“Risk comes from not knowing what you’re doing.” —Warren Buffett
Confirming what many at individual utilities already knew, the Dow Jones Utilities Index posted another year of solid gains in 2006 (see Figure 1).
The Dow Jones Utility group rebounded following the collapse of the energy sector in 2001-2002. Yet after unprecedented 20-plus percent gains for three consecutive years (2003-2005), another year of such gains would have been tough, and it was. In fact, in 2006, the Dow Jones Industrial Average beat the Utilities Index for the first time since 2003 (see Figure 2).
Key drivers for the gain for the Utility Index were AES, Centerpoint, PG&E, FirstEnergy, and Duke Energy (completed merger with Cinergy), which all posted stock price gains of more than 20 percent in 2006. Laggards, which recorded stock price gains of less than 10 percent, were Con Ed (reliability problems), Edison International, and PSEG (failed merger with Exelon).1
As might be expected, in connection with both the near-term and longer-term historical investor performance of the utility sector, there’s a story within the story. Further, this performance history provides a context against which the impact of both current and emerging issues can be assessed.
To examine how well utility investor have fared, dividends also must be considered; therefore, we examined the Total Shareholder Return (TSR)— dividends plus change in stock price—of some 80-plus utility companies. We considered TSR performance in 2006 and over a three-year time period.2
To understand the impact of alternative strategies on investor performance, we grouped these companies by their asset mix, business focus, and corporate strategies into the following categories.
Energy Delivery. Companies in this group formerly were considered integrated electric and gas utilities. However, in connection with restructuring initiatives, these companies sold their power-plant assets. What was left was the so-called “wires and pipes” or energy delivery business.
Gas Distribution. Companies in this group actually are quite similar to energy delivery companies except for one difference—their delivery business consists exclusively of “little pipes” (i.e., delivery to energy end users). They have no “wires” business and no significant presence in connection with “upstream” gas businesses (e.g., interstate pipelines).
Integrated Gas. Companies in this group operate across the natural gas value chain—gas production and marketing, gas processing, interstate pipelines and storage, and gas distribution.
Power Generation. There are only a few companies in this group. They do not have a significant presence in the retail or energy delivery business. Their primary business focus is in developing and operating unregulated power plants.
Integrated Electric and Gas. This is the largest group. It consists of companies that have power-plant assets (sometimes regulated, sometimes non-regulated) as well as electric and gas energy delivery assets and customers. Some of the companies in this group are aggressively pursuing non-regulated growth strategies (e.g., Constellation Energy), while others are pure regulated utilities (e.g., Western Resources).
Most utilities recorded double-digit TSRs in 2006. To make the top quartile, a company had to show almost 30 percent returns.
For 2006, top-10 utilities showed single-year returns of 38 percent or better (see Figure 3). Companies in each group were represented, but it is worth noting that three of the four companies in the Power Generation group were in the top 10.
In the list of companies that had negative or modest TSR performance in 2006, several in merger situations stood out, specifically PSEG with its failed merger with Exelon, and WPS with its announced merger with Peoples Energy (see Figure 4).
In 2006, the utilities in our data set added almost $105 billion in overall market value. While most of that value came from the largest group (Integrated Electric and Gas), the group with the highest percentage growth in market capitalization was the Power Generation group, Dynegy increasing 86 percent, NRG 86 percent, and AES 42 percent in overall value for 2006 (see Figure 5).
Accordingly, in examining TSR for 2006, when weighted by market capitalization, returns for the utilities in the Power Generation group significantly outperformed all the other strategy groups. The Integrated Gas group also did well. Traditional utility groups (Integrated Electric and Gas, Energy Delivery, and Gas Utilities) showed returns that were similar and below those of the other two groups.
The top performing group over the past three years was dominated by companies that had rebounded from poor investments, energy marketing debacles, or investor disdain for Enron-clones (TXU, Williams, Allegheny Energy, AES, Edison International, CMS, Reliant, and El Paso). Companies with an upstream gas play (Questar, Energen, Oneok, Equitable, and Southern Union) also recorded top-quartile performance.
Two growth-oriented utilities stood out in the top-quartile group—Exelon and Constellation. While both of these companies suffered from failed mergers and were “middle of the pack” in terms of 2006 performance, their longer-term performance suggests that investors will be rewarded in connection with growth strategies that are “done right.”
About half of the companies in the bottom quartile were either:
(1) Gas distribution utilities or utilities with a high concentration of gas customers (Washington Gas, Vectren, Peoples Energy, KeySpan, NiSource, Puget Energy); WPS also could be included in this list with its acquisition of gas properties from Aquila (2005) and its announced merger with Peoples Energy (2006);
(2) Energy delivery companies (Central Hudson, Energy East, Duquesne Light, and United Illuminating).
