Lehman Brothers and others say upcoming rate cases and falling unregulated earnings mean some IOUs will have less to show for their effort.
Even as utilities enjoy the spoils of higher valuations as a result of the dividend tax repeal, institutional investors and Wall Street experts predict a continued threat to earnings from upcoming rate cases and underperformance in unregulated activities. Daniel Ford, equities analyst at Lehman Brothers, in a report titled A Blast From the Past, says, "The enacted dividend tax reduction is now fully incorporated into utility valuations. Dividend safety and growth will become important for individual electrics to maintain their new higher valuations."
Ford's concern is that rate cases are likely the greatest threat to utilities' dividend growth and safety. "[Lehman Brothers] expects a surge in regulatory activity in the coming years arising from 1) low interest rates; 2) the end of deregulation transition periods; and 3) new capital investments and costs not reflected in rates.
Historically, Ford notes, allowed returns or return on equity (ROE) have been 393 basis points above the 10-year Treasury yield (+/-153 basis points), which implies decisions in the 9 percent plus range could be ahead. In addition, experts say this may mean quite a clip in ROE for some utilities, as Lehman Brothers own research shows many utility companies are enjoying several hundred basis points above that level.
In fact, Ford writes, "The current low interest rate environment is likely to lead to more rate cases and lower allowed returns. … Since 1980, the average allowed ROE was 13.8 percent (1,101 decisions) and since 1990 it was 11.8 percent (355 decisions). In the first quarter of 2003, the only decision out of six that was below a 10 percent ROE was the 9.96 percent received by Energy East subsidiary Rochester Gas & Electric. It is worth noting, however, that this decision applies to only a one-year period and its ROE could be reset higher in the following year."
However, Ford says that he has begun to see staff recommendations in rate cases in the 9 percent range. "For instance, New Jersey Board of Public Utilities' staff recommended a 9.75 percent ROE for Public Service Electric & Gas and Jersey Central Power & Light. Since 1980, the spread to treasuries was lower when rates were the highest. [Lehman Brothers] thinks it is only a matter of time before [we] see rate case decisions with allowed ROEs in the 9 percent to 10 percent range."
Unregulated Earnings: Analysts Are Still Not Convinced
Meanwhile, the increased scrutiny on the dividend as a result of the dividend tax repeal in turn has focused investors and Wall Street on sustainability of payout levels and potential for real dividend growth-especially as investors have been buying yield in some instances at the expense of valuation and risk, Lehman Brothers notes. Furthermore, even as yields have improved in the utility sector, Lehman's Ford notes that the fundamentals of electric utilities have not yet improved to the same degree. Perhaps that explains why some analysts have been even more cautious and skeptical of so-called unregulated earnings plans of some diversified utilities.
Case in point, Duke Energy's May analyst conference in Charlotte, N.C., failed to impress Lehman Brothers. "In our opinion, [Duke] remains overvalued relative to its fundamentals," wrote Ford in another report. "Duke's earnings continue to be challenged by weak commodity markets and ongoing asset sales, its utility must borrow to cover the current dividend, and Duke Capital is still at risk for a one or two notch downgrade."
Furthermore, the Lehman analyst noted the poor contribution from Duke's unregulated arm, saying, "Comparing Duke's segment [Earnings Before Interest and Taxes] EBIT contribution with its asset composition is telling. The regulated businesses represent 47 percent of Duke Energy's total assets and are projected to generate 80 percent of its 2003 EBIT, implying strong returns. The unregulated businesses, which are expected to generate returns greater than regulated returns, are clearly under-performing. Duke Energy North America (DENA), in particular stands out with 25 percent of the company's assets but contributing only about 6 percent of total EBIT."
Ford also notes that Duke's unregulated arm will have significant hurdles to meet earnings targets: "Over the next three quarters, DENA needs to generate an incremental $832 million in gross margins to meet its full year EBIT projection of $200 million."
Between hedged generation output, its un-hedged gas requirements, he doesn't believe that target is feasible.
"If we assume the company sells all of its un-hedged output to generate the yet to be sourced gross margin, it implies a spark spread of about $11/MWh (=$362 million/55-21 MM MWh). This seems unrealistic given the current outlook for the summer spreads of approximately $7/ MWh, the declining volatility, and lack of market liquidity."
Moreover, Dan Gabaldon, senior analyst at Avalon Research Group, recently initiated coverage on Constellation Energy Group (CEG) with a sell recommendation; "Constellation Corp. promises investors 10 percent EPS growth through 2005, principally by rapidly expanding its competitive power supply business. However, we believe investors are overlooking the challenges posed by its business model, including: the difficulty of growing market share outside its home territory, low overall market growth, and its exposure to continued regulatory uncertainty."
Furthermore, much like it was pointed out with Duke Energy, Gabaldon points out that CEG's above peer-average valuation depends critically on attaining its ambitious growth targets. … Rather than returning to basics like its utility peers, CEG promises investors both attractive income and yield via a strategy of increasing its share of sales to wholesale and non-residential customers." Certainly, many experts believe that equity research analysts' skepticism of exceptional utility growth plans is warranted, given the last 18 months. We've all heard the promises before, but this time, will utilities deliver?
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