When we first saw the numbers for this year’s Fortnightly 40 report, two rankings immediately stood out from the rest.
First, a wholesale energy company that emerged from bankruptcy less than five years ago—Mirant—rocketed into a coveted top five position in the F40. At the same time, Mirant’s former parent, Southern Company, sank into the bottom half of the rankings (#28) after being a perennial leader since the F40’s inception in 2005 (see Figures 2 and 3).
Not coincidentally, Moody’s downgraded Southern Company’s credit rating just as this issue was going to press. The rating agency pointed to some of the same factors that dragged Southern downward in our analysis—including a balance sheet burdened by negative cash flow and ballooning capital expenses (see Figure 5). Moody’s also identified ratemaking challenges in two of Southern’s regulated markets—Florida and Georgia.
With regard to Mirant, its position in the rankings will be short-lived, because earlier this summer the company agreed to be acquired by RRI Energy (formerly Reliant). Nevertheless, the diverging fortunes of Southern and Mirant combine to suggest an obvious trend, namely: From the shareholder’s point of view, the industry’s financial momentum seems to be shifting away from the traditional rate-regulated, cash-flow oriented utility business and toward unregulated, growth-oriented business opportunities.
Indeed, analysis of revenue sources for the top 10 and bottom 10 companies in the 2010 F40 reveal that such a trend has been building for at least four years (see Figure 7). The same phenomenon also is evidenced in dividend payouts for the top 10 versus the bottom 10 ranks in the F40(see Figure 8); namely, as a group, the top 10 companies—even excluding those like Mirant that don’t issue dividends—consistently pay out much more of their revenues in dividends than do their peers at the bottom of the F40. The conclusion: Growth-oriented companies apparently are delivering stronger overall shareholder performance than their peers, as measured by Fortnightly’s comprehensive benchmark (see “Behind the Fortnightly 40 Rankings”).
However, changes in corporate business strategies aren’t the only possible explanations for this statistical trend. For example, as GDP-linked retail energy sales have stagnated along with the economy, companies with unregulated investments have been in a better position to deliver returns—a situation that might reverse itself in a different economic situation. Additionally, regulated utility companies experienced a substantial degree of regulatory lag in 2009, following 2008’s record capital spending.
Such factors likely will continue playing an important role for shareholder performance for the foreseeable future. Although the economy might be slow in its recovery, electricity sales seem to be rebounding across the country, and not just because we’ve had a hot summer in 2010. “We see demand coming back, albeit slowly,” says Chaka Patterson, vice president and treasurer of Exelon (ranked #2). “In PECO’s service territory, demand growth is driven principally by commercial and industrial customers. Those are bellwethers of the economy when you think about demand, so we see that growth as a good sign.”
At the same time, utilities are bringing a slew of big rate cases before state PUCs. Requests range from PECO’s $317 million T&D upgrade filing to Duke Indiana’s petition for a second increase in its rate rider for the 618-MW Edwardsport coal-gasification project—originally estimated to cost $1.985 billion and now priced at $2.88 billion. Companies across the country are hoping to move forward with other projects of similar scale, involving all types of utility infrastructure.
“The Big Build stalled with the recession, but is showing significant signs of returning,” says Jean Reaves Rollins, managing partner with the C Three Group in Atlanta, which developed the Fortnightly 40 model and provides financial analysis for each year’s report. “For many years the industry has made little investment except for critical expansions to serve economic growth. There’s a huge pent-up demand to replace aging infrastructure. Now, as long as the recovery in unit sales stays on track, the pressure on capital budgets should ease.”
Of course, spending leads to rate increases, and a long list of companies in the past several months have requested double-digit rate increases at PUCs. Not surprisingly, many of these rate cases are encountering tough resistance, arriving as they have in the midst of economic malaise and the mid-term election campaigns. As a result, the stakes never have been higher for regulatory relationships among utility companies.
“Being such a capital-intensive industry, it’s crucial for utilities that their investors understand what they’re going to get back for their investment,” says Robert Laurens, senior executive in Accenture’s strategy practice. “With utilities’ credit ratings depending on confidence around cash flows, the regulatory situation is paramount.”
