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CFOs SPEAK OUT
Looking Beyond Power
Chief financial officers discuss new strategies and the possibility of further convergence inside and outside the energy industry.
October 2005
Interviews By Richard StavrosWith the repeal of the Public Utility Holding Company Act of 1935 (PUHCA) as part of the Energy Policy Act of 2005, the utilities industry is beginning to have a sobering discussion on its own future. What was for decades was just idle speculation today is a very real discussion on what types of consolidation and business strategies will carry the industry forward.
For example, many have said PUHCA repeal would promote consolidation with other parts of the energy industry, or more of the so-called convergence mergers typified by the late 1990s and early 2000s. Although this time around, such convergence mergers, they say, will include oil majors in addition to gas and pipeline companies.
A whole new cast of characters is expected to enter the energy industry-overseas ventures, telecom firms, insurance companies, and financial-services groups.
But even as the future seems to hold boundless opportunity, utility executives and industry experts continue to disagree on what sort of consolidation is right.
Many utilities failed in their diversification efforts related to energy trading, insurance, banking, and the international space. But some oppose this characterization, saying that the utility diversification failures of the 1980s and 1990s were no greater or less than the typical diversification failure that took place in corporate America.
"There are many utilities that have successfully diversified their businesses over the years," says a former energy regulator. "There is nothing inherent in diversification that makes the utility industry incapable of succeeding in this strategy."
Of course, the question is not only what areas the utility industry might expand to, but which industries might want to expand to the utilities industry.
To shed light on some of these issues, Public Utilities Fortnightly, for its annual forum on CFOs, invited outsiders from the oil and telecom industries to voice their opinions. While Occidental Petroleum joined this year's forum to discuss consolidation, the CFO of Verizon declined. The reason: Verizon wasn't really sure how to contribute to the discussion. "Buying utilities to use their power lines to expand our broadband networks is an intriguing idea," said a Verizon spokesman. "I can have our chief technology officer speak to the idea. But given our pending MCI merger, this idea is way too far out for us to discuss."
The Occidental Petroleum CFO also has very specific ideas of what type of convergence could occur. His view, much like that of Verizon's, is that mergers between utilities and outside industries will be few and far between. But even as some dismiss such mergers, others are making a case for the value of such combinations. MDU Resources, with its combined utility and oil and gas operations, is proving to shareholders' delight, that such combinations can be done successfully.
We asked several other utility CFOs what strategies can go beyond power. The CFO of Sempra explains how LNG will be a big part of the company's business some day, and the CFO of PPL tells how they have been successful in their international operations, which provide up to 25 percent of the company's earnings. Furthermore, Progress Energy's CFO explains how his company's gas investment continues to pay dividends. We hope you enjoy this year's CFO forum.-Richard Stavros
Making Convergence Work
Warren L. Robinson, Executive VP and CFO, MDU Resources
"In the 1920s we discovered some oil and gas. ... In the mid-1980s, we really broke it out and started to develop oil and gas fields outside our region."Do you think the repeal of the Public Utility Holding Company Act will mean more consolidation? If so, what do you foresee?
Warren L. Robinson: I believe that there will be further consolidation. I don't know that the repeal will have a tremendous amount to do with it. There will obviously be a positive impact. But I think many companies, if you look at Warren Buffet, Duke, and others, have been ignoring the holding company act already. I think it was a foregone conclusion that would be repealed at some point. But the fact that it has gone away I think will take away any reasons that companies might have for saying that they really can't look beyond their traditional areas ... I think the state regulators will be focused on how mergers will affect the ratepayers. ...
Now, I do think you are going to see continued consolidation [by] people like Warren Buffet that have an expertise in the business. Generally, I think it is a very positive development, but I don't think it is going to be a massive change in the outlook for utilities.
What is the percentage breakdown of the business line contribution to the bottom line? How do you think your earnings mix might change in the future?
