Americans love comebacks; particularly great comebacks like those memorialized in movies like Rocky Balboa, in real-life stories such as George “The Gipper” Gipp, and in corporate America such as Apple and Chrysler.
The results of this year’s Fortnightly 40 (F40) financial rankings of electric and gas utilities and pipelines epitomize that grand American tradition. This year several companies have, at long last, overcome significant and very public adversity from the California crisis, the Enron debacle, the merchant crises, international losses, and various other financial calamities.
One utility that was long missed from the Fortnightly’s rolls and was widely predicted to make the F40 this year was Duke Energy, which makes its debut this year at #22—a hard-fought win for the utility, which was mired for many years in the merchant downturn and had to do significant corporate repositioning and reorganization. But one anonymous analyst says the company masterfully streamlined its operations with the sale of its unprofitable merchant arm (removing a huge burden), while its merger with Cinergy drove economies of scale.
Companies like AES and Mirant, which debut this year at #35 and #39, respectively, also have made dramatic improvements in their corporate balance sheets. Many financial analysts had predicted their rise as well.
Moreover, there are a few companies that have been moving up through the rankings year-on-year consistently: Westar, CLECO, First Energy, Entergy, and PG&E Corp. While all have faced their fair share of adversity, their rankings over three years show continuous improvement (see chart). Many predict their continued rise.
“Then there were also a number of companies in the top 10 that were just focused on getting the basics right: the Energens, the PPLs, EnergySouth,” says Jean Reaves Rollins, managing partner, the C Three Group LLC. “There was nothing sexy about any of their strategies. They were steady players.”
The top-ranked energy company in the United States this year is none other than TXU, which has been red hot for various reasons. Its placement atop the F40 possibly is the most provocative of all the rankings, and the most controversial—and certain to be the most studied by utility executives in the F40’s short history.
Beginning next year, the new Fortnightly.com website will feature an interactive online database, including the Fortnightly 40 ranking.
Correction: An error in calculating the 2007 Fortnightly 40 resulted in erroneous rankings for one company, NStar, in the printed edition. The correct rankings are shown here.
The winners of this year’s F40 raised as many questions about corporate performance as were answered.
To those of you new to the F40, in 2005, the inaugural year for the rankings, the industry wanted to know which energy companies were the best financial performers.
Given the increasing diversification of electric utilities into exploration and production (E&P), and E&P companies into local gas distribution and pipelines, operational benchmarking analysis (and other measures) no longer offered meaningful answers to the questions senior executives had about how best to manage their companies.
In fact, the industry and our readers demanded a type of analysis that more truly communicated value to future investors, future owners, energy asset operators, regulators, and consumers (see sidebar, “A New Performance Standard”).
Every year the challenge remains the same. What do the numbers tell us? But TXU’s top rank this year raises several questions, particularly as the F40 hopes to isolate in its ranking management’s sustainable contribution to financial performance. Critics claim that the reason TXU won has more to do with its low-cost coal in a market set by high-priced gas than any other strategic reason or management policy. Further, these critics say, TXU has an advantage over other companies as it has not reinvested in its infrastructure as much as others.
Moreover, those same analysts believe that TXU would not have been able to sustain the top spot had it not terminated plans for the construction of 8 of 11 coal-fired power plants as part of its agreement to be bought by Kohlberg Kravis Roberts and Co. (KKR) in the largest leveraged buyout (LBO) offer in history. At press time, the $32 billion dollar LBO deal was pending shareholder approval, scheduled to be voted on Sept. 7.
Of course, given the fact that the sale will take TXU private, we may never know if TXU’s business model really was sustainable—and capable of the high performance that would keep it on top of the F40 in years to come. Certainly, TXU follows in an awkward (sometimes welcomed) F40 tradition where winning companies have attracted overtures from private- equity firms and other utilities seeking mergers and acquisition.
Kinder Morgan, which was the F40’s previous #1 for two years running, also went private via a $13.5 billion purchase last year—the largest management-led buyout at the time, and one of the largest buyouts in history.
TXU CEO C. John Wilder, through a press representative, declined our invitation for an interview, citing the still pending deal with KKR. According to a proxy filing with the Securities and Exchange Commission released in late July, TXU announced that Wilder would be leaving the company, and receiving approximately $300 million in compensation— including stock awards and deferred compensation.
Wilder has been credited for TXU’s turnaround from the financial losses the company suffered in Europe, taking $4.2 billion in charges in the fourth quarter of 2002, primarily to write off its struggling European business. Many analysts say the TXU CEO was effective in pairing down the balance sheet by selling unprofitable businesses and keeping costs low.
“That is what distinguishes us,” Wilder told the Fortnightly, in a June 2005 interview. “We’re moving down the path and have made, frankly, very good progress in running TXU, particularly TXU’s manufacturing business, as an industrial company by trying to achieve operational excellence and cost leadership.”
