We are who we are. We like to say we're genetically conservative. We like the low-risk end of the spectrum. We talk about our strategy in the super Southeast being the business we know, with the customers we know, in the place we know." Fanning says Southern plans to grow by 5 percent every year. Three of the 5 percent will come from the regulated retail business and the remainder of that 5 percent will come largely through the company's competitive wholesale generation business.
Furthermore, true to the company's risk-averse nature, even Southern's wholesale business will be low risk, he says. "I think one of the hallmarks of Southern is not only that we get attractive returns, but that we are arguably the lowest risk investment in the industry. And in fact the character of our competitive wholesale business is that we invest exclusively in assets that have long-term, bilateral, wholesale contracts with credit-worthy parties. All of them are investment grade, 90 percent are A-rated or above. And the weighted average duration of those contracts is over 10 years. As you look at it, it's a very sustainable profit picture. … We don't take fuel risks, we don't lay awake at night and worry about spark spreads, it's a very kind of safe, conservative, regular, predictable, sustainable business model."
Meanwhile, Fanning says Southern feels it has reached an economy of scale in its business that it needs to be successful and does not feel it would pursue growth through merger or acquisition. But Fanning does acknowledge the growth challenge when interest rates begin to rise. "Certainly the utility industry has historically benefited from rates that are declining rather than increasing. From an investment standpoint, when you go to this total return proposition of 5 percent yield, 5 percent share growth, you can compare the 5 percent yield state of investment in a long term treasury bond, and what we can say is that we'll give you the same with a little bit better yield that you would get buying a U.S. treasury and you get a growth option with our interest share growth." But he admits that, "to the extent rates go up, then that certainly would have a negative consequence to our ability to replicate an investment in U.S. treasuries as a yield investment."
Nevertheless, he doesn't think that Southern will respond to pressures to show significant differences in the company's growth strategy and he doesn't feel that there is any momentum for deregulation in the energy market in the Southeast that would change the company's core business plan. But curiously, Southern does have a small gas company competing in Georgia's deregulated gas markets. Is Southern planning for a day that it too must compete against others in the marketplace? Fanning says no. "The integrated electricity model will stay in that manner for a period of time. However, we want to keep kind of our finger on the pulse, on a real retail deregulated market. We think that's important. It's almost intuition for us. We learn lots of lessons in that market that we can translate over."
FPL Marries Wind, Wires
Moray P. Dewhurst, vice president, finance and CFO, FPL Group
FPL's CFO has seen it all. He remembers how a little while ago it was all about independent power or merchant players. Before that it was those utilities that had international strategies. In fact, if you look back far enough in history there has always been a utility strategy that was the flavor of the month. "It seems to me if you look at the utility business, now and again different business models become more or less in phase. They become almost fads at the moment," Moray Dewhurst says. As a result, FPL's CFO says, if you look at any given time at the highest P/E (price-to-earnings ratio) multiple company in the industry, that may not be the same company that has the highest P/E multiple five years from then or 10 years from then. "You don't want to be constantly striving to be the one outlier because in doing so you will force yourself into adopting a business model that ends up being risky and time based in not too long a period," he says. Especially, as the industry is fiercely competitive and opportunities for being significantly better than the competition are not huge, he says.
"Real success is defined as being a little bit better than the next guy and sustaining that over a long period of time," Dewhurst opines.
The way FPL plans to sustain its earnings growth, or go the distance as it were, is by maintaining its basic conservative approach to a business that balances steady returns with growth opportunities. "You have the traditional regulated utility at FPL and the great virtue there is stability [exhibiting 3 percent growth and producing 85 percent of earnings on a net income basis]. But to your point those businesses historically have tended to lag in terms of capital market performance during economic upturns. But that is one piece of the portfolio. Then, we also have the component at FPL Energy [that produces 15 percent of earnings on a net income basis] where because of the nature of the investments we made, not just the wind business, but also the merchant generation positions we have there. We have good upside leverage as the cycle starts to turn. That is certainly how we do differentiate ourselves," Dewhurst says.
Moreover, as the industry's biggest wind power developers, we asked what contribution that endeavor is contributing to the bottom line. Currently, wind represents less than a third of FPL Energy division earnings, but Dewhurst expects that contribution to increase over time. "The investment community [increasingly sees] the wind business as good solid incremental growth in a business where it difficult to find good sources of growth." Furthermore, part of FPL's growth plan to maintain its FPL Energy subsidiary's contribution between the ranges of 15 to 20 percent will also involve strategic acquisitions.