WLR: What I'll do is give you 2004, and I'll comment on how that might change for 2005. Our natural gas and oil production had 54 percent of the earnings last year. That is a little larger than what historically it's been. But that is because of the higher commodity prices. But it will be in that range again this year because commodity prices continued to be very strong. Our construction materials business is about 25 percent. Our IPP business in 2004 was 13 percent. The utility business (both electric and gas distribution combined) was 7 percent. Our pipeline and energy services were 4 percent. Now, the utility services were in a loss position [in early 2005], but we're experiencing a turnaround. So, [in 2005] it is going to be in the range of 5 percent to 6 percent of earnings, and I would say the pipeline's [earnings] is in the 5 to 6 percent range and the utility would be in the 6 percent range. The rest of them are going to be relatively close to what they were last year.
The CFO of Occidental believes there will not be convergence between oil and utilities because of cultural differences in both industries. Is that your view?
WLR: Well, I have to speak from our perspective. There clearly is a different mentality that goes with running a utility versus the development of oil and gas reserves. There is no doubt that there can be conflicts there unless you have the expertise within the company and understand the differences and manage them appropriately. For example, we really have a separate management team that manages our oil and gas interests than the one that manages our utility interests. And frankly if you look at our various business segments, we have business executives, chief executives officers, at each one of these lines of business that are really focused on the specific mission of that business unit. Unlike what some utilities have done in the past, where you run the business in and try to manage it from the top with one management team, we've never chosen to do that. We are very decentralized in terms of our management teams that operate each of the business segments. Of course, that is one reason that MDU Resources has been so successful over the years in terms of our growth program.
How does MDU Resources define success?
WLR: I'll give you a few statistics. In the last 10 years the compound annual growth rate in revenues for our company has been 20 percent. The compound growth rate in earnings has been 18 percent over a 10-year period. ... Our one-year total return to shareholders has been 20 percent. Our three-year total return has been 21 percent. Our five-year total return has been 18 percent. Even if you go back 20 years, we have provided a total return on an annual compound basis of 14 percent. So, our strategy has not been a short-term strategy. We have provided success to our shareholders. This is not a new strategy, this a proven strategy. So, we have had substantial growth. And it has really been growth in all of these lines of business. We really manage each one of these businesses separately and stay focused on the disciplines and the characteristics of that industry or that business that make it successful. We don't try to interfere with the management of those operations. We think that our ability to grow into the future has never been better than it is right now.
From a strategy standpoint, why is it advantageous to wed an oil & gas operation with an electric or gas utility, as MDU Resources has?
WLR: In the case of our company, we have been a utility for 81 years. We started in 1924. And when we first started we were using natural gas as a fuel source for generation. That caused us to do some exploration for oil and gas reserves. In the 1920s we discovered some oil and gas reserves. From there, we then developed our pipeline and our natural gas distribution business as we developed the natural gas reserves. So, that put us in the pipeline business. We continued to grow and maintain that expertise in the oil and gas area. In the mid-1980s we really broke it out and started to develop outside of our region oil and natural gas fields to supplement the reserves that we had. So, today we now have reserves that stretch all the way from the Canadian border down into the Gulf of Mexico. But if you trace it back it really started in the 1920s, focused on how we used the oil and gas for our utility customers.
What made you get in to the independent power producer (IPP) business? How has your experience been different?
WLR: All of the generation we own is under contract with investment-grade customers. Again, it is a way of taking our expertise from the utility business and expanding geographically into other areas, including international. We are a unique company in the sense that every business that we are in basically has its roots with the original utility operations. We only do those things that we really know how to do. And you can trace each one of our lines of business back to the foundation of the utility that was formed back in 1924. What we have done has not been a revolution where we have gone out and bought these businesses. ... It has evolved. We've started slow and we've grown that business internally and built a sizeable business unit in each of these lines.
If in fact oil and gas prices are to moderate in the next few years, as some experts predict, what will MDU Resources do to replace those lost earnings?
