The old paradigm—a strong inverse correlation of high interest rates and lower utility valuations—once again takes hold.
Ian C. Connor is a managing director in Goldman Sachs’ Power & Energy Group, where he specializes in mergers and acquisitions. Prior to joining Goldman Sachs, Connor was a managing director at investment bank Lazard in its Power & Energy Group. He has advised on numerous transactions in the power and utility industry, including the recent Duke Energy merger with Cinergy. Contact him at Ian.Connor@gs.com.
The recent breakout of the benchmark 10-Year Treasury yield from the recent mid-4 percent yield band to approximately 5 percent (with some market expectation that it may increase further) potentially has important strategic and value implications for the power and utility industry.
Power and utility industry valuations before the 2003 dividend tax cut were highly negatively correlated (approximately 0.69) to the 10-Year Treasury yield, which is generally viewed as a proxy for interest rates.1 This negative correlation between the 10-Year Treasury yield and industry valuations, however, “decoupled” following the 2003 dividend tax cut. The negative correlation inverted to a positive, but nominal, correlation of 0.33 since January 2003, as industry valuations expanded and sustained at historically elevated levels, even as 10-Year Treasury yields increased or remained static (see Figure 1).
This decoupling of the historical correlation between industry valuations and the 10-Year Treasury yield likely was attributable largely to the after-tax yield effect of the 2003 dividend tax cut, particularly relative to Treasury yields. Historically, utility dividend yields and the 10-Year Treasury yield maintained an approximately 1:1 ratio (the “yield ratio”) on average; that is, if the 10-Year Treasury yield increased to 6 percent, industry valuations would adjust accordingly, such that industry dividend yields also were at approximately 6 percent (see Figure 2, p. 26). However, following the 2003 dividend tax cut, utility dividends became taxed at a significantly lower rate (15 percent) than Treasury yields (35 percent), suggesting that the 10-Year Treasury yield needed to be significantly higher than the average industry dividend yield to maintain its traditional yield ratio on an after-tax basis (assuming that the historical 1:1 yield ratio applies on an after-tax basis).2
Adjusting for this after-tax impact, the implied adjusted pre-tax yield ratio between the power and utility industry average dividend yield and the 10-Year Treasury yield should now have to be approximately 0.76x (the “adjusted yield ratio”). For example, assuming an average industry dividend yield of approximately 3.5 percent, the 10-Year Treasury yield would have to increase, or be projected to increase, to approximately 4.6 percent before the 10-Year Treasury yield again would approximate its historical yield ratio on an adjusted after-tax basis and re-correlate to power and utility industry valuations.
This re-basing of the yield ratio to adjust for the after-tax relative yield effect of the 2003 dividend tax cut likely explains the decoupling of Treasury yields and industry valuations since January 2003. This after-tax yield differential effectively created a period of “elasticity” between industry valuations and Treasury yields as, contrary to historical correlations, industry valuations expanded and dividend yields correspondingly declined, notwithstanding that since January 2003 the 10-Year Treasury yield has increased from less than 4 percent to, until very recently, approximately 4.5 percent (creating the anomalous positive power and utility industry P/E-to-10-Year Treasury yield correlation of 0.33 noted above) (see Figure 1).
However, this period of “elasticity” between the 10-Year Treasury yield and the power and utility industry’s dividend yield theoretically should persist only until the point where these respective yields re-base at the adjusted yield ratio of approximately 0.76x, at which point they should again fluctuate in-line and negative industry value correlations should re-emerge. This point appeared to be reached in late January 2006, as the 10-Year Treasury yield increased sharply to approximately 4.6 percent.3 With the power and utility industry average dividend yield then at approximately 3.5 percent, the yield ratio for the first time since January 2003 approached the implied adjusted yield ratio of 0.76x. Since then, as historical metrics adjusted for the effects of the dividend tax cut would suggest, the power and utility industry average dividend yield and the 10-Year Treasury yield have sustained at approximately the adjusted yield ratio (see Figure 3).
Just as important, the corresponding negative correlation between the 10-Year Treasury yield and power and utility industry valuations re-emerged and has been 0.81 since late January, in line with pre-Dividend Tax Cut correlations (with the negative correlation increasing to 0.91 since April 1). By comparison, during the previous several-month period, there was no such meaningful correlation. As a result, with the 10-Year Treasury yield increasing to approximately 5 percent, the industry’s average 2006E P/E ratio has compressed from above 14.5x to below 14.0x currently (see Figure 4).
Implications for Utility Valuation
This re-correlation of interest rates and industry valuations has several important implications for the power and utility industry. First, industry valuations likely will be challenged to expand significantly above current levels absent a decline in interest rates or some other value catalyzing event. If interest rates continue to rise, power and utility valuations may experience incremental compression. As a result, notwithstanding a particular utility’s success in executing on its plan and delivering projected earnings growth, it may nonetheless realize declining shareholder value over the short term unless it is able credibly to deliver earnings growth sufficient to outstrip the negative value effects of potential multiple compression.
Second, with the dividend-yield component of many utilities’ total return propositions no longer having an after-tax advantage relative to Treasury yields, investors may focus increasingly on a utility’s earnings growth proposition as a value differentiator, both on an absolute and relative basis. Utilities therefore may pursue potential growth-enhancing opportunities more aggressively to sustain shareholder value, including unregulated investment initiatives, merger transactions, or a combination of both.
Third, this new interest-rate environment has important implications for capital structure and capital-return considerations. Utilities should revisit their total return propositions to make sure that their dividend policies are calibrated properly for this likely higher, and value-correlated, interest-rate environment. For those utilities pursuing equity issuance or repurchase initiatives, a potential declining valuation environment may present execution complexities, including important considerations related to value and timing.
While interest-rate considerations are important for the power and utility industry, particularly with respect to valuation, a myriad of other externalities that are not captured in the above empirical data and derivative observations also affect industry trading dynamics and valuations, including the risk that the 2003 dividend tax cut will not be extended, or that it may be repealed. However, the analyses and metrics noted herein strongly suggest that, after several years following the 2003 dividend tax cut where the industry traded relatively decoupled from interest rates, the thumb of interest rates (both positively and negatively) appears to be once again on the scale of power and utility industry valuations.
1. For the purposes of this memo and the analyses referenced herein, the 10-Year Treasury yield is referenced as a proxy for interest rates.
2. For the purposes of this analysis, the 10-Year Treasury yield is assumed to be taxed at the marginal tax rate of 35 percent. Further, this analysis does not adjust or otherwise account for the fact that some power and utility industry investors may be tax indifferent.
3. Treasury yields increased sharply on Jan. 25, 2006, following strong published economic data. The sharp decline in mid-to-long-dated Treasury prices indicated a growing market consensus that U.S. interest rates would begin trending upward and that the Federal Reserve would continue to increase rates, with Federal funds futures moving to indicate a 75 percent chance that the Federal Reserve would increase the target funds rate to 4.75 percent in March after an initial increase to 4.50 percent at its Jan. 31 meeