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 themselves?"

Furthermore, he says that instead of increasing dividends, corporations are trying to preserve financial flexibility by using the cash to buy back shares in the face of economic uncertainty and are concerned that the dividend tax reductions of 2003 could be repealed. As evidence, non-financial corporate net equity issuance declined to minus $160 billion at an annual rate in the second quarter 2004, or nearly three times the decline in 2003. Certainly, stock buybacks have been the order of the day in the utilities industry. Berner says, "As CFOs consider future growth alternatives, acquisitions and dividends will compete for that cash. And many will be forced to step up buybacks to avoid dilution from options exercise; already my colleague and equity strategist Henry McVey notes that for the top 25 companies, 40% of the buybacks merely offset dilution. Which CFOs are good stewards of that cash could prove pivotal in future investment returns." And good stewardship in the utilities industry means upping the dividend as investors rediscover utilities in a low-growth environment.

A Lower-Return Universe

Growth expectations for corporate America and the U.S. economy overall are not that strong. Perhaps that is why utilities are faring better with investors and why utility finance chiefs are being cautious about their growth plans. In an interview with CBS MarketWatch, Don Cassidy, a Lipper senior research analyst, put it succinctly. "In the environment we're now in … investors would rather have $1 of dividend in hand than the promise of $2.50 of earnings going to $3. Utilities should become increasingly popular."

"The sector looks incrementally attractive in several aspects of our work," Richard Bernstein, Merrill Lynch's chief U.S. strategist, wrote about utilities in a research note a few weeks ago. Bernstein said investors should expect annualized U.S. stock returns of between 5 percent and 7 percent over the long term. Against that backdrop, even a 3-percent yield is a nice head start, he says. And economic forecasts seem to support an ongoing low-growth environment.

Steve Roach, managing director and the chief economist at Morgan Stanley, writing in September, believes "that the economic recovery, by most conventional measures, has been amazingly lousy."

"Annualized growth in real GDP has averaged 3.4% over the first 10 quarters of this upturn, far below the 5% norm of the previous six business cycles," Roach says. "Non-farm payroll employment is up only 0.1%, on average, over the past 10 quarters-hugely deficient when compared with the 2.7% record of the past six recoveries. Real wage and salary disbursements-the essence of the economy's organic, or internal, income-generating capacity-is up at only a 0.8% average annual rate over the past ten quarters versus the 3.9% norm of the previous six upturns. The federal government budget is out of control, having swung from surplus to deficit by six percentage points of GDP from 2000 to 2003. This was key in pushing the net national saving rate down to its all time low of 0.4% of GNP in early 2003. Lacking in domestic savings, the U.S. has had to import foreign savings in order to keep the economy growing; that has given rise to a record current account deficit of 5.1% of GDP. All this speaks of a vulnerable and exceedingly low-quality recovery in the U.S." And speaks to an environment where investors will need a more conservative, low-risk, higher-yielding investment.


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