WLR: That's an easy answer for us because we have all of these other business lines where we can continue to grow, where a lot of companies that are strictly focused on oil and gas will have a tough time replacing those [earnings]. Our construction materials business is in 11 states right now. The highway spending bill passed by the federal government is the largest highway spending bill in the history of the United States. So, for the next four years you are going to see record spending-not only in the states we're in, but throughout the United States. We do construction such as highway work, bridge work. It is actual construction work using sand and gravel reserves. Last year the business was $1.3 billion in sales, providing 25 percent of our earnings. So, you can see that business is going to grow. ... We do believe oil and gas prices will pull back as well. So, companies will have to figure out how to replace the earnings that we have seen from these very high prices. We are [also] growing our utility. Because we believe the utility infrastructure in this country is in need of repair. So, our [utility services business] is going to continue to grow. We are going to double our utility in size over the next 10 years. So, we have a number of ways that we can continue to grow our earnings in to the future.
Utilities: Not Interested
Stephen I. Chazen, Senior Executive VP and CFO, Occidental Petroleum
"I think the skills of a utility management are different than the skills of an oil management I don't think those are related industries. I don't think the skill of selling electricity to someone's house is really the same as the skill of an oil company."Energy experts have long speculated that PUHCA was a big barrier for oil majors consolidating with the utilities industry. Do you find the power utilities industry more attractive now with the repeal of PUHCA? And what are your views on further convergence?
Stephen I. Chazen: I think it is unlikely. I don't think the problem was PUHCA. Running power plants is really not what oil companies do. And you also have-even though you are allowed to do it-you do have the rate regulation problem. Most oil companies don't like any more government regulation than they currently have. I think it is pretty unlikely except as an ancillary activity. I don't see an oil company wanting to buy a Consolidated Edison or something.
I do see that Occidental Petroleum owns 2,100 MW of power plant. What type of plants do you operate?
SIC: Those are mostly related to our chemical plants. Those are cogeneration facilities. Their purpose is to make our chemical business more efficient, as opposed to just because we like being in the power business. Our chemical business is one of the largest buyers of electricity on the Gulf Coast. What we do is take the electricity and turn it into chlorine and caustic soda, similar to Dow's business. And so that is a big business for us. Power is a major cost of that business. It is important for us to control our costs, so we have a power-marketing business. And then we also use a lot of electricity in our West Texas operations, which have a lot of pumps. Our major variable cost is power.
Do you use your power plant as an entry into power marketing?
SIC: We do, of course, sell the excess electricity from those plants, and it is part of our trading operation-mostly tied to our natural gas business. I don't see us looking for more power facilities.
How does each Occidental business contribute to the bottom line?
SIC: It would be 85 and 15 [percent] between oil & gas and the chemical business.
How about the energy-marketing business? What percentage does it contribute?
SIC: I can't tell you because [sales are] netted back. It's a fairly sizeable activity. But it is related to our electricity needs, mostly in the Gulf Coast, in marketing the excess power that we have. For example, in a time like now, where natural gas prices are high, we might find it to our advantage to not run the chemical plant and just sell the electricity that we produce.
You say that the chemicals business is not a natural ancillary business to oil. Then, would you say it is just the regulation that you find unattractive about the utilities industry?
SIC: It's the regulation more than anything. It isn't that you couldn't do it. I don't think the holding company act was what kept people from our business away from it, per se. It would have if they would have thought about it. But the thought never comes to mind. I just don't see us wanting to be in the rate-regulated business nor the retail business. For us it would have to be related to our business rather than being in the power business.
From an oil perspective, let me try a scenario on you that has been suggested in a post-PUHCA environment. An oil-and-gas major achieves virtual vertical integration by gathering the LNG from overseas and bringing it to its terminals in the United States, delivering via pipelines they own to unregulated gas-fired power plants they own, then selling this power to wholesale or even to retail customers.
SIC: That's not unreasonable. For example, we have a permit to build an LNG receiving terminal at Ingleside, [near] Corpus Christi, Texas. We have a cogen facility there, and we use a lot of electricity there. So, we'll use some of that gas to turn into electricity to power the plant and sell the excess. It wouldn't be whacky to say, 'Well I'll build a bigger electric plant there because it is easier or better to transport the electricity then it is [to get] the gas out of Corpus Christi. And then, we can use the heat from the chemical plant to gasify the LNG and save some money and operations. FERC has granted us a permit to build a terminal there.
How big do you think the LNG market can become for Occidental? What conditions would have to exist for you to expand your operations to include LNG?
