What defines high performance in the utilities industry? Who will be the winners? And what factors suggest long-term, sustainable leadership? These are tough questions—the seminal questions of business.
In a stable, relatively homogeneous regulated market, measuring performance leadership is somewhat predictable. In today’s changing market, however, it’s become complex, opaque, and the fodder for endless debate. More important, measuring performance has become as misleading as it is illuminating, typically failing to provide much insight on future performance, long-term potential or looming performance threats. While analysts attempt to sort this out for investors, the question remains: What really matters?
In the end, there is no short and simple answer. However, there are a few themes to keep in mind when evaluating industry performance assessments:
• Market sub-segments exist, and the definition of leadership varies among them;
• A spectrum of measures is better than one measure, providing reinforcing and countervailing indicators;
• Because they best align with your strategy and value-creation model, over-weight measures;
• A future versus historical bias should be maintained, e.g., trend metrics that “suggest” future performance; and
• Metrics should indicate actions—strategic changes and capability gaps to fill.
During the past 10 years, there has been little consistency in utility performance. Sustained leadership, in terms of total return to shareholders (TRS), has been practically non-existent as the market has ridden out the wholesale debacle, the return to basics, and significant asset repositioning and merger activity.
As utilities shifted from strategic growth to improving core operating performance post-Enron, reducing costs and risk, utility stock prices responded. The S&P 500 Utility index rose 20 percent in 2004 and 17 percent in 2005, boasting an average dividend yield of 3.3 percent—nearly double that of the S&P 500 during the same period. Was the market actually responding to improved core operating performance? Was it anticipating growth and consolidation? Or was the market simply responding to low interest rates, wholesale workouts, and a general investor flight to safety? The answer to all these questions is a qualified “yes.”
To some, high performance is defined by superior profit margins, asset turnover ratios, and return on assets (ROA). To others, high performance means achieving the highest TRS or the greatest spread between return on invested capital (ROIC) and weighted average cost of capital (WACC).
The Fortnightly 40 takes another approach: a hybrid model that incorporates historical growth trends and force-ranks performance against key elements of the classic DuPont model.
Each approach yields a different list of high performers, but only two companies—PG&E and Energen—appear on all four lists (see Table 1).
While none of these rankings provide a complete performance picture, in aggregate, they do provide a set of insights into what the market is valuing. A key question revolves around the apparent disconnect between the DuPont rankings and TRS performance. Does strong performance against the DuPont translate into shareholder results? What about positive market expectations? Fig. 1 shows TRS performance measured against the DuPont Index. TRS is not correlated with the DuPont Index (R2=0.0342). One explanation is that the DuPont is a decidedly historical measure and does not take into account future indicative trends. It is a trailing index, tailored for mature capital intensive industries and does not reward growth or pick up market expectations.
Taking TRS as the bottom-line performance indicator, a number of performance insights emerge:
• There is a strong correlation between TRS and ROIC-WACC.
Consistent with other capital-intensive industries, capital efficiency, as reflected in the ROIC spread, is the most predictive factor for overall shareholder performance (see Figure 2). Historically, the regulatory compact covered a multitude of capital spending sins. However, increasing deregulation, coupled with elongated regulatory cycles, tougher regulatory review in many jurisdictions, and escalating capital demands, is making capital allocation and management increasingly predictive. Unlike many operational measures that are driven by demand and jurisdictional characteristics, capital management has a large discretionary component and is highly controllable by management over the long term.
• There is little correlation between operational performance and TRS.
Operational leadership is not highly predictive of overall shareholder return in the utilities industry. For example, operational performance, measured by operating margin, has a low correlation with TRS or ROIC-WACC (R2=0.076 and 0.30, respectively). The regulatory compact historically has not rewarded top decile operational efficiency. High performers typically are not the most efficient operators, but rather, they are good, typically second- quartile performers that manage the service and regulatory sides of the performance equation. The exception is generation, where cost leadership is highly advantaged for like fleets, assuming similar availability factors. Translating operating performance to bottom-line shareholder value is highly dependent on being in a favorable regulatory jurisdiction. Gain-sharing regulatory mechanisms and increasing exposure to unregulated competition will increase the importance of operational performance.
