Wall Street's Egalitarian View

Investors are making little distinction between regulated or unregulated business strategies. One banker suggests it will be difficult to stand out.
Fortnightly Magazine - April 2006

It seems history does repeat itself all too often. In the late1990s, a common complaint by utility CEOs was that utility price-to-earnings (P/E) multiples did not take into account whether a com- pany was a pure-play regulated utility, a diversified utility with a merchant subsidiary, or something else. Many say investors at the time just didn’t understand the different business models that were emerging after electric restructuring.

It was not until after the Enron debacle, the California crisis, and the merchant overbuild that investors began to fully understand the risks.

Moreover, as many have observed, stock prices have performed extremely well across the sector for three years running. In fact, utilities continue to outperform the Standard & Poor’s index. To a great degree, over the last few years, the earnings multiples have reflected the true value and risks of each business model.

But that was then. These days, valuation levels again are converging as they did during the 1990s, which is quite a surprise after investors’ previous educational experience.

Laurie Coben, managing director and co-head of the Energy & Power Group, Merrill Lynch, identified this new trend in her presentation at Exnet’s 19th Annual Utility M&A Symposium. “On a relative basis, companies with different strategies are trading at a very little difference in P/E multiple,” Coben said.

“You see a less than one-point multiple difference between integrated utilities, merchants, integrated transmission and distribution [T&D] utilities and LDCs,” she explained (see Table 1). “The same is true on a P/E total return basis. Multiples have barely moved for each group” (see Table 2).

Naturally, there are significant implications to the industry if such a trend continues to be true. First, if valuations are in fact converging, it means that mergers will be more difficult to justify, because investors are saying they are indifferent (and will not assign a premium) to mergers with even higher growth segments of the industry.

But there is some question as to whether this is the case.

Convergence in P/E multiples could just mean that a new class of investor (such as hedge funds or private-equity investors), with billions on tap to invest, does not really understand the risks involved in each segment of the industry, and their sheer investment strength is blurring the lines among industry segments. If true, utility executives will once again have to figure out what strategies really do produce shareholder value.

A Skeptical View

Leonard Hyman, senior associate consultant at RJ Rudden Associates, a Black & Veatch company, adds a cautious note on whether energy company valuations are converging. The P/E chart may not be reflecting the cyclicality of the merchant industry, he says.

“The volatility in the LDC data makes me question whether the chart [presented by Coben] really indicates convergence,” he says.

In addition, Hyman says looking at P/E multiples may not be the best way to gauge changes in investor sentiment, particularly because the use of estimated earnings when calculating the latest P/E ratios sometimes can have the consequence of making the multiples converge. Hyman says if he were doing the analysis, he would look to other indicators to substantiate P/E multiples convergence. “I would look at returns earned or potential returns, and I also would look at the book value. If you look at integrated utilities and the LDCs, those companies will earn a flow of income determined by the investment that has been made.

Hyman says: “I would look at how the market-to-book moves back and forth over time and do that to some extent in relation to interest rates. I would also look at what is going on with dividend yields if you take the view that the dividend is a proxy for what is going on with dividend yields.” Coben did not return calls for comment by press time.

EES North America

Moreover, Hyman emphasizes, the question of whether the chart shows convergence, and the issue of whether investors truly understand the risks of their investments, are quite different. “It’s certainly a legitimate question. What are people paying for now?” he says.

For example, Hyman argues that at least in the T&D space, investors may not be fully taking into account the risks that exist given some of the provider of last resort obligations that these wires companies are taking on in some states.

Meanwhile, Coben notes that although utilities have been performing well, the S&P 500 has come down substantially and the value proposition represented by the industry compared with other broader industrials may not be as compelling. In fact, she says, consolidation trends, higher commodity prices, and rate pressures will make it much more difficult for utilities to stand out from their peers.

“The industry is in a position where there are some great opportunities, but probably more risks than we have seen in the past,” she adds.

Mixing It Up

If investors are forming an egalitarian view of the industry, it’s probably because many utilities are a mix of different business strategies. In fact, many arguments have broken out over the years over how to categorize some utilities that have everything from unregulated merchant arms, regulated utilities, pipelines, and exploration and production, all under one roof.

As utilities consolidate, albeit slowly, the larger companies that emerge will have a much more difficult time standing out in terms of earnings growth due to size.

Furthermore, size in some ways will dictate the strategy options open to utilities.

For example, the 10 largest companies now are expected to be 56 percent of the total versus 32 percent in 1995, Coben says. “To be a top 15 utility in 1996, all you needed was a $5 billion market capitalization. Today that number is double,” she says. So too has the size and scale gone up in the generation and customer ranking areas.

Ten years ago, 10,000 MW of generation would have been considered large and, the utility thought, competitive. “Today, that number is 20 [thousand], 30 [thousand], or even 40,000 MW.”

On the customer side, 1 million customers used to be the benchmark for a good-size customer franchise. “Today, that number is 2.5 million and counting,” she says.

A lot of this consolidation has been due to M&A activity. Coben notes that about half of the largest companies have done major M&A transactions, and many of the others have been active acquirers on the asset side.

Moreover, as far as business strategy, if you look at the earnings makeup of the 10 largest utilities, “you can see that there is a good mix of regulated and unregulated businesses,” she says. And some of the largest utilities still are purely regulated and have made the decision to exit their non-regulated businesses. “So, clearly the large companies have the ability to choose where they focus strategically,” she notes.

Furthermore, Coben observes that with capital expenditures and credit requirements, and the costs to add generation for their regulated customers, many smaller companies have made the strategic choice that they need to focus purely on the regulated business.

“The top 10 companies are a mix between strongly regulated, strongly unregulated, and somewhere in between. When you get down to companies [ranked 22-30], very few of them have big non-regulated businesses.

“If you look at the few that have some, it is largely in the form of regulated generation that has been deregulated. Again, most of the midsize companies aren’t very aggressive in the non-regulated area any more.”

Coben states the non-regulated business is limited to some extent by the regulated business that tries to maintain balanced earnings and a good credit profile.

She says, “There is worry about regulatory claw-back of generation profits. They are making a lot of money on one side of the business through high commodity prices, and their customers are feeling pressure from the rates.

“Whether this model remains the model is one of the more interesting questions the industry will have to deal with. The other issue is whether they will get the same valuation in the market on balance or would the market want them to separate.”

That’s why it might be a good time to ask: Could spin-offs and carve-outs be the next act in the current merger wave?