SIC: One Bcf/D [billion cubic feet per day] is what we're looking at. The purpose [of building the LNG facility] is to make our chemical business more efficient, not to be in the LNG business. If it turned out that the [LNG business] was better, we would expand our power facility there. The question really is, you've got this gas, what are you going to do with it? If it turned out that it would be more economic to turn it into electricity and ship it as electricity, rather than ship it as natural gas, we'd do that.
The big question about creating a global gas market has been how to avoid the political dependence issues involved in oil. Is there a way to do that?
SIC: No, there isn't. The shipping countries can't eat the gas or the oil. It is a codependency. It isn't just that we are dependent on their oil. They are dependent on our money. Especially for LNG-they have a lot of gas but really no market except for the developed countries, like the United States, Europe, and Japan. If they withhold it, so what? They really hurt themselves. There are a lot of things that the United States is dependent on. It is never going to be independent for energy as long as we are in a fossil-fuel cycle. If we could somehow make it out of solar, that would be different. But that is a long ways away. So, there is a lot of gas in this world from a lot of different sources. It isn't just OPEC countries. West Africa, Malaysia, Indonesia, Venezuela-there's a lot of choices for us, and there's a lot of gas for us.
Gas futures for the winter months were, at press time, around $12/MMBtu. How will LNG moderate U.S. natural gas prices in the future?
SIC: It will, once it's significant. You have the terminals that are up right now, and they are only running half. So, there is not enough supply of LNG yet to matter. If there was, they'd be running full. So, right now it can't do much. But it will over time moderate [natural gas prices]. I do think the volatility will still be quite high, because the shippers will want to ship the thing on a regular pattern. So, they will be shipping at times when the demand is less, so the gas will have to go into storage. I don't think it will make it less volatile, but on average there will be lower volatility.
Do you believe the $70 per barrel oil prices will moderate? If so, over what time period do you expect it to moderate?
SIC: Yes. Seventy is more than the long-term price. I don't know whether it's $35, $30, $40, or $50, but I think $70 is beyond what one would reasonably expect. I think a series of circumstances right now has created this high price. As the circumstances subside and a little more production comes on in the next year or two, you'll see a decline certainly from these levels.
Do you think oil's best days are ahead of or behind it? Is natural gas the next big thing?
SIC: Gas is certainly the next big thing. There's a lot of gas, and it is easy to get. You don't have any risk of finding it. Gas is really important, especially for the large companies, the Exxons, the Shells and the BPs, which have enormous resource bases. But as far as finding new oil, that's pretty hard stuff today. Most of the oil is controlled not by the companies but by the countries. The places with oil are controlled by governments-not by Exxon or Shell. So, the Exxons or Shells and BPs are using their engineering expertise to move the product, find it, or transport it. But as far as finding goes, most of all big companies, including us, are focused on exploiting known resources.
What is it about the cultural differences between oil and utilities that you believe prevents them from converging?
SIC: I really don't see a large convergence, except possibly this LNG theory, where you say, 'OK, I'll build a power plant near the LNG terminal to convert the gas into more useable form. But I don't think anyone is going to go out and buy Reliant Energy to do that. I don't think the [utility and oil business] are natural fits. I really don't. I think the skills of a utility management are different than the skills of an oil management. I don't think those are related industries. I don't think the skill of selling electricity to someone's house is really the same as the skill of an oil company. We are users of energy. The energy business uses a lot of energy. To that extent, you have to manage it. I'm not sure anyone is going to want to go into the power business, except as a small part of something to make something else work. I could be wrong, but I don't see anybody wanting to do that.
Growing Overseas
John R. Biggar, Executive VP and CFO, PPL Corp.
"We are satisfied with the level of investment in international properties, which are essentially all electricity distribution businesses."Why did PPL recently revise its growth rates upward? What is driving the revised numbers?
John R. Biggar: When we reported second quarter earnings at our analysts meeting on August 2 in New York, we announced a number of things that improved the long-term outlook for the company. In this regard, we revised our long-term, annual compound growth rate from 3 to 5 percent to 6 to 7 percent in earnings per share through 2010. This is a significant increase in our growth forecast over the longer term.