• Growth expectations are driving TRS. Yield is inversely correlated to implied growth.
Utilities stocks have an embedded average implied annual growth rate of more than 6 percent—with a wide range from just over zero to more than 13 percent. These are aggressive figures for an industry with approximately 2 percent intrinsic growth. It is driven largely by the market’s confidence in a company’s strategy, value propo- sition, and associated capabilities, and it is influenced by management. ROIC spread is a good interpretative factor of a company’s ability to realize growth expectations. It is an indicator of how well management’s portfolio priorities and investments are bearing fruit. In general, higher-yield companies have lower implied growth expectations.
In other words, new value-chain models, good portfolio management, and superior capital efficiency are being recognized by the market and translated into growth expectations to the extent that strategy and positive ROIC trends suggest future earnings growth. Adjusting for interest rates, and “rebound” stocks such as AES, TRS performance in the industry is being driven largely by these growth expectations. Incremental operating improvement will contribute to achieving this growth, but it is not enough. The DuPont rankings, which are strongly correlated with historical operating performance, do not provide strong guidance on which companies will sustain performance, grow, and translate execution into bottom-line results over the long term (see Figure 3).
High growth expectations, coupled with the seeming disconnect between operating performance and TRS, reflect the continued separation of the utility market into growth and value stocks.
Dividend yield, price-to-earnings ratios, and implied growth in the share price vary between the two groups, as do the key underlying drivers of performance.
The growth group has an average TRS about six times higher than the value leaders, at similar DuPont indexes. The strongest differentiator is ROIC spread. The growth group is being discounted slightly in terms of price-to-earnings ratios because of perceived risk, and, we believe, a general difficulty articulating value propositions. Table 1 compares the two groups.
Value utilities are typically more highly regulated, core-focused companies. They include traditional vertically integrated utilities and delivery (T&D)-focused companies. They emphasize maximizing cash-flow growth through operational excellence and regulatory strategy/execution, aligning operational performance to stakeholder expectations. They are not necessarily cost leaders. Value leaders typically are in advantaged regulatory environments and create shareholder value through increased dividends.
Growth-oriented companies typically are hybrid regulated/unregulated models with more than 40 to 50 percent of their revenues unregulated. They are value-chain portfolio managers who are “commercially reintegrating” the business.
Growth utilities typically have significant operations in de-regulated states, are multi-commodity, and have comprehensive value-chain positions. They are likely to have made asset or value chain extension acquisitions as opposed to core business consolidation. They also are likely to maintain some portion of the core business to provide predictable cash flow and access to cheaper capital. For most, not over-weighting the unregulated portfolio, relative to the regulated, is an important consideration. Growth utilities are active portfolio managers and not hesitant to divest of assets.
In summary, independent of the chosen strategy—value or growth—utilities should focus on the fundamental creation of value through their deployment of capital. Having a positive spread between ROIC and WACC is the key to shareholder value creation.
Accenture systematically has researched high-performance drivers in the utilities industry. We have isolated five key explanatory factors that predict utility TRS performance (see Table 2). Growth and value companies are driven by different core financial drivers, as implied by their strategies. Only capital efficiency, as reflected in ROIC spread, is a consistent performance factor across all companies and company strategic groupings.
Capabilities and execution ultimately define performance and the ability to navigate through market cycles. Four capabilities are characteristic of sustained leaders. These factors are consistent in principle across all industry groups:
• Strategic Discipline
Performance leaders possess strategic focus and clarity. They have a clear, explicit value proposition that drives execution. They seek to create and maximize structural, economic, and regulatory advantages by anticipating the market. They typically have a balanced, integrated portfolio encompassing diversified parts of the value chain to provide natural hedges and reduce earnings volatility.