Looking past changes in individual companies’ F40 rankings, one trend seems evident in the survey’s aggregate data: The average company’s capital budget dropped substantially in 2009, compared to 2008 figures. The recession forced many power and gas companies to reduce their construction plans, and even now—two-thirds of the way through 2010—many still await clear signals to resume major cap-ex programs.
While the recession drove a large share of the industry’s investment delays, projects have been pushed back for a multitude of reasons. For example, environmental permitting challenges along the route for PSEG’s $750 million Susquehanna-to-Roseland line prompted the company to push back its ground-breaking date until 2014 or later. “Most of it is located on existing rights-of-way, where we already have smaller lines installed,” says Caroline Dorsa, CFO of the #7-ranked PSEG. “We’ve been working very hard with all the communities along the way, and they recognize this line is needed for reliability. But it’s a reminder of how difficult it is to build transmission in this congested area.”
Uncertainties about air emissions regulations also have driven some delays in capital investments, especially for generating capacity. “Our understanding is that many big companies are actively revising their assessments about what plants will need to be refurbished or mothballed,” says Jim Hempstead, senior credit officer with Moody’s. “So there could be a significant aount of capital on the sidelines that’s not yet incorporated into plans.”
“We have a lot of catching up to do on the generation side,” says Mark McGettrick, CFO at Dominion Resources (#9). “We’re the second-largest importer of power in the country. We have a construction plan through 2012 for electric generation and transmission and also gas transportation projects. But environmental regulations are a moving target, particularly regarding CO2 emissions.”
McGettrick notes that in Virginia, where most of the company’s generation is located, the Virginia Corporation Commission (VCC) provides rate-rider treatment for new gas-fired generation needed to replace coal units that Dominion might have to shut down. This makes implementing its construction strategy easier, but the company is still waiting for clarity on its path forward.
Changing regulations also are causing delays in non-fossil projects, such as wind farms. Two provisions of the American Recovery and Reinvestment Act (ARRA)—bonus depreciation and an option for owners to claim grants in lieu of investment tax credits—were set to expire in 2009 and 2010 for most eligible projects, and Congress hasn’t extended them. Further, the U.S. Senate has tabled proposals to enact a federal renewable portfolio standard (RPS), which only last year appeared to be strongly supported in Congress.
These policy factors, combined with flat electricity demand and low gas prices, have weakened America’s appetite for wind power.
“Without a federal mandate, wind projects are very difficult to build in the current environment,” McGettrick says. “We have about 700 MW of wind generation under development, and we’re taking a wait-and-see approach. We’ll wait for the regulatory and economic signals, and go whichever way the wind blows.”
The shifting political and regulatory outlook is affecting some companies more than others. Most notably, NextEra Energy, formerly FPL Group, returned to the F40’s ranks this year after a two-year hiatus. But its strong unregulated earnings, driven by major wind power investments, seem unlikely to grow at their previous pace. At the same time, NextEra faces a tumultuous regulatory environment in its home state.
Earlier this year, the Florida Public Service Commission stunned both Florida Power & Light and Progress Energy by deeply cutting their proposed rate increases. FP&L had sought nearly $1.3 billion, in part to cover reliability investments required to comply with federal mandates, and the commission granted only $75.5 million, prompting the utility to put $10 billion in cap-ex projects on hold and causing rating agencies to downgrade the company’s credit rating (see Figure 11). Since then, the state legislature engaged in what pundits call “payback” against the commission, proposing legislation to constrain the governor’s authority to appoint commissioners and ousting four incumbent PSC members. “The PSC’s decision was bizarre, and now all the utilities in Florida are facing a lot of regulatory uncertainty,” Rollins says.
The Sunshine State might be an extreme example, but regulatory controversies are slowing down utility investments in many states. In Maryland, for instance, the PSC in June 2010 rejected Constellation (#26) subsidiary BGE’s smart-grid project proposal, in the context of a contentious gubernatorial race. At press time the PSC approved a revised proposal, but the case exemplifies the pressure utilities are facing in the regulatory arena. As a result, many utilities are thinking twice before initiating rate cases that might have seemed straightforward before the recession.