In fact, in late September, FPL Energy recently announced an agreement with British Energy LLC to buy its 50% ownership in AmerGen Energy, which owns three nuclear power plants totaling 2,480 MW. But don't expect the utility to go on a spending spree. "This company has a very strong record of financial discipline which we plan to maintain and that means when you are in an acquisition mode not overbidding for particular assets. So, you have to be firm in setting a price that gives you good economics and then being willing to stick with it. As a consequence, it is very hard to know how many of those opportunities there will be," he says. But even as utilities hope to grow their businesses during an economic upturn, Dewhurst reminds us of the reality that is the utility industry.
"What everyone has to remember about the utility industry, much as we might like it to be otherwise, it is as an industry likely to be a modest growth industry overall. Virtually everybody in this country has access to electricity, so we are not going to sign up a lot of new customers collectively. The industry has tried to innovate in terms of product design, but none of us have really yet shown that we can come up with new product forms that customers want to buy in the same way that, for example, cell phone providers have come up with all kinds of different ways of getting a higher share. The customer really wants from the utility industry in general is good quality, reliable, low-cost power. I think if we both here at FPL and in the industry focus on the basics, doing it well and doing it efficiently, then we can continue to offer a compelling value proposition for our shareholders. Where we as an industry have gotten away from that seems to be where companies got themselves in trouble."
Northeast Utilities Eyes Return to Growth
John Forsgren, vice chairman and CFO, Northeast Utilities System
If Northeast Utilities were likened to a prizefighter, the utility has had to take it on the chin on more than one occasion in the last few years. In the 1990s it was almost TKO'd, coming perilously close to bankruptcy due to the financial strain put on the company from the shutdown of its troubled Millstone nuclear complex.
Later, according to Raymond E. Moore, equity analyst at Shields & Co., "the company's three largest … ventures, including trading, retail, distribution and utility services … Those businesses (including parent expenses) lost money, lots of it, $70 million in 2002 ($0.54 a share). Traditional utility operations earned $222 million ($1.72 a share)." If this were not enough, Northeast Utilities in the last year, and in the coming year, will have to patiently sweat through the potential financial impact to its business from several regulatory proceedings. Hanging over the company are a series of disputes involving:
- Implementation of locational marginal pricing (LMP) in Connecticut;
- Major distribution rates cases in New Hampshire and Connecticut;
- Requests for approval of transmission projects;
- The status of power supply contracts between bankrupt NRG and the NU subsidiary Connecticut Light & Power Co. (CL&P); and
- The legal affair over the failed merger with ConEd.
Certainly, with all this financial uncertainty tied to the utility's various regulatory bouts, one might be forgiven for putting odds against the company. But John Forsgren, vice chairman and CFO at Northeast Utilities System, says it won't pay to bet against this company. "I think if you look at a probability analysis of all those issues and look at 2003 versus 2004 and the future, the probability is on balance that those things will come out more favorable to us than more negative. And even with very conservative assumptions in our planning, we look pretty well set to achieve very decent earnings growth," he says.
And Forsgren does have good reason to believe his company will be the one left standing after all is said and done, as financial conditions at the utility already appear to be improving. Northeast Utilities has been able to restore its competitive energy marketing subsidiary to profitability after several years of losses, Forsgren says. The utility's competitive subsidiary earned $11.9 million in the second quarter 2003 and $17.1 million in the first half of 2003, compared with a loss of $9.2 million in the second quarter of 2002 and a loss of $29.7 million in the first half of 2002.
Specifically, the turnaround is attributed to improved results in the wholesale business, the absence of energy trading losses, better performance in the retail energy and services businesses, and heavier precipitation in southern New England, according to company press materials. Not to put it mildly, Forsgren says the company is having a good year. In fact, the company was emboldened, as were financial markets, when the Connecticut legislature approved energy-related legislation in May that would allow an increase in electricity rates by up to 10 percent beginning in January 2004 and extends the transition period by three years to year-end 2006 for all electric distribution companies in Connecticut (the increase calculation excludes any federally mandated congestion costs).