• Capital Management
High performers yield significant value relative to the capital employed. They consistently have positive ROIC spreads. They also have strong balance sheets providing significant financial flexibility for investment and they are increasingly taking advantage of selective opportunities to lever up to reduce their cost of capital.
• Regulatory Management
High performers have solid regulatory strategies and good relationships with regulators and other stakeholders. They develop operating strategies that support stakeholder priorities. They often tradeoff cost efficiency for higher service levels or “gold-plated” capabilities. Customer satisfaction is one area where higher customer service capabilities and costs, and hence satisfaction, is often leveraged into higher rates of return. A positive link can be found between customer satisfaction and rate decisions.
• Focused Operations Excellence
High performers are above average operators, but not necessarily top decile performers. High performers focus on a few key market capabilities—those that most directly create value and can be differentiated. They attempt to maximize differentiation in these key areas and out execute their peers by paying particular attention to performance management and the people side of the equation.
Let’s examine the value and growth groups specifically.
Value-focused companies are challenged by four primary trends: 1) Exhaustion of traditional cost-reduction programs; 2) high capital spend requirements on aging infrastructure and new generation; 3) regulatory overhang and increasing expectations; and 4) few “lower”-risk growth options.
Value-focused companies will look to improve performance by redefining their cost structures and targeting capital spending programs on low marginal cost supply assets and recoverable capital upgrades:
• New operating models and productivity enabling capabilities and operational excellence;
• Process versus functional orientation; standardization;
• Selective application of real-time data and decision-making tools; and
• Increasing use of third-parties to fulfill non-core, low differentiated processes at fixed, predictable prices.
• Selective acquisitions to leverage leading operating models/capabilities, and nascent scale; and
• Balanced supply portfolios with low negative supply and fuel exposures.
Value leaders over the long term will be excellent consolidators operationally. The majority of acquisitions today fall in this category, e.g., Mid-American, and National Grid. These acquirers can be expected to build acquisition platforms that leverage transferable best practices and scale, where available, to create advantage. Translating this advantage to shareholder value will require focusing on the highest impact capabilities for stakeholders and innovative regulatory constructs. Operational due diligence also will be vital to ensure achievable/ exceedable price premiums.
On the other hand, growth-focused companies will focus on three trends: 1) growing presence of financial institutions; 2) increasing appetite for energy project exposure by non-traditional investors; and 3) escalating exposure to international market forces influencing domestic commodity prices.
Growth utilities will look to build value along the value chain by reintegrating the disaggregated value chain. They increasingly will redefine their positions in the market to concentrate on higher-growth value opportunities, such as multi-commodity wholesale supply, unregulated generation, or innovative financial structures around infrastructure, such as ITCs. They will play in multiple markets with different asset portfolios. They will seek to maximize investment return and cash flow to stakeholders by reinvesting free cash flow in high return projects in the utility’s asset portfolio. They will focus on:
• Capital/resource allocation: strategic management rather than operational;
• An integrated portfolio management model that emphasizes value creation at points of value chain integration, e.g.:
• Supply and Trading;
• Retail and Supply Acquisition; and
• Trading, Pricing and Structuring.
• Active portfolio management
• Targeted asset acquisitions rather than whole company deal; and
• Innovative disaggregation of assets, e.g., distribution versus field services.
• Risk management: focused risk-taking;
• Core operations leveraged for predictable cash flows and lower cost of capital; and
• Aggressive shedding of non-core activities.
Even though growth companies provide a decidedly superior TRS performance, their risk and range of performance is higher than with value companies. We believe both growth and value companies have strong value propositions for the future and will continue to develop as the competitive and regulated aspects of the deregulated market continue to evolve and mature. Each group faces a set of common and unique challenges—leaders will surpass their peers in aligning their value creation strategies to their asset portfolios, business capabilities, and regulatory/stakeholder strategies.
High performance in the utility industry will be defined by companies that clearly can choose and deliver on their strategic aspirations—value or growth.