“I would rather be certain of a good result than hopeful of a great one.” —Warren Buffett
“Widows and orphans” is a term that has been used to describe typical investors in electric utility stocks. The utility companies, however, prefer to describe their appeal to investors as “long-term investments.” Accordingly, rather than focus on one-year returns, many utilities emphasize their shareholder performance over the long run—typically a three- or five-year period.
To better understand the performance of the electric utility sector from both a short-term and long-term perspective, we examined the total shareholder return (TSR)—dividends plus change in stock price—of 58 electric companies1 for 2005 and for three- and five-year periods.2
We grouped these companies into four categories to better understand the impact of alternative strategies on investor performance:3
Recovering utilities. During the past five years, recovering companies have changed their strategies. Their earlier strategies for aggressive earnings growth, through access to easy credit plus balance sheet leverage, generally failed. So over the past several years, these companies have been recovering by pursuing the so-called “back-to-basics” strategy—selling businesses and assets, scaling back wholesale and retail energy marketing initiatives, and focusing on core utility operations.
Traditionalist utilities. These companies have pursued a consistent strategy during the past five years—and even longer for many of them. Even though most traditionalist utilities have unregulated businesses, their management teams are not focused there. These companies always have emphasized their regulated utility businesses in terms of capital investment, management attention and focus, and positioning with investors.
Growth utilities. These companies are more complex. In response to the Enron collapse, many of these utilities scaled back their growth strategies, but only to a point. Without exception, growth companies have utility businesses that they strive to run well. However, they also focus on their competitive businesses, e.g., non-regulated base power-plant development, wholesale and retail energy marketing, oil and gas exploration and production, and LNG development.
Merger utilities. These utilities are pursuing “scale” mergers and have announced transactions during 2005. In connection with each of these transactions, the merger companies have indicated that M&A is part of a larger growth strategy.
For the second year in a row, the Dow Jones Utility Index outperformed its Industrials counterpart in 2005. Moreover, 2005 was the third consecutive period in which the Utility Index showed annual gains of more than 20 percent. The 2005 gains primarily resulted from:
Even so, among companies that recorded double-digit TSRs in 2005, most of them either recorded strong performance from growth or merger strategies or they posted gains linked to ongoing recovery efforts. Traditionalists that were among the 2005 leaders typically counted on returns in the form of strong dividends (see Figure 1).
However, it appears that most of the top 10 companies are pursuing growth strategies. Both TXU and NRG, for example, were recovering utilities a few years ago. In the case of TXU, new leadership has cut costs, repaired the balance sheet, and transitioned to an aggressive growth strategy premised on operational excellence and the implementation of a high-performance operating model. NRG is using a restructured balance sheet to aggressively purchase additional power-plant assets. Constellation Energy (CEG) is pursuing a national growth strategy across all parts of the energy value chain. MDU Resources is pursuing growth through a more classic diversification strategy complemented by power-plant acquisitions.
Perhaps even more interesting, traditionalist utilities dominated the list of companies that had negative or very modest TSR performance in 2005 (see Figure 2). Heavily regulated electric utilities with limited wholesale businesses (e.g., UIL Holdings, DQE, Energy East, and Puget Energy) were vulnerable to higher wholesale prices or could not enjoy the earnings associated with those higher prices. Rising gas prices and the market’s fear of a related increase in conservation and bad debt expenses negatively affected utilities with significant downstream (and limited upstream) gas businesses, such as Keyspan and NiSource. Other utilities, such as PNW, recorded lower earnings due to unfavorable regulatory decisions.
Overall, in 2005, the 58 utilities in our data set added almost $75 billion in market value. Most of that value came from companies in the growth and merger strategy groups. In particular, Exelon, TXU, and Dominion combined contributed about 25 percent of the total value created, mainly because of their size and significant market gains. Companies such as PSEG, while smaller, got a boost from merger announcements.