For instance, back in 2008 Dominion announced plans for a $600 million smart-grid rollout that would have provided advanced metering infrastructure (AMI) for Virginia Power’s 2.4 million customers. But in the 11th hour, just as the VCC was scheduled to rule on the rate case, Dominion removed the AMI rollout from its plan. “We’re taking a very cautious approach to smart-grid implementation,” McGittrick says. “We’re doing pilot projects to ensure the benefits are clear for customers. That process will take a number of years. When we get comfortable with the results, we’ll either go to the commission to propose a larger implementation or we’ll stay with things as they are.”
In the midst of these uncertainties, many companies now are moving ahead with cap-ex programs—some of which are reflected in this year’s F40 numbers, and others that will begin hitting their balance sheets in time for the 2011 and 2012 rankings.
For the 2009 fiscal year, just 10 companies accounted for fully 40 percent ($34 billion) of the industry’s total $83 billion in capital expenditures. At the top of the list, Southern Company spent nearly $4.7 billion on capital projects in 2009—the biggest annual cap-ex number in F40 history. And Southern is just getting started, with plans for more than $16 billion in cap-ex through 2012. Some of the company’s largest and highest-profile investments:
• Plant McDonough, a project to repower an existing 600-MW coal-fired plant with a three-unit, 2,520 MW natural gas-fired facility, is under construction near Atlanta. Because of reduced demand expectations through 2012, Southern’s Georgia Power subsidiary delayed the project’s schedule by several months—with the first unit now expected to enter service in 2012. The company said the delay would increase total project costs by 7.7 percent to somewhere in the neighborhood of $1.8 billion;
• In Kemper County, Mississippi Power is scheduled to bring 582 MW of integrated gasification combined-cycle (IGCC) capacity online in 2014. The company had considered walking away from the $2.4 billion project until it reached a revised settlement in 2010 with the Mississippi PSC. The clean-coal project is proceeding with $682 million in federal support; and
• At Plant Vogtle, Georgia Power has started early site work on two new nuclear reactors that are scheduled for startup in 2016 and 2017. Early this year, DOE awarded the project an $8.33 billion loan guarantee, covering more than half of the reactors’ expected $14.5 billion cost.
Additionally, the company expects to invest $2.4 billion in emissions-control equipment, and more than $4 billion in T&D infrastructure from 2010 through 2012, including continued smart-grid investments; already Southern has installed smart meters for about 2 million of its 4.5 million customers.
The costs and risks of such extensive cap-ex plans contributed to Moody’s decision in August to downgrade Southern Company’s credit rating, along with the ratings of Georgia Power, Mississippi Power and Gulf Power. Moody’s cited regulatory risk in Florida and also Georgia, where the company recently asked the state commission for an 8-percent rate increase plus a tracking mechanism to price-in its planned capital expenditures.
Additionally, the investments are happening at a time of transition for Southern’s management. This summer, CEO David Ratcliffe announced his plans to retire at the end of the year, setting in motion a succession plan that results in COO Thomas Fanning becoming CEO, CFO Paul Bowers becoming COO and Alabama Power CFO Art Beattie ascending to CFO. The company also announced at least a dozen management changes at the VP level or higher.
For the next few years, these factors likely will weigh on Southern’s financial performance—and its F40 ranking. Although Southern is one of the largest utility companies in America, with a $30 billion market capitalization, no U.S. utility can spend $20 billion over four years without straining its balance sheet and testing the indulgence of regulators and customers. Even so, Ratcliffe says Southern Company takes a long view on its cap-ex plans and the resulting public debate.
“The public has to understand that we’re trying to find the best solutions for them in the long term,” he told Fortnightly in an interview earlier this year. “We’re fortunate in our jurisdiction to have an IRP process where we go before the regulators and ask for agreement on the actual amount of need we have, and then we go back in a separate process and determine exactly what technology makes the most sense, in terms of the mix of assets that already exist, the need for reliability and the desire for a cleaner footprint. That way we get a decision that the commission and the public has input into, and agreement that we should move forward. We’d never be able to build [the plants we have planned] if not for that public process and the cooperation of regulators and the communities we serve.”