The rest were either solid back-to-basics companies like Southern Co., Ameren, and Great Plains or companies recovering from bad investments such as Teco Energy and Progress Energy.
In looking at group-level performance, the differences are striking. The Integrated Gas group led the way over the three-year period. The Power Generation and Integrated Electric and Gas Utility groups (groups representing utilities with some stake in power generation, either regulated or unregulated or both) also had strong performance.
In comparison, the Gas Utilities and Energy Delivery groups had returns significantly less than the other groups. A significant portion of the TSR for companies in these groups is in the form of dividends. And so, with returns of 48 percent (Gas Utilities) and 40 percent (Energy Delivery), these groups’ stock-price performance significantly underperformed relative to the Dow Jones Utility Index which was up over 70 percent from the 2004 to 2006 period. What does that say about the attractiveness to investors of pure play, regulated energy distribution businesses? Or was the 2004-2006 period an anomaly?
After Enron’s fall and the collapse of the sector, each utility has its own story. Some need to retrench and rebuild; some highlight the fact that they have always been about the “basics.” However, going back to 2003, some have recorded four straight years of solid stock-price gains.
So, entering 2007, several key questions emerge:
1. Overall, are utilities due for a correction vis-à-vis other sectors?
2. Will the appeal of steady but lower earnings growth and dividends appeal to investors?
3. Are there industry dynamics that will impact the attractiveness of utilities to investors?
There are many issues that may impact any one company. However, there are a few issues that will affect almost every utility company and, potentially, shareholder performance.
The first issue is constraints on greenhouse-gas, or GHG emissions. GHG legislation is anticipated widely within the next couple of years, perhaps linked to changes in Congress and the administration. GHG constraints in the form of cap-and-trade or a tax will have one immediate effect—higher energy prices. The higher prices will force electric utilities (recall the TSR groups considered) to move away from higher-GHG emitting power plants—that is, away from coal-fired power plants. In the long term, higher prices also eventually will lead to lessened demand (Economics 101). But in the short term, higher prices will translate into negative public reaction and related media attention. In other words, coal-burning electric utilities likely will be seen as culprits in terms of both GHG emissions and higher prices. This has the very distinct possibility of translating into TSRs from an investor perspective.
The second issue relates to the need for significant investment in generation capacity in the coming years. The need for new capacity is connected somewhat to the GHG issue but has some additional twists. Last year, most regions of the country experienced new records in terms of peak electricity demand. This summer many regions are bracing for another set of records. Higher demand calls for new power-plant capacity additions. Estimates for required incremental capacity vary, but it’s safe to assume that many new power plants will need to be constructed and, therefore, financed. To finance the new construction, utilities will need to issue new common stock. Although the timing and link between “growth” and new investment, and returns on that new investment are complex, Economics 101 would suggest that an excess supply of new shares could have a dampening effect on prices—in this case, the prices of utility stocks.
The last issue is financial in nature. Utilities long have recognized that they are exposed to changes in interest rates. When rates go up, utility dividends don’t look as attractive.
Another long recognized relationship involves the tradeoffs between equities and bonds (i.e., interest rates) and in our case, between utility stocks (as quasi bonds) and equities. In examining the relationship between non-utility equities (represented by the Dow Jones Industrial Average) and utilities (represented by the Dow Jones Utilities Index, utilities may be viewed as being overvalued. This would set the stage for a future correction. Regardless of what the overall market does, utilities would not fare as well or suffer worse to restore the traditional relationship between equity groups.
Our analysis of utilities groups indicates that Gas Utilities and Energy Delivery companies didn’t do as well as those with upstream gas or power plant assets and investments. With the issues noted above, will the situation flip? Will Gas Utilities and Energy Delivery companies outperform the other groups? Or will all groups suffer and Gas Utilities and Energy Delivery companies suffer negative TSR (i.e., dividends not making up for the fall in share price)?
Forecasting stock prices is foolish. However, a safe bet is that utilities will face significant issues in the coming years, and how well they respond undoubtedly will affect how well they reward their investors.
1. The Dow Jones Utilities Index consists of Dominion Resources, Con Ed, PSEG, TXU, FirstEnergy, Exelon, AEP, Southern Co., PG&E, Edison International, Duke, NiSource, Williams, CenterPoint, and AES.
2. The one-year return measured returns in 2006; the three-year return measured returns for the 2004-2006 period. Each “year” reflected a Jan. 1 through Dec. 31 perspective. Dividends used in the TSR calculation were “paid” during that period.