There were a number of factors that we looked at in revising our forecast. We are upgrading a number of our generating assets to improve their power output. Essentially, we will be able to get 255 MW of additional capacity at the plants that we currently own and operate. The bulk of that, 177 MW, will be through a power uprate program at our Susquehanna nuclear plant. Also, we will be replacing some turbines and other equipment at our coal-fired plants, which is more efficient equipment that allows us to get more output for the same thermal input. When fully implemented by 2010, these power plant uprates are expected to result in about $100 million of additional margin annually. We are improving our power plant reliability. We currently have an equivalent availability factor of about 91 percent. We expect to get that up closer to the 94 percent range as we go out over the next several years. Each percentage improvement in equivalent availability adds about $20 million per year in margins for us. We have a number of long-term power supply agreements that have been in place for a number of years. Those power supply agreements will expire over the next several years. Because the market prices have increased dramatically from the time those contracts were put in place, we would expect to sell that power at the higher prices, reflecting current forward-price levels. In total, these factors are expected to add about $570 million in additional margins above the $1.58 billion of margins projected for this year.
What earnings are you forecasting for 2005 and 2006?
JRB: As you may know, we announced a 2-1 stock split that became effective on Aug. 24, so all of the per-share amounts I'm going to discuss are post split. Our 2005 forecast of earnings from ongoing operations before August 2 was $1.90-$2.10 per share. We have raised the lower end of the forecast range to $2.00 per share. So, the current forecast range for 2005 is $2.00-$2.10 per share, with a $2.05 per share midpoint. We also announced our earnings forecast for 2006 about four months earlier than when we normally announce the upcoming year's forecast. We are expecting earnings on a post-split basis for 2006 to be $2.15-$2.25 per share, which produces a midpoint of $2.20. That represents a 7.3 percent increase in earnings growth from 2005 to 2006. In August we announced an increase of the dividend of about 8.7 percent. We took the annualized rate from 92 cents per share to $1.00 per share effective with the Oct. 1, 2005 dividend payment. This is the second time this year that the dividend has been increased. In December 2004, we also announced a target of hitting a 50 percent dividend payout ratio by 2007. In our August 2 analyst meeting, we announced that it is our intention to get to that 50 percent target in 2006. If you combine that statement with our 2006 earnings forecast, it would suggest that there is another meaningful dividend increase on the horizon for 2006.
PPL Corp., like a lot of other companies, has recently increased the dividend significantly. How do you think utilities will be able to manage high dividend payouts if interest rates rise or utilities must ramp up infrastructure expenditures? In other words, what if utilities' cost of capital rises or their capital expenditures/O&M costs increase dramatically? Will there still be enough left over to pay out to investors?
JRB: It is up to each company to be satisfied with its dividend-payout ratio. At PPL, we were comfortable increasing our dividend payout ratio to the 50 percent level. PPL has a very significant capital expenditure program over the next five years-including about $1.5 billion of expenditures for emissions-control equipment that we will be installing on our coal-fired plants in the eastern United States. During this period, we see very strong earnings growth, which means we will have very strong growth in retained earnings. I would expect that our retained earnings will grow on average by about $350 million annually. Our cash position is expected to improve. So, we expect to be able to fund our capital expenditure requirements with a combination of cash generated from operations and the issuance of debt securities and, at the same time, continue to pay a robust dividend. We don't expect to issue any common stock during this period of time.
A research report projects that your free cash flow will move into positive territory once the environmental costs related to scrubber installations are complete. These analysts speculate that you will repurchase shares. Why is this the best strategy, or is there another plan to use the free cash flows in other ways?
JRB:The repurchase of common stock is one of a number of alternatives, including additional investments, to improve shareowner returns. In other words, if there is an opportunity for an investment that will provide a better return for shareholders than the repurchase of stock, then the company would clearly be looking at that investment.
What is the percentage breakdown of the business line contribution to the bottom line? How do you think your earnings mix might change in the future?
