Experts debate how energy companies should be valued in the wake of electric restructuring and Enron.

How should you value a diversified energy holding company with regulated and unregulated subsidiaries? How should you value a pure play merchant generation developer, an electric utility distribution company, or a stand-alone vertically integrated utility? Which is the good investment and what's the ideal energy corporate model?

Furthermore, should energy companies continue to pursue accelerated growth strategies, or avoid it by focusing on the regulated (and some say safe) stable earnings?

Ever since electric restructuring began in the mid-nineties, industry executives, mutual fund managers, Wall Street equities analysts, and ratings agencies have been struggling to find the answers.

Over the last half-decade, the energy industry has experimented with spinning-off its generation, or transmission, or distribution, or an entire subsidiary. Some companies have gone into energy trading, merchant development, or have taken a more retail focus. Others diversified into energy technology development, telecommunications or pursued international holdings. And still others decided to continue having a hand in all these businesses. Finally, some companies decided they were happy being vertically integrated regulated utilities and stayed out of the game altogether ().

Of course, observers say that all this wheeling and dealing has turned once very predictable and transparent companies into black boxes that some energy executives, financial analysts, and investors do not fully understand. This, of course, is not a new problem.

Oddly, the current perceived mess in valuation stems from the previous attempt to qualify and quantify deregulated utility businesses. As early as 2000, Wall Street and others were advising utilities to spin-off or carve-out their unregulated subsidiaries to give financial transparency to analysts covering the sector and potential investors.

Those bankers and analysts, from investment banks J.P. Morgan, Deutsche Bank, Morgan Stanley and CIBC World Markets, told the in March 2000, that it was difficult to evaluate the earnings growth number because it was difficult to evaluate a given energy trading or merchant subsidiary when paired under a holding company structure with a regulated utility.

Furthermore, many bankers complained that energy-trading or merchant operations results were poorly reported by the holding company. They explained that's why the holding company received a modest price-to-earnings (P/E) ratio. The P/E earnings ratio is the price of a stock divided by its earnings per share.

The P/E ratio, also known as a multiple, gives investors an idea of how much they are paying for a company's earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

During the 2000-2002 periods, many of the companies that carved-out their merchant activities did earn higher P/E ratios from investors than diversified utility holding companies.

Then, the California crisis and the Enron debacle happened, introducing new wrinkles to how the market valued these companies. The energy merchants discovered they were captive to investors' impressions of the supply picture. The whole industry was penalized for being involved in the same business as Enron, although their corporate structures and debt situations, in most cases, were much different than Enron's in terms of assets, organizational structure, and culture. Energy merchants and traders like Aquila and NRG decided they were better off having the considerable balance sheets of their former parents and carved themselves back in due to credit concerns prompted by the Enron misadventure.

This has put the industry back to square one, introducing once again the problem that bankers first unearthed in early 2000: How do you evaluate these diversified structures? The current situation has prompted calls by many in the industry for utilities and analysts to work on a new framework for reporting and analyzing energy companies-to shed light on the black box, as it were. But to date, both the industry and the financial community seem to be struggling for a common evaluation language.

Building the Better Valuation Model: Making Sense of the Noise

Dr. J. Robert Malko, a certified rate of return analyst (CRRA) and professor of finance at Utah State University College of Business, says there has been a shift in recent years in the way energy companies are valued.

"Under traditional rate-based regulation, a lot of emphasis was on historic cost. With [electric] restructuring and more sales, there is a logical shift to looking at an income approach. And in theory, the income approach is the theoretical correct approach to value a property. What are the expected cash flows the company is going to generate?" he asks.

Malko says that relative emphasis, or weighting, must be determined in evaluating companies when using the indicators of cost, income, and markets (known as the comparable sales approach). Certainly, there is still debate over how much emphasis to put on the indicators, but the overall weighting has shifted to analyzing cash flows.

For example, he says, in terms of looking at a company's costs, you have the choice of using historic, replacement costs, or a trend in historic cost. When calculating income in estimating the future cash flows, the challenge is calculating the appropriate discount rate and then looking at comparables.

"Once a parent holding company goes into a wide range of business activities and has a wide-range of subsidiaries, the measurement of risk on the parent is certainly more complex than if you turn the clock back and have a more traditional integrated public utility. The complexity and the type of diversification activities clearly changes the risk profile," Malko says. In terms of measuring of risk, if you look at the beta values (coefficient measuring a stock's relative volatility) on the pure non-regulated generation companies, they have higher beta values than the traditional regulated companies.