In some respect, many U.S. power and gas companies are facing a crossroads, and they’re seeking direction from among industry leaders like the companies that appear near the top of Fortnightly’s ranking year after year. However, the strategic lessons taught by these companies can seem confusing. For instance, the back-to-basics trend of the post-Enron era hasn’t exactly reversed itself, but unregulated business activities are making a distinct comeback, generating strong returns for many companies. Investors value strong cash flow and steady dividends, but the leaders in the F40 pay lower dividends than many of their peers.
Such apparent contradictions might in fact belie the secret to success in shareholder performance. Dominion, PSEG and Exelon provide noteworthy examples.
In 2007, Dominion Resources embarked on a strategic redirection that it’s still implementing today. The company sold its offshore hydrocarbon exploration & production businesses, as well as its properties in the Marcellus Shale region and a gas distribution company in Ohio, which was outside its primary service area in Virginia. Dominion aims to reduce the proportion of its earnings attributable to unregulated business, down from its previous 75 percent to about 40 percent. Yet the company intends to grow substantially, with plans to invest in pipelines, transmission systems and power plants, which it can build in Virginia under a 2009 rate case settlement that provides special power-plant riders with a 12.3 percent rate of return.
“We refocused to become a low-risk energy infrastructure company with a growing dividend,” McGettrick says. “We were able to grow our dividend by 30 percent from 2007 to 2009, and we’ll continue growing it for the next two years. At the same time our payout ratio is modest, now 55 percent and going to 60 or 65 percent. That gives us flexibility that many other companies don’t have.”
Further east in New Jersey, PSEG has refocused its strategy by divesting international assets and concentrating on domestic business. And the company recently completed a cap-ex program that improved environmental performance at its coal-fired power fleet. “Other states now are questioning whether they should invest in coal plants,” Dorsa says. “We’re relatively set up, because we try to take a long-term view and think about the issues well ahead of time.”
Toward that end, PSEG now is investing in unregulated solar generation, including a 12-MW, $100 million photovoltaic installation in Ohio and a 15-MW project under construction in Jacksonville, Fla. “We don’t look at these investments as loss-leaders or early incubation things. They generate value for our shareholders,” Dorsa says. “We’re pretty excited about it and look to grow that business.”
To the west, in Pennsylvania and Illinois, Exelon is likewise looking to expand its rate base, while also making the most of unregulated business opportunities. The company considers this a “protect-and-grow” strategy, according to Patterson. “We’re protecting the value that we’ve created, and we’re growing the long-term value,” he says.
Specifically, Exelon is uprating its nuclear fleet to add 1,500 MW of new capacity, which Patterson says the company can accomplish “for half the cost of a new reactor, with substantially less risk and no incremental O&M (operations and maintenance cost.)” The company is planning regulated transmission investments to serve reliability needs and to take advantage of FERC incentive rates, as well as merchant transmission investments to support its wholesale energy business. And finally it plans to spend $700 million on distribution infrastructure, including a PECO project that won a $200 million ARRA smart-grid stimulus grant.
Like Exelon, PSEG and Dominion, companies throughout the F40 ranking exemplify a multitude of strategic approaches—with greater or less emphasis on regulated and unregulated investments. “There’s no homogeneous answer to what drives long-term performance,” Laurens says. “The most successful companies are those that execute a strategy that’s consistent with the company’s core competencies and its market context—whether it’s a regulated or non-regulated business.”
So the unifying element for success isn’t a formulaic strategy, but a rigorous approach to strategic planning and execution. Perhaps more than anything else, the F40 makes this clear, with a diversity of sizes, strategies and geographies represented among this year’s top three companies, all of whom have been perennial performers in the F40 (see Figure 3). Exelon, for instance, has consistently ranked in the F40’s top five, with a multi-market nuclear-focused strategy and significant unregulated holdings. The other two are Dayton Power & Light (#1), a small vertically integrated utility with 500,000 customers and 10 power plants; and Energen (#3), a small gas utility with major upstream E&P holdings.
Companies like these consistently deliver value for shareholders because their leaders have established clear strategic direction, aligned the company toward it, and maintained long-term progress through all manner of setbacks and challenges. Most companies won’t be able to follow their examples in terms of resource mix or asset plan, but they can learn from their success in pursuit of a winning strategic vision.