What to Do With All that CASH?Seeing no need to build, utility managers are looking
to invest. Can they be trusted
with stockholder money?With little of the fanfare that surrounds the debate on utility competition, robust cash flows and declining capital outlays have created forces that will reshape the industry no matter how competitive restructuring unfolds. Cash generation already exceeds investment in core utility activities, and the differential will grow sharply over the next several years. Utility managements face two options: 1) they can retire securities and shrink their capitalizations, or 2) they can invest unabsorbed funds outside their core businesses. Their choice will exert a major impact both on the future business activities of utilities and on shareholder values.
Growing Cash Flow,
In the last several years, the relationship between electric utility cash generation and the industry's investment opportunities has changed dramatically. Although it enjoys the cash generation capability of a capital-intensive industry, electric utilities have actually become less capital intensive. Current cost-based rates provide utilities with large amounts of capital recovery through depreciation and amortization, yet capital expenditures are shrinking rapidly due to three factors:
s Continuing excess capacity has limited the need to build new generating capacity.
s Utilities are no longer the sole provider of new generating capacity.
s New technology (em especially combined-cycle gas turbines (CCGTs) (em sharply reduces the capital intensity of electric generation. (A CCGT now requires as little as one-third the investment per kilowatt of capacity that a new coal-fired unit did six or eight years ago.)
These forces are shrinking capital expenditures but not cash flow. Corporate capital expenditures for a sample of 77 utilities that account for 95 percent of investor-owned utility (IOU) capitalization peaked at $29.1 billion in 1992 and declined to $26.4 billion in 1995. Managements project a continuing decrease in capital spending, to $24.5 billion in 1996 and $23.5 billion in 1998. By contrast, depreciation rose from $17.6 billion in 1992 to $21.6 billion in
1995, and is projected to reach
$25 billion by 1998. Thus, where capital spending exceeded depreciation by $11.5 billion in 1994, the gap narrowed to only $4.8 billion in 1995, and spending should exceed outlays by $1.5 billion in 1998. After 1996, utilities will be disinvesting in their core businesses.
Total internal cash generation, including retained earnings and deferred income taxes, already exceeds capital expenditures. Cash generation not absorbed by capital spending reached $2 billion in 1995, and is projected to grow to $5 billion in 1996 and $8 billion by 1998. Unabsorbed cash will likely total $40 billion between 1996 and 2000.
Options: Retrench or Diversify
Unabsorbed cash generation of this magnitude can be used to accomplish a variety of objectives. Let us consider two alternative financial strategies. The first applies all unabsorbed funds to retire outstanding securities. The second invests all unabsorbed funds outside the core franchise business.
If the entire $40 billion were used to retire securities while capital structures and dividend payout ratios remained constant, the industry's common equity would shrink 20 percent (em roughly 4 percent per year over the next five years. Of course, any growth in earnings per share would depend on the prices at which the stock was repurchased. At present prices, about 1.2 billion shares of common stock would be repurchased, and earnings per share would grow about 3 percent per year.
A much different picture emerges if utilities should invest their unabsorbed funds outside the core business. Again, let's assume that the dividend payout ratio and capital structure remain constant, which implies borrowing to leverage retained earnings. In this case, outside investment would run about $14 billion annually, yielding a total of $70 billion between 1996 and 2000. By 2000, these investments would account for over 15 percent of earning assets; earnings growth between 1996 and 2000 would depend entirely on the profitability of these investments. With a 12-percent return on incremental equity, earnings per share would grow 3 percent per year. With no return on outside investments, however, there would be no earnings growth.
Shareholders at Risk?
How utility managements choose to invest their unabsorbed cash will test their commitment to shareholders. The pivotal question is how willing utility managements will be to shrink their capitalizations and remain within their core businesses if attractive investments are not available. Conversely, to what extent will managements feel compelled to expand beyond their core businesses regardless of the quality of the investment opportunity?
The decision to retrench or diversify is made more complicated by competitive restructuring. Future utilities are unlikely to resemble their former selves. They will not be able to downsize and become smaller capitalized versions of themselves. The outlook for utilities investing in the electric power industry beyond their franchise areas also remains highly uncertain. The risk for investors is that managements will invest despite unfavorable prospects.
Apart from a few notable exceptions, such as Florida Power & Light, managements exhibit a strong preference for investment, as is evident in purchases of foreign utility properties and domestic merger agreements. In many instances, these investments do not appear directed toward strategic goals. Too often, foreign investments have taken the form of passive portfolio participations, instead of direct management involvement that would build expertise. One frequently has the impression that investment professionals could develop these portfolios just as well as utilities.
Similarly, merger agreements tend to be driven by a desire to grow, rather than by strategic objectives. Given the success of management efforts to cut costs, it seems plausible that cost savings equivalent to those claimed for mergers could be achieved without the mergers. Utilities naturally manage their cost-cutting in ways that will enable them to enjoy the benefits as long as possible. This strategy sometimes means a delay in cost reductions if regulators are in a position to pass the benefits on to customers immediately (thus denying such benefits to utility stockholders). However, by attributing such cost savings to a merger, a utility can capture the benefits of the cost-cutting opportunities by using them to finance the merger. In the process, the utility gets bigger but not necessarily better.
Given a history of unsuccessful diversification, the current eagerness of utility managements to expand beyond their franchises raises questions about the priority that will be given to shareholder interests. The hostile attempt by Western Resources to buy Kansas City Power & Light (KCP&L) is a case in point. Western has shown itself so anxious to acquire KCP&L that it is willing to pay a price that carries important risks for Western shareholders. And by rejecting Western's excessively generous offers, KCP&L appears so eager to pursue its own expansionist agenda that it will disregard the interests of its shareholders. t
Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in economics from Columbia University, and specializes in economics and financial research on electric utilities.
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