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Will a back-to-basics strategy meet investor expectations?
Fortnightly Magazine - October 2004


Will a back-to-basics strategy meet investor expectations?

It's an issue that is coming to the fore with greater force-the debate over how utilities should honor their obligation to stockholders. But this time there seems to be quite a difference of opinion over strategy-or so we found in our annual finance issue.

Read any one of this issue's articles on mergers and acquisitions (M&A), and you'll see financial experts and consultants making a compelling case why utilities need to consolidate. Then read our annual Q&A forum with four prominent utility CFOs (see p. 38) and you'll see that they argue for greater self-reliance and self-restraint.

At the heart of this debate is whether a back-to-basics plan (eschewing growth in favor of a reliable stream of dividends) will be enough to satisfy investors when interest rates rise or the economy begins to grow at a faster clip. How do utilities keep investors from being lured away by higher-yielding financial instruments such as U.S. Treasuries or competing equities with higher-paying dividends-all while maintaining their appearance as stable, low-risk investments? Also, will utilities lose out to growth stocks when they come back in the stronger part of an economic recovery?

Even financial experts are at odds over the answer. In our August 2004 issue, Leonard Hyman, a consultant with R.J. Rudden Associates and a veteran Wall Street equities analyst, challenged another financial consultant who claimed that the utility back-to-basics strategy would produce an earnings gap. "The average back-to-basics utility yields about 5 to 6 percent and might grow 3 to 4 percent per year, which adds up to produce a total return expectation of 8 to 10 percent per year, not far from the return that the journals posit for the market. Where's the gap?" Hyman quipped.

Utility executives, for their part, seem to exude a new confidence-at least those with positive free cash flows. But their caution and hesitance to engage in growth discussions on M&A may be explained by the wider corporate hesitancy in the United States, where some economists and business executives believe the country is headed for an extended low-growth environment. That is why, they say, an unprecedented number of corporations in various industries are sitting on ever-increasing cash flows.

Sitting on the Cash: A Wider Phenomenon

Richard Berner, managing director at Morgan Stanley and the firm's chief U.S. economist, recently wrote of the dichotomy between investors who worry that earnings growth is on the verge of fizzling, and corporate America, which is swimming in cash. "Indeed, the common perception is that hesitant CFOs are hoarding cash and refraining from spending on cap-ex or acquisitions in a low-growth world characterized by a dearth of profitable investment opportunities," writes Berner. "In my view, earnings are decelerating, not fading, and managers are more disciplined about their spending than they are hesitant. But whatever the cause, the cash raises a critical question for both investors and companies: Will companies return more of that cash to shareholders and give them the right to decide how to reinvest it, or will they choose to reinvest it