JRB: Looking at 2005, we expect the supply business (our generation and marketing operations) will provide about 55 percent of our earnings from ongoing operations. Our Pennsylvania delivery business will provide about 20 percent of our earnings from ongoing operations. And our international delivery businesses will provide about 25 percent from our ongoing operations. The supply business is the growth engine for the company, so as we get out to the 2010 timeframe, we would expect the supply business to provide about 70 percent of our earnings from ongoing operations, with the balance pretty evenly split between the international delivery and Pennsylvania delivery businesses.
You have significant international investments. Do you plan to expand those operations?
JRB: We are satisfied with the level of our investment in international properties, which are essentially all electricity distribution businesses. They are providing solid earnings for us. They are providing cash flow. About three-quarters of our investment in international properties is in the United Kingdom. The balance is invested in Latin America with the bulk of that in Chile, which has a strong economy. We think that we have added value to those companies, and they are adding to PPL. Our distribution company in the United Kingdom, for example, has won the Charter Mark Award five times for superior customer service, and we are the only electric delivery company in the United Kingdom that holds that distinction. No other electricity distribution company in the UK has won it once-and we've won it five times.
The fact that we have good customer service in the UK was reflected in the last rate review in the UK. We were awarded an extra 1 percent in revenues. ... Why have we done well? Just as we run all of our businesses, when we make an investment, we provide active management. Since 2002 our earnings from ongoing operations from our international investments have increased 133 percent. In 2002, our earnings per share from our international properties was 22 cents, and our estimate for 2005 earnings is between 50 cents and 53 cents per share. That's about $190 million of earnings.
Enter the Mega Utility
Geoffrey S. Chatas, Executive VP and CFO, Progress Energy
"[We are] focusing on running efficient utilities in growing states that have favorable regulatory environments so that you have the opportunity to earn that kind of 12 to 13 percent return on equity on the utility business."What is the reason your company grew as fast as it did in the last three years?
Geoffrey S. Chatas: The utility business grew organically [in terms of] net income. Also the unregulated business-we ramped up our gas business. That went from contributing nothing to contributing $30 [million] to $40 million. And then our commercial competitive operations went from having negative to positive results in that period. Synthetic fuels had an important impact-but clearly it was not the only driver.
What was the basis or strategy for those consistent earnings over those years?
GSC: Focusing on running efficient utilities in growing states that have favorable regulatory environments so that you have the opportunity to earn that kind of 12 to 13 percent return on equity (ROE) on the utility business combined with not going crazy on the asset investment in terms of plowing billions and billions in investments that don't produce. I think that again the gas businesses has been a very efficient use of capital in terms of producing earnings. We did sell some gas assets last year and added others. So, it has been very efficient in terms of total return. Think of it like a private equity investment. Those are really the major reasons.
What are the top contributors by segment to your earnings?
GSC: The utility contributes 80 percent. Next would be synthetic fuels and then third would be our competitive operations in gas.
What is your strategy going forward? Where will your earnings come from? How will your asset mix change?
GSC: We have always said that we are targeting 80 to 90 percent regulated and 10 to 20 percent unregulated. The real driver of our earnings is the utility, and our cash flow especially is what funds our ability to pour more money back into the utility.
In your forward strategy you would concentrate on growing the regulated utility?
GSC: Obviously, the bulk of the dollars will go to the utility where we are generating these good returns.
You say that being in parts of the country that are growing is your recipe for success. Which of your service territories is growing the fastest?
GSC: Florida is actually growing faster. But North Carolina is growing. In the last 12 months we added 33,000 customers in Florida and 28,000 customers in North Carolina. So, there are lots of people moving in. In percentage terms it is about 3 percent in Florida and 2.5 percent in the Carolinas. We have good growth. And that's every year. It's always a challenge in converting that in to bottom-line growth, and if we do that successfully we win.
There has been a lot of talk about what Progress Energy will do to replace its earnings from the synthetic-fuel business production business. Could you give us an update on that business?