Malko believes it is important that a comprehensive assessment of business risk be made in addition to financial risk in the industry.-business risk in term of the variability of earnings before interest, taxes, depreciation, and amortization (EBITDA).

EBITDA can be used to analyze the profitability between companies and industries because it eliminates the effects of financing and accounting decisions. A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow.

What contributes to EBITDA are factors that impact revenues or factors that impact cost of operation, Malko says.

"Clearly, in this growingly complex environment more scenario analysis sensitive to business risk with respect to forward looking cash flows needs to be done. That is clearly one weighted for potential buyers and sellers to get a handle on," he says.

Focus On Regulated Utilities: True Love at UBS

UBS Global Asset Management's John D. Quackenbush won't mind if you call him conservative. As a utility analyst, his recommendations help drive the firm's investment decisions for its equity funds. In fact, UBS Global Asset Management has $405 billion dollars in assets under management as of December 31, 2001. UBS Asset Management is one of four business groups of UBS AG, along with UBS Warburg, UBS Paine Webber and UBS Switzerland. The firm's outlook on utility companies hasn't changed in the last decade, he says. They like regulated businesses, regardless of whether they are in generation, transmission, or distribution. "We take a fundamental long-term investment view and that hasn't changed. ... We still prefer the integrated providers because of our long-term focus." In fact, it is this long-term focus that has kept Quackenbush from investing in highflying energy trading or merchant generation companies. He says that unregulated businesses are not out of the question, but he looks unfavorably on companies that would stray away from its core competence of running a utility. Quackenbush says that, although evaluating regulated companies on a case-by-case basis, he looks to see whether the utility has incentives for achieving cost savings that they can keep. "[Furthermore] I think there are some marketing, trading and generating opportunities that are far astray. However, if marketing and trading activities are focused on trading around assets, or targeting certain niche customers, that could be a business we would look on favorably," he says. Quackenbush also evaluates long-term supply and demand forecasts. "It still appears to us that there is plenty of supply to meet demand over the long-term,... even after considering plant cancellations, and other plants that haven't been formally cancelled but are unlikely to be built. There are exceptions regionally, but from a national perspective, there seems to be plenty of supply to meet demand over the long-term. For specific companies, we determine the valuation by projecting cash flows and reach some type of probability assessment of the likelihood that they could meet those cash flows." He explains that UBS Global Asset Management works on a globally integrated investment platform that allows analysts to compare companies on a global basis. "We have analysts in London and Tokyo and elsewhere (that work together). If we decide to compare U.S. utilities to European utilities, this global platform will permit us to make those types of comparisons." Furthermore, UBS Global Asset Management uses techniques such as internal price projections to come up with expected cash flows to determine the current value of companies. Quackenbush believes that there can be negative results when utilities go too far astray from their core competencies. "I think it is in basically sticking with something that they know, [that utility companies] do well." He believes in companies that generate free cash flow, pay solid dividends, and even buy back stock from time to time. "We think that it is [important to demonstrate] disciplined management rather than taking excess cash flow or free cash flow and making investments that are far astray," says Quackenbush. When evaluating individual companies, he applies a higher discount rate to take higher risks into account. "We wouldn't necessarily say a company has to grow by 5 percent or 10 percent. Growth would be one factor to take into consideration. But there could be a very solid company with a lower growth rate that would be acceptable compared to another company that is in a completely different situation." Quackenbush measures success by comparing the performance of the utility stocks within UBS Global Asset Management's funds against utility benchmarks, like Standards & Poor's utility index and the MSCI World Standard Utilities Index. For example, since year-end 2000, the global utility stocks owned by UBS Global Asset Management have outperformed the MSCI World Standard Utilities Index by 1,100 basis points. —R.S.

Of course, Malko believes the real issue will be how regulations are developed in reaction to Enron, and how those new regulations affect the future cash flows of energy companies.

"Until some of this stuff settles, you'll have that uncertainty. If you look at business risk, competition, weather, regulation, [and] availability of power supply are [will be] the drivers of valuation."

In a nutshell, Malko says the problem you get into is the qualification and quantification of all these business risk components, the changing of those components. The way these factors impact cash flows is certainly more complex today than it was 10 years ago.