Furthermore, Forsgren says that after dealing with the learning curve caused by the restructuring process, he feels the company is "properly structured to continue making money and to make money within a reasonable risk profile that the utility parent can live with." On the regulated side of the business his plan is to grow the rate base. "We cut rate base almost in half as we went through restructuring by selling off all of our generation. So now we're rebuilding rate base as we invest in transmission and distribution. Unfortunately, we are in a region that needs a lot of upgrading of transmission distribution so we have opportunities to invest. As we recover that investment we'll rebuild rate base and transfer that growth," he says.
On the unregulated side of the business, he sees opportunities for growth in going more aggressively into neighboring markets, i.e., New York and PJM. "We think retail is attractive. We don't have any plans to market at the residential level or even the small [commercial and industrial] level. We are a viable and potentially attractive business with large customers," he says. The utility CFO believes these plans will translate into high single digit growth for the company. To date investors seem to be taking the CFO's promises of future growth at his word. The price earnings ratio based on 2003 earnings is 13 times compared to 11 times for the typical integrated company.
This higher price might signal a comeback.
Aquila's Rise, Fall and Rebirth
Richard C. Green Jr., chairman, president, and CEO, Aquila
Not more than three years ago, the company known as Aquila was at its apex, a highly sophisticated and innovative go-getter that was revered as a staple of what was to be the new breed of power companies.
But the tables would turn on this once great disciple and progenitor of open markets. Caught in the violent credit crunch of 2002 that followed the Enron debacle, Aquila has grappled with billions in debt and hundred of millions in losses. On the brink of bankruptcy in October 2002, Aquila's board of directors called Richard C. Green Jr. back to the post of CEO. His mission: Save the company. And it has been with this singularity in purpose that Green has made the grimmest of choices.
In June 2002, the company makes plans to exit the merchant energy trading business and return back to the company's utility roots, which go back to 1917. In an instant, a merchant business that took Aquila 16 years to build, which represented more than half of the company's earnings at one time, would be severed like a cancerous tumor. Looking back, Green says he viewed no middle ground and believes Aquila could ill afford to ride out the credit crisis with its merchant subsidiary intact, as some utilities have tried.
"We were not willing to take the risk of betting on that option, which is a huge risk, I mean, you're betting the company … You don't have one foot in and one foot out … we needed to create liquidity to work through this because the transition meant we were taking a balance sheet for what was a $40 billion company and were ripping out more than half the cash flow, more than half the earnings, and reducing and still reducing that down to a balance sheet that will live around a seven-state utility. So you just needed to liquidate to pay down debt and manage liquidity through the restructuring," he says.
Certainly, the company's financial problems have been quite serious. According to the company's 2002 annual report, Aquila's bottom line for 2002 was a fully diluted loss of $12.83 per share, or a net loss of $2.1 billion on sales of $2.4 billion. Restructuring charges, impairment charges and net losses of sales of assets, losses with discontinued operations, and margin losses incurred during the wind down of the company's merchant portfolio contributed to the majority of the loss, the report said. Not to mention, "the company's credit ratings fell below investment grade, charges and impairment wiped out years of earnings, we suspended our quarterly dividend, and our share price fell by more than 90 percent," said Green, in the letter to shareholders section of the 2002 annual report.
In August 2003, Aquila reported a net loss for the second quarter was $80.6 million or $.41 per fully diluted share, including $14.5 million of net income from discontinued operations, compared to the 2002 second quarter net loss of $810.0 million or $5.69 per fully diluted share, which included $15.5 million in net income from discontinued operations.
Meanwhile, Green has been selling, selling, and selling billions in assets to restore his company to financial health in the last year. Green, who was interviewed in late July, said that the company had a debt level of $3 billion and planned to reduce it to the range of $1.2 billion to $1.5 billion. Of course, given the furious pace of asset sales in the last six months those numbers are constantly changing, he says.
Moreover, his plan is what he calls a, "clean and disciplined strategy the objectives are financial stability, business stability, built on credibility."
In an August 2003 shareholder update, Green said the company was working diligently to return to profitability after 2004 and that the company's short-term liquidity was sufficient to execute its restructuring plan and support continuing operations.
"We're going back to the Aquila group of 1995, 1996. … So when you think about some of your metrics there, [Aquila is] going back to being a regulated utility, so that means that whatever earnings you make will have a 10 to 12 multiple on them because it's a utility. We don't pay a dividend now but a regulated utility, I believe by definition, should pay one so that's something we'll begin to do when we [return to] profitability."