Says C Three’s Rollins, “Clearly, we can say that TXU reaped the benefits of the deregulated structure in Texas.”
In fact, the Dallas Morning News reported last year that TXU Corp. nearly doubled its profit for the third quarter compared with 2005, thanks to higher electricity prices. TXU’s third-quarter net income in 2006 rose to $1 billion, or $2.15 a share, from $565 million, or $1.16 a share in 2005. The increased revenues have attracted a storm of criticism from Texas legislators, putting into question whether TXU’s new private-equity owners will be able to reap higher profits in the future without triggering a more sustained public backlash.
Meanwhile, one analyst familiar with TXU defends Wilder, saying he believes the utility’s success came both from the broader transformation of the business led by the CEO, and the commodity play. “It’s both,” he says. “I’m sure we could sit down and dissect which part of the uplift is due to the commodity play or the transformation. But Wilder transformed the company’s cost structure—outsourcing, unbundling of their field force, outsourcing call centers and shared services, dramatically reducing costs. He also started off with the smart grid, AMI, and BPL. He really hit a lot of the drivers needed for financial performance.”
Others say TXU’s success may forever be an enigma of the Texas energy market, and will remain a contentious subject among some industry watchers. But with respect to the F40’s other winners, some basic observations can now be made in its third year of tracking financial performance.
“About three quarters of the [F40] list makes it from one year to the next,” Accenture’s Jack Azagury says. “And there are a few companies that really stand out. There are four or five companies which make the top 10 every one of the years.” In fact, among those companies that have made the greatest improvements, three drivers define the jump in ranking.
Azagury, senior executive with Accenture’s Enterprise Transformation Practice, specializing in utilities, says the first driver is a broad transformation that led to significant operational improvement for these companies, such as implementing major cost cutting, or making other big changes that were driven by new personnel in the C-suite.
The second driver is a recovery from the merchant collapse in the early part of the decade. “By getting that part of their portfolio cleaned up, they have seen uplift in their performance,” Azagury says.
The third driver is positioning themselves in the right place of the value chain at the right time, such as taking advantage of the seven-year cycle for power.
“The winning companies are able to anticipate those trends and reshape their portfolio, divest assets at the right time, acquire assets in the right sectors at the right time, or change their hedging strategy to accommodate for that,” Azagury says. “It’s really having that strategic focus and being able to react in advance of those trends that can affect the industry.”
For example, Anthony J. Alexander, president and CEO at First Energy, which ranked 15th this year on the F40, took charge of the company just a year after the 2003 Northeast blackout, for which the company was faulted, and faced the multi-year financial and media fallout from the Davis-Besse reactor pressure-vessel head degradation. Alexander attributes the company’s turnaround to management’s focus on improving the performance of the various business units.
“When I took over in 2004, I spent the next few years concentrating on improving the company’s operations across the board in all areas and focusing the organization on the future,” he says. “First, we focused on safe operations of the nuclear fleet. Second was continued and improved performance out of our baseload fossil fleet. And third was improved reliability on the distribution side of the house or wires business.”
Alexander believes the streamlining of those three businesses has contributed most to free cash-flow improvement. Alexander described the change in the overall strategic focus at First Energy as “trying to simplify our goals to get everyone aligned so that we were all working for the same purpose.”
Moreover, where various companies capitalized on high natural-gas prices (whether E&P or pipeline companies) and dominated the upper tiers of the F40, it’s difficult to identify one business focus that dominated all others. The winners were adept at their specific area of expertise or business sector, Azagury says. “It really comes down to the underlying capabilities of performance,” he says.
“There really is no specific trend in the [F40] in 2007. We see companies in the top 10 that have less than 5 percent of their revenue from unregulated businesses to companies that have two-thirds of their revenue derived from unregulated sources,” Azagury says.
The mix in the top 10 is no different than the mix in the rest of the F40. In addition, research was done in response to F40 reader questions over the years of whether the ranking favors small companies (less than $5 billion in revenues). “The average revenue in the top 10 is just under $5 billion, and the average revenue in the entire sample is also around $5 billion,” Azagury says. “Success will come down to underlying capabilities such as operational improvement, asset management, strategic agility, portfolio management, and being in the right sectors at the right time.”
One performance trait cuts across the entire F40 ranking— the strength of the regulatory relationship. In fact, various experts over the years have cited evidence to support a very strong correlation between the regulatory relationship and customer satisfaction. This result may seem intuitively obvious, but it has not always been so in an industry where the idea of customer satisfaction is a relatively new development. Regulators are looking for ratepayers to be satisfied with rate levels, service, and response—even as the very term “ratepayer” is becoming a dirty word among these forward- thinking utilities. Peter Darbee, chairman of the board and CEO of PG&E Corp., a company that continues to move up the top 10 of the F40 (moving from #7 last year to #6), credits the success of the company to a focus on the customer.