GSC: With that business we are storing credits up right now. We actually lose cash flow producing them right now because it costs us more to produce them than we get in actual tax credits that we can use in a given year. So after 2007, when we stop producing, we will no longer have the loss on production, but we will continue to then be able to use the credits. In that sense, we will actually have cash coming in. So, one way to replace those lost earnings is to payoff debt and/or buy back stock. That is one piece. The other is expanding the unregulated piece, just growth in those lines of business to replace some of those lost earnings like coal terminals that we were using for synthetic fuel and freeing up for competitive coal, blending, and marketing.
What kind of unregulated businesses do you favor?
GSC: We have competitive generation in the Southeast and then gas, which is in Louisiana and Texas. The gas is production. We have 225 [+/- 250] billion cubic feet of proven reserves.
How long do you believe high natural gas prices will continue?
GSC: That's a good question. Although for us its an ability to get the gas. We actually bought the gas at an average price of $1. 99 [$/MMBtu]. We are way in the money. Even if prices settle down, we'll still be very profitable.
Will mergers be part of the growth strategy?
GSC: Certainly it is not something we're planning on right now, but something we always look at. No, our current plan would envisage just improving the operational and financial efficiency of the company as it is.
Playing LNG for All It's Worth
Neal E. Schmale, Executive VP and CFO, Sempra Energy
"Make sure you manage the risk. ... We're very careful in that area. ... We're not building the LNG plants until we have the output contracted for."How would you say your company differentiates itself from other utilities?
Neal E. Schmale: The interesting thing about Sempra compared to many [other] companies is that we are 50 percent utility and 50 percent other [businesses]. If you look at the $895 million in earnings we had last year, almost exactly half of that was from San Diego Gas & Electric and SoCalGas combined. The other half was from businesses that were developed since the merger in 1998. At the time of the merger, we didn't have any of these other businesses that contribute half of the earnings. Certainly, they were in their infant stages. But now the generation business and the trading business, the pipeline and storage business that we have, coupled with the LNG business, which is being developed-these things are roughly equal in size to the utility side. This is pretty unique. The biggest earner on the unregulated side is the energy trading company known as Sempra Commodities. There are really four great big businesses, two of which are utilities and two of which that are not.
How has Sempra been able to remain in the energy trading while others have not?
NES: You have to have a strong balance sheet to have a strong trading operation, because they do require a lot of liquidity and a lot of potential liquidity. But we are a conservative company in the way we manage the place under any set of circumstances. We realize that commodity prices go through cycles and that if you are going to take advantage of opportunities you have to have a strong balance sheet. If you are going to be able to weather a commodity price cycle, you do not want to have too much debt. We've been that way, and that has allowed us to take advantage of opportunities and weather some very relatively difficult commodity price cycles and still be in a position where we can continue to grow the company. Growing the company in our case means largely investing in the liquefied natural gas business.
Is there a certain return that you look for when Sempra makes its growth investments?
NES: We have a very classic Finance 101 view of life here. Look at how good the asset is. Look at the returns on the asset. Separate the investment from the financing decision. Make the best investments that you possibly can. Maintain the appropriate level of leverage given the nature of the risk of the business. Make sure you manage the risk properly. One of the things that has made us successful has been our risk management operation. We're very, very careful in that area. Most of our generation is sold forward. We're not building the LNG plants until we have the output contracted for. So we're very careful to understand the risk associated with the asset and take that into account when we decide how much leverage to put on the company.
How did you go from being a utility to managing unregulated businesses?
NES: When Sempra was first formed back in 1998, we were paying out effectively almost 100 percent of our earnings as dividends. One of the things we did in 2000 is we simultaneously repurchased stock and lowered the dividend. That, in turn, preserved some of the cash that was being generated internally for reinvestment, which in turn allowed us to make the type of investments we have that have succeeded. Obviously, having the money available to invest was only part of the story. Spending it on the right things is the other part. LNG won't come on until 2008.
Where are Sempra's future areas of growth?
NES: What is going to make the numbers look good-I'm speculating a little bit-are probably three things from the standpoint of Sempra. One is that the utilities are very profitable utilities. They have high returns. Starting with the foundation of very profitable utilities, we have been able to add to that in two particular areas that have been profitable as well: the energy trading operation and the generation business. And to that, going forword, we have identified a third area to invest in, which at this stage is the LNG receiving business.
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