Frontlines

Deck: 
Wall Street wants utilities to return to basics, but the CEOs worry it won't be enough.
Fortnightly Magazine - October 15 2003

Frontlines

Wall Street wants utilities to return to basics, but the CEOs worry it won't be enough.

One can certainly understand why so many utility chiefs steered their companies back to basics over the past two years. They read the newspapers. They knew what the financial community was saying. Investors and debt-rating agencies might have overreacted, I suppose. Some on Wall Street seem to think so. Not all utilities should have been downgraded or downsized, they argue. Not all business plans were suspect. Yet some energy companies certainly deserved to be investigated and downgraded. Or even bankrupted.

But a key problem remains. As the economy improves, utilities recognize they must soon return to the front lines and face the music. How do they generate enough growth to keep investors from being lured away by higher-yielding financial instruments such as U.S. treasuries (interest rates are on their way up) or competing equities with higher-paying dividends-all while remaining to appear as stable, low-risk investments?

While attending a utility industry conference last month in New York City, sponsored by an investment bank, most executives told me this issue would occupy utilities for the next 12 months. They suggest that merger deals will offer the only likely and available route to sustained growth. They say that the common strategy of combining energy trading, international ventures, and retail power distribution has been discredited because of the huge financial losses that utilities have suffered.

This recommended flight to M&A deals should not surprise anyone. Who can argue with the logic of consolidation and greater earnings growth through cost cutting and economies of scale? Naturally, these bankers echo what they believe is possible in the current investment environment.

But for myself, I'm not so sure that the bad experiences seen so far with international, retail, or energy trading rise to the level necessary to fully discredit these ideas as viable business strategies. Many of these business plans would also improve efficiency. Someone eventually will figure out how to do it right.

Everybody Lost Money

The pain of financial losses seen during the past few years ought not be sufficient reason to avoid growth strategies in the future that might go beyond the scope of a simple merger between like utilities. After all, many industries also lost plenty during the go-go '90s.

For example, telecom companies lost billions and over-invested in infrastructure. Yet you don't see calls for that industry to drop their ancillary businesses. In the 1990s, investment banks also lost countless billions in their foray into Russia, but they continue to have an international presence. And Internet companies continue to bring new retail offerings, even as many of their retail strategies failed, dramatically.

Yes, we saw cases of accounting fraud and misrepresentation of earnings. And those cases cut across a number of industries. But Congress and the SEC have dealt with that. Let's move on.

Energy trading, while not the growth engine everyone thought, is acknowledged as a necessary function of the industry. It did, however, need to be cleaned up in the way it reported its earnings and risks. Improved market monitoring and tougher rules were called for, but those are now being pursued. I'm not even sure of the argument that utility credit quality is not strong enough for proprietary energy trading.

I think that was just an easy way for ratings agencies to get out of having to understand high-level math. Organizations with much smaller balance sheets than utilities trade any number of commodities. Let's face it: Risk has always been a part of the business, whether analysts woke up to that reality after Enron or not.

In fact, when one looks at the Internet, telecom, investment banking, and utilities industries, they all were swept up by the irrational exuberance of the times, and all paid dearly for it one way or another. A clear argument has not been made for why utilities cannot pursue growth strategies such as international, energy trading, or retail competition, or some other derivative of their business.

Why Not a Core Competency?

Tell me why the buying and selling of power and power plant development should not qualify as a core competency for electric utilities.

Sure, the industry failed to properly value its international investments. But how many times will that happen-particularly in this current environment, where every utility dollar is scrutinized, and lightning-fast ratings downgrades are the order of the day? I'd more trust a utility with international growth plans or energy trading now than when the money to build and buy anything was flowing freely from the commercial banks, and those paid to scrutinize such things were asleep at the switch.

Maybe the better idea was not to buy plants outright in other countries, but to partner up with foreign companies that might have had expertise in properly evaluating those assets. Certainly, the current restrictions on how much debt a utility can incur for any growth plan is much more limited.

It stands to reason that utility business plans today would be more thoughtful. This can be said of anything a utility does from here on out. Debt restrictions are a caveat for any plan.

As for retail competition, some U.S. utilities have been able to prove that they can make a profit from selling to commercial and industrial customers, even if the residential retail business is still an enigma.

Of course, many will be skeptical of the energy-trading portion of the business after sham trades and price-fixing charges. But a utility that manages its surpluses and shortages properly through energy trading and risk management will be able to better contain financial losses to ratepayers and investors. Even regulated utilities and their regulators see the benefits in proper risk management, if not trading per se.

Last but not least, the merchant function also must come around. In a few years, demand for power will outstrip supply. We'll need more power plants. International ventures, energy trading, retail, and merchant gen will come back.

But do analysts believe that?

Naturally, most analysts say it will be 12 months before investors will entertain any growth ideas. And given the last two years, most expect that utility growth plans will be extremely conservative.

"It's too hot to touch," says one.

If Not, Then What?

As George Bilicic, managing director and head of Lazard's Global Energy and Power Group, wrote in our Sept. 15th issue, "the organic growth prospects of many utility and power companies fundamentally relate to demographic and macroeconomic trends, which suggests much lower growth rates." In fact, some analysts predict that earnings growth may fall well below the 5 to 7 percent normally associated with regulated utilities.

That has prompted many energy execs to begin looking at strategic options, albeit grudgingly. Many bankers have confessed that merger discussions are happening all over the industry.

But some utility CFOs have found these higher growth expectations to be quite unfair. During last month's conference, a utility CFO said to an investment banker:

"What does the market want from us? Here is our business and this is what we do. We do this year-in and year-out. Sometimes it is viewed favorably and sometimes it is not. When we are not being fairly valued or being valued below our peers, people tell us they want growth. If that is my business and you want growth, then I have to do something else. And when I do that something else, you are not happy when it doesn't work out."

 

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