Revenge of the ’70s


A guide to the galaxy of low growth, high interest rates, and the dark side of the Force.

Fortnightly Magazine - June 2005

Many executives are hoping to avoid a repeat of the 1970s, when Stars Wars first hit the big screen, and when inflation, nuclear cost overruns, and diminishing returns came calling in an economic climate that today's markets threaten to emulate.

The salvation was to come from natural gas, but even that prophecy could prove wanting. Too much reliance on a single resource poses risk. Look at crude oil. In a recent research report, Morgan Stanley equity research analyst Kit Konolige notes that integrated utilities with single commodity exposure are falling out of favor. The only exceptions still in favor are companies with unregulated nuclear [nuclear capacity that is sold into unregulated wholesale markets] or companies that have locked in low coal costs and can take advantage of wholesale markets where prices are set by higher-priced gas. But even this is not a given.

There has been much discussion among industry experts about the recent decline in gas prices, driven by mild weather and bulging gas inventories. The decline has occurred in the short term; at the end, however (where utilities are bigger players), prices have fallen only slightly.

In fact, as a result, Konolige predicts that this may be the beginning of a period of out performance for regulated utilities, where regulated utility stock will trade at a premium to integrated utilities. Konolige and his team break down the prospects in this way:

  • On Commodity Plays: "We continue to hear … that it's hard to expect good risk-reward characteristics for positive-gas-correlation companies with gas around the $7/MMbtu level…
  • On Pure, Regulated Utilities: "The core utility investors-long-only utility funds, income funds, and close-end funds with current income requirements-are bound to find the regulated [utilities] increasingly attractive on a yield basis. …."
  • On Coal Plant Owners: "Higher expenses for coal, emissions allowances, and scrubber capital spending are reasonably under control (although we believe they imply a materially lower level of earnings and significantly negative free cash flow, except in [one utility's case])."
  • On Interest Rates: "We continue to think that if rates were to rise sharply, the entire group of electrics would be affected in roughly the same proportion."

What's the Right Play?

EES North America

With all this evidence indicating a large tectonic shift in earnings prospects for utilities, the challenge becomes how to stay on top of the revenue list.

In an exclusive interview at Accenture's 16th annual International Utilities and Energy Conference (IUEC), Omar Abbosh, Accenture's global managing partner for the utilities industry, outlined some of the issues and tough decisions facing senior executives regarding people, policy, and growth.

"My fundamental premise," he says, "is that growth is there to those who understand how to access it."

Yet Abbosh doesn't necessarily believe that maintaining a "high-performance company," in Accenture parlance, will require holding companies to jettison the regulated utility.

"What [investors] are looking for is real cash-flow growth."

When it comes to being at the high-end of the universe in terms of growth, Abbosh says that not all strategies will work for all utilities, and he admits that not all utilities may be seeking high growth.

Know Yourself, Know Your Enemy

Abbosh says that many of his utility clients primarily are concerned with asset information. It's very simple, he says:

"Historically we have not needed to capture information about these assets. Most organizations today cannot analyze their asset information data in a way that just gives them very obvious answers." (About whether to expand, for instance.)
"We do a lot of work and advise on these issues." He adds that utilities increasingly want to know how to use data to minimize costs or minimize volatility.
"Lack of information is costly in terms of reliability. In other cases it is an efficiency-driven thing. In other cases what is driving it is that companies see a doubling of [capital investment] in the next 10 years, with one-third less workforce than they used to have. The ability for us to plan, sanction, commission, and operate those schemes is going to be hard. They have a real bottleneck in terms of skills and workforce to actually do all of this in a world where all the forecasts say you are going to need a ton of investment," he says.

But even with having an ultra detailed knowledge of assets, and knowing a growth opportunity when seeing it, a study conducted by Accenture finds it is very difficult for utilities to sustain high performance. In fact, a study conducted by Accenture identifying high-performance European utilities may be instructive for U.S. utilities that are aspiring to the greater scope and scale of their counterparts across the Atlantic.

In his presentation of results to the conference, Abbosh said; "Only 43 percent of utilities examined were able to deliver profits over six years. It's hard to sustain high performance." He also notes that only one in 10 companies outperforms its peer group over more than 10 years. These top performers all pursued a strategy of deliberately planned unregulated growth while addressing regulated rate-base growth.

This European experience suggests that large company size doesn't guarantee profits. In fact, according to the report, high-performing companies profited from timing the launch of their takeover bids while paying the lowest price for assets.

Are U.S. utilities capable of achieving this paradigm of buying and selling assets in their portfolio in a way that is timed perfectly with acquisitions?

Abbosh says that utilities always will be defined by their own specific operational, geographic and regulatory environment. Some utilities will have more difficulty buying and selling assets than will others to maintain maximum growth.

Of course, some in the financial community say it is for this very reason, and because single-generation assets are beginning to sell at replacement value, that the best play may be to buy whole companies with a portfolio of assets in the region (if the acquisition is at the right price). But even large utility-to-utility mergers face significant regulatory and investor scrutiny. Exelon-PSEG and the Duke-Cinergy proposed mergers have introduced the prospect of more $40-billion market cap utilities.

Will larger utilities be the high performers in the next 10 years, or will they be outpaced by smaller, nimbler competitors? If the European experience is any guide, U.S. utility growth strategies may get 50/50 odds, at best. Unless, of course, your utility is on the right side the Force.