"So, that's really what analysts are trying to get a handle on. We do have indicators based on actual sales that we didn't have 10 years ago that gives us some direction. But on the other hand, we have complexities and uncertainties about what kind of regulation we are going to have. What is going to happen to the holding company act and what kind of new accounting standard will come in play? Then, there is the state vs. federal issue. These are business risk factors that make the forecasting of these forward looking cash flows much more complex," he says.

"What has gone on in the past year or so is raising flags that analysts have to be sensitive to what assumptions companies are making regarding these earnings projections and how sensitive they are to changes in the business risk climate."

Meanwhile, with a possible increase in interest rates on the horizon, analysts are already looking at how valuations might possibly change.

"Everything else being equal, if treasury rates are going up, the rational investor is going to want more for an expected cost of common equity. In terms of the utilities cost-of-capital going up, it depends on the debt position and whether the company needs new debt."

John D. Quackenbush, a certified financial analyst (CFA) and analyst with UBS Global Asset Management, sees different aspects to a possible interest rate jump. "One, the discount rate would increase as the cost of capital increases. Corresponding with an interest rate increase would be a general pickup in the economy, so perhaps there would be greater revenue growth or economic activity associated as well. Perhaps they would be offsetting. But for specific companies, there might be some netting one way or the other," he explains.

The Earnings Schizophrenia: Regulated and Unregulated, Same P/E?

Jeff Bodington, president of Bodington & Company, a financial and consulting boutique, believes that the financial markets are at a loss for how to analyze and evaluate energy companies in the electric restructuring era, especially after Enron. "I think that many analysts are getting it wrong and focusing too much on the downside risk and being overly conservative. They are damaging valuations as a result of things like Enron," he says.

Because the differences between most diversified utility companies and Enron have not been widely appreciated, "the stock values of these other companies have been hammered. ... If you look at what has happened to those stocks since Enron's announcement, they have gone down, down, down. Whereas, there is really no new information," he says.

In fact, many so-called growth companies found their P/E ratios in January and February 2002 below even those of traditionally vertically integrated utilities. For example, Calpine's P/E has been under four, AES has been under six, and Reliant's has been under eight.

Bodington attributed the stock drop to nervousness about companies that have been associated with Enron. The result of this nervous reaction by Wall Street and investors is to increase the debt/equity ratios of these companies as the market value of the equity in the company falls and the debt in proportion to total capital rises, he says.

"As a result, the lenders which for years have financed the asset-heavies' expansion programs, are not only saying we won't lend you anymore, but we think you should sell assets and use the cash to pay down some of the debt to bring your debt/equity ratio back into comfortable relationships," says Bodington.

Mark Ciolek, a partner in PwC Consulting's energy industry practice, a business arm of PricewaterhouseCoopers, is also puzzled by the lack of distinction between very different businesses in the energy industry. If you look at a wires model, a merchant generation company, or a vertically integrated utility, the P/E ratios, in the early part of the year, were all relatively the same, he says.

"Of course, I think that whole market sector has really been unfairly punished, and maybe it is the flip side of being overly valued for the last two years that now they are seeing the crunch from Wall Street. On the other hand, some of the turn downs in valuations for some of the pure IPPs like Calpine and NRG and Mirant probably reflect the fact that they have been over-leveraged and people have been paying too much to get assets in the generation sector.

"[Moreover], a year ago, the P/E ratios for the generation companies were significantly higher. I have a hard time believing that the P/E ratios for all these different business models can remain the same. I think we'll see a movement back to the generation side. But not generation like Calpine where you are just constantly adding new capacity and increasing your leverage. But a carefully managed model like an AEP or Duke," he says (Note: merchant generator P/E ratios did rebound slightly at press time).

Going forward, Ciolek says that he believes that generation-focused companies are going to have higher earnings and growth than just a regulated transmission company (transco) or a regulated distribution regional company.

"I have to believe that the P/E ratios and the earnings potential of the merchant will be larger than what we see in the regulated wires business, and then likely you will see the integrated utilities somewhere in between there," Ciolek says.

But Ciolek believes that European utilities and oil majors, which have been rumored to be on the hunt for U.S. power and gas acquisitions, will impact such valuations. If you look at a company like Shell, they have more cash than long-term debt. In addition, the Europeans have enormous market capitalization and can come in and swallow most domestic utilities pretty easily.