Shootout in Texas:
TXU Bites Bullet, Dices Dividend
Dan Farell, executive vice president and CFO, TXU
Will investors once again put their trust in TXU after last year? At 3:45 A.M., on Oct. 14, 2002, the utility's chairman in a surprise announcement revealed plans to slash its dividend by 80 percent and abandon its cash-strapped U.K. subsidiary, TXU Europe. According to press reports, the news also shocked investors, who were reassured only a week before that TXU had "ample funding for the strong dividend" and a strong commitment to its flailing European subsidiary. In other press reports, one financial analyst at the time, said, "they never even said they had a liquidity problem..."
Furthermore, much like the Watergate fiasco, to this day many still wonder what TXU executives knew and when they knew it. William J. Murray of Austin, who was a senior vice president in TXU's energy-trading unit, recently claimed he was fired last year for complaining about the company's financial disclosure practices, and alleges that TXU executives knew about potential multibillion-dollar losses in TXU's European operations three months before disclosing the problem to investors, which caused the company's shares to plunge. TXU heatedly denies this. Erle Nye, the utility's CEO, has reiterated the company discovered the magnitude of its European troubles only in September of 2002.
Whoever is to be believed, the damage has already been done. TXU paid dearly last year for its failure in Europe, taking $4.2 billion in charges in the fourth quarter of 2002, primarily to write off its struggling European business. Not to mention that on the day of the Oct. 14 announcement, the ratings agencies downgraded the company and Wall Street crushed the stock, pushing it down 46 percent to a decade low of $10.10, according to press reports. Plainly, investor confidence has fallen to a historical low.
That is perhaps why the task of putting the pieces back together and winning investor confidence back will be up to a new management. Dan Farell, named executive vice president and CFO of the company in February 2003, will be one of the new faces investors will see, joined soon by a new CEO who is to be announced between two board meeting scheduled for August and November. TXU's new chief is expected to take the reigns full time possibly at the 2004 annual meeting.
As for Farell, he seems to be a straight shooter. He has a clean-cut plan to restore TXU. "Our strategy for this year and next year is to deliver on our plan to reduce costs within the business substantially, to defend our leadership position, and to strengthen the balance sheet. Those are very simple financial goals for this two-year period. Any thought of getting into a growth mode will follow this two-year financial strengthening program that we are on," he says.
On that score, Farell has raised billions to pay down debt. The company has stated that it plans to reach a total debt-to-capital ratio of 53 percent by the end of the year. Not to mention, Farell plans to grow earnings in the coming year.
"We would hope to see a growth of 4 to 6 percent on earnings per share. We'll do that. I think we know where that growth will come from. It will come through organic service territory growth both in Texas and Australia. It will come through improving the financial performance of our gas business. We have a gas rate case underway right now that should payoff for us next year. We'll be making more investments in our transmission grid, and we will be reducing debt. Those will be the near term drivers of growth," he says, confidently. For 2003 fully diluted earnings from operations will be in the range of $2 to $2.10 per share, the company has stated.
Meanwhile, in the two areas of Australia and Texas, TXU seems not to be concerned about the competition or losing market share. Its financial gains in those territories appear to bolster the utility's claims that it's a savvy player in competitive markets.
"On the regulated business [in Australia], demand growth we are seeing is 2.8 percent in power and gas growth is 3.7 percent. That is physical demand growth. We combine that with the ability that we have demonstrated this year to actually compete effectively in the market for customers who have choice for their energy supplier, and that is where the 8 percent customer growth comes from," Farell says.
In fact, Farell says Australia's contribution to the bottom line is "on the order of $70 million in after tax U.S. dollars. That is about 10 percent or so of our total earnings guidance for this year." In late September, the company said it was considering a partial float or initial public offering in 2004 of its Australian subsidiary to pay down debt and help fund growth.
As for Texas, TXU believes that the customer attrition rate will be below the 5 percent the company had earlier stated. "I think that was with the realistic view that we were the largest retailer in the market. I think the recent results would suggest that we are performing favorably against that expectation. I think our cost position is such that we are well positioned to secure some customer growth outside of our conventional area," he says. Certainly, of TXU's growth plans, it will be deeds and not words that matter.
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