“People use to use the term ‘ratepayer’ a lot around here. What I did is say, ‘We really want to eliminate the use of that term because “ratepayer” suggests someone that is the prisoner of a monopoly, whereas “customer” suggests someone that has choice each and every day,’” he says. Darbee says that he changed the terminology when he took the helm of the company in 2005, beginning the process of transformation for the company.
“I think it ties back to the vision. We really set out a course to be the leading utility in the United States. Our belief was that in order to do that we had to please multiple constituencies. It starts with the customer. We have to serve the customer well,” he says.
In fact, Darbee envisioned a philosophy and culture at PG&E Corp. that would be like a competitive company serving its customers—better, faster, and more cost effectively. Right from the beginning, the company set out to benchmark the very best practices of other utilities to achieve the intended transformation. In PG&E Corp.’s nationwide analysis of the industry, Darbee recalls finding that not all best-in-class U.S. utilities are the best at everything. For instance, Darbee says companies like FPL were found to be clearly ahead of the industry in renewables, while companies like KeySpan (at the time of the analysis) were first in new connects. KeySpan ranks #32 and FPL #26 on this year’s F40.
“It has really been an integrated plan. The strategy focuses on knowing our customers’ needs very, very well and then transforming our relationship with the regulators, which was an adversarial relationship, to what is now a collaborative relationship, as we have very common interests,” he says.
Darbee believes that the focus on operational excellence, on driving costs out of the business, and on using capital more effectively has had the effect of reducing costs, increasing profit, and increasing cash flow. And, Darbee notes, all of those things have a positive impact on the financial performance metrics measured by the F40.
Darbee is not alone in understanding the alchemy of regulatory relationships. Michael H. Madison, president and CEO of CLECO, which achieves the #3 spot on this year’s F40, leads a company that many say exemplifies the type of constructive relationship with regulators that can benefit ratepayers and shareholders alike. In fact, when asked about the overall strategy that has led to CLECO’s success, Madison highlights the duty to serve. “I think it’s a focus on the customer, the focus on stable earnings, focus on credit rating, and therefore free cash flow. If we keep those in front of us at all times we will make the right decisions. I think our record over the last few years has proved that,” he says. Indeed, CLECO’s total return to shareholders over the last 10 years was superior to both the Edison Electric Institute (EEI) and the S&P 500 indexes.
A positive regulatory relationship is going to be crucial to the success of the future infrastructure build that utilities must initiate to meet future power demand, and to the utility’s financial health as it shoulders the considerable risks associated with this endeavor. CLECO’s announcement in 2006 to build a $1 billion solid-fuel unit at the company’s Rodemacher Power Station near Boyce is a case in point. Rodemacher Power Station Unit 3, as it is known, is a 600-MW unit that will use circulating fluidized-bed technology, developed under the U.S. Department of Energy’s Clean-Coal Technology program. Madison explains that it was the regulatory relationship that made building the unit possible, given the regulatory treatment. “One of the key things is to be able to borrow money and maintain an investment-grade credit rating,” he says, adding that the $1 billion investment in the power plant is huge given the company’s size. So Madison approached his state regulator about the credit implications and the financial challenges.
“When the commission saw the savings that these customers would receive over the 30-year life of this new solidfuel unit, they did not hesitate, and in April of 2006, when we started construction, they allowed us to recover 75 percent of allocated funds used during construction,” he says. Madison says the agreement, and the collection of funds that began more than a year ago, has allowed the company to maintain its credit rating, and the cash flow has allowed the utility to finance the project.
C-3’s Rollins explains, “On the free cash flow issue, if you are allowed to put it into ratebase and earn a return as you are building the plant, that’s going to give you a significant edge over someone that has to finance it with debt and equity, at least on the F40.” This is because of the way that the F40 calculates free cash flows without the contemplation of debt or equity, she explains, noting that the F40 does not contemplate any type of debt other than interest or cost of equity other than return on equity (ROE).
Even as one can now identify strategic decisions that were prescient for the F40 rankings, today’s challenges and those of the future are mounting for the utilities industry. These issues will make staying on top in financial performance that much more difficult. Accenture’s Azagury explains, “The broader question is on long-term sustainability. We looked at the top 40 and the entire utility universe that was ranked and looked at earning growth expectations. We saw that between full year (FY) 2007 and FY08 the analysts are expecting about 7- to 8-percent average growth.” Expected earnings growth over the next five years is just under 7 percent, he says.
Azagury points out that natural growth in the industry of 2 to 3 percent, pension costs, wage increases (often above the rate of inflation), and tightening of allowed rate of returns make it that much more difficult to meet Wall Street expectations.
“So, achieving a 6- to 7-percent earningsper- share growth rate in this environment is going to be very challenging. Over the next five years, the winning companies will need to have a step change in their strategy.”
So, who might be the winner next year? Companies like Dominion, which sold off its E&P business this year, and which are really transforming or repositioning the business, may make strong showings in 2008, says Rollins. Watch these pages to see who makes next year’s Fortnightly 40.