The Corporate Structure Debate: Pure Play vs. Diversified

Ciolek calls it the $64,000 question. What is the ultimate corporate structure that can adequately bring value to shareholders and withstand economic downturns and the uncertainty and risk involved in deregulated markets?

Being in that part of the value chain-the generation and the merchant side-you have to have a sizeable balance sheet. "It is pretty comparable to the upstream on the petroleum side, where they have such enormous balance sheets and have such diversification of risk through different projects over the world that they are able to weather the booms and the busts much better than what we have seen in the utilities or the energy sector because of the fact that most of these guys are relatively small from a market capitalization perspective," he says.

So, the model of the Dukes, the Exelons, and now that NRG is brought back into Xcel, "I think the added balance sheet capabilities from a credit and cash perspective is the model that will be the dominant model at least for the next to the three to five years," he says.

Ciolek believes that the diversified holding structure also provides better protection than say a vertically integrated utility possibly merging with other vertically integrated utilities in the interest of gaining size and scope. For example, a few years ago when oil prices hit all time lows the oil majors took such a defensive tactic.

PwC recently completed an analysis of all the mergers since 1996 in the energy sector and tried to classify them. It looked at the stock performance for the 14 days before the announcement and the 14 days after the announcement to see what the market thought of the strategy and then looked over the past year since close (). The findings showed that the mergers that were strictly vertically integrated utilities matching up with one another for the purposes of obtaining scale have not been very effective from the market's perspective.

Ciolek says the lessons of Enron and California were that it is very difficult to be a pure play merchant. Going forward, he believes there still might be some companies that want to brave the pure play business model.

But it is a high-risk business with boom-bust commodity driven cycles, which would expose those entities to a great deal of risk, he says. The corollary would be an upstream oil company. When oil prices are going up, things are like gangbusters, but when power prices drop they bear the brunt of it.

Certainly, energy merchants like Calpine and Mirant could benefit from a pairing with an oil major because of its strong balance sheet. Bodington also agrees with this idea. He says that if he had to choose between the diversified utility model or a merchant developer owned by an oil major, he would choose the oil major as the ideal corporate structure.

Take, for instance, Shell trading. Here we have a company that is not involved in vertically integrated utility operations but is a very big trader and they have a AAA credit rating, he says.

"If you want to be a trader, you have to have a AAA credit rating. If it is supported by a vertically integrated utility, great, but if it is supported by a global energy business that involves oil that is fine too. I don't see any reason that trading needs to be restricted to somebody supported by a vertically integrated utility. I think what you have to do if you want to be an effective trader is of course know what you are doing and have a good credit rating, and how you get that is really not very important. You can do that by owning a utility or the Shell model.

"I would have Shell at the top of the list. One of the good reasons for deregulation is that the industry was moribund and had ossified and badly needed to become more aggressive and more dynamic. In a corporate structure where there are subsidiaries that do different things, the approach of having one unrelated businesses has been largely discredited. The approach that involves businesses that can take advantage of each other's skills is proven," says Bodington.

He says the trading organization benefits more from an entrepreneurial culture involved in all kinds of risk management activities than from a highly regulated culture. "I think the skills and the mindset of the entire Shell organization are better suited to supporting a trading company than those of a Duke-like entity."

Trading companies can be very useful and don't need to have hard iron or assets, he says. What any trading organization has to have is a focus on risk management, whether you manage risks through owning iron or power plants or manage risks through financial instruments really don't matter that much. You have to just manage the risks. That is why he doesn't necessarily agree with the recent industry convention that energy-trading companies have to have assets, and cannot be a pure play.

"In a perfect world," he says, "I don't see any difference. In today's market, trading organizations are being devalued more because investors are skeptical over how good the risks are really hedged. Enron showed that it really wasn't hedging its risks but hiding deals gone badly.

"[A trading organization is viable] to the extent that you can give investors confidence that you can manage risks. In the long-term, I don't really see any difference between owning a contract and owning a power plant as long as the contact is with a credit worthy owner of a power plant. So, I'm not sure accounting changes are necessary. I think better judgment is necessary."

Articles found on this page are available to Internet subscribers only. For more information about obtaining a username and password, please call our Customer Service Department at 1-800-368-5001.