In examining TSR for 2005, when weighted by market capitalization, returns for the utilities in the traditionalist group significantly underperformed relative to all the other strategy groups (see Figure 3). This illustrates the premium that the market placed on companies with solid but aggressive growth strategies—as opposed to companies with solid but conservatively positioned strategies centered on their core regulated markets. This marks a change from the market’s view two years ago, when it rewarded companies with solidly regulated businesses. In particular, wires companies such as Energy East, Northeast Utilities, and DQE did much better in 2003 than in 2005. Even integrated electrics like Southern Co. and Pinnacle West (Arizona Public Service), which are back-to-basics companies, returned only 3.1 percent and -2.5 percent, respectively, in 2005, compared with 11.6 percent and 22.4 percent, respectively, in 2003.
But as noted earlier, utilities, especially traditionalists, often are not focused simply on single-year returns. What about returns over the longer term?
In the 2001-2005 period, our set of 58 companies created $133.3 billion in shareholder value in connection with an overall (weighted) 39 percent return over the five-year period (see Figure 4).
But the return trajectory was not a smooth upward glide through the period. Immediately following the collapse of Enron, all utility stocks fell out of favor, followed by a rebound beginning in 2003. Over the three-year period, 2003-2005, the set of 58 companies created $212.5 billion in shareholder value in connection with an overall 80 percent return.
Led by the explosive recovery of companies such as TXU, AES, Allegheny Energy, and Dynegy, a company had to have 90 percent returns over the three-year period to make it to the top quartile of this ranking. Only eight utilities had returns of less than 20 percent over the 2003-2005 period. Most investors that carefully moved into utility stocks when the industry settled down and entered the back-to-basics period did very well.
However, with the hit that all utilities took in 2001-2002, investors that had a long-term “hold” strategy for their utility investments saw lower returns over that longer 2001-2005 period. Clearly, investors would have been better off had they—as many did—sold utilities as soon as events unfolded following the collapse of Enron and then rebought utility stocks once they bottomed out.
Surprisingly, even from the perspective of a long-term investment strategy for the past five years, investors would have seen great returns by investing in growth companies, as well as seen very respectable returns in investments in companies in both the traditionalist and merger groups.
But most likely, investors would have seen losses associated with their investments in companies in the recovering group. Companies such as Dynegy, Aquila, AES, CMS Energy, and Allegheny Energy, when viewed from a long-term perspective, did recover, but not enough to overcome the hit they took when Enron collapsed.
Perhaps utilities as potential investments never were a homogenous group. However, entering the period of the late 1990s, we saw utility companies pursue one of two strategic paths: Some went after aggressive earnings growth through investments in wholesale energy marketing, international operations, or merchant power plants, while others stayed closer to their utility roots.
Today, we can see winners (growth) and losers (recovering) comprising a single strategy group that pursued earnings growth beyond what the typical utility business provides.
Our so-called growth group includes companies such as Sempra, PPL, and MDU Resources. These companies continue to make bets in competitive businesses and are succeeding in delivering income and returns from these investments. The growth group also includes companies, such as TXU and NRG, that have recovered from the crisis period of 2001-2002 and now are executing aggressive earnings and acquisition strategies.
The recovering group includes companies such as Reliant, Teco Energy, and Allegheny Energy, which made similar bets to deliver aggressive earnings growth and have thus far failed to deliver. Either the margins and earnings weren’t forthcoming, the companies overpaid for assets, they took on too much balance-sheet and credit risk—or all three!
From a TSR perspective, investors that made long-term investment bets with companies in the combined growth-recovering group either won or lost depending on the stocks they purchased (and held). If they won, their reward was better than average returns (i.e., traditionalist). If they lost with an investment in a recovering company over the hold period, investors ended up with lower or negative returns.
1. To be included in this analysis, a company had to provide electric power services to regulated energy end-use customers. We excluded those companies that had an equity market capitalization of less than $500 million, as well as companies in the midst of bankruptcy proceedings (e.g., Calpine).
2. The one-year period measured returns in 2005, the three-year period measured returns for 2003-2005, and the five-year return measured returns over the 2001-2005 period. Each year reflected Jan. 1 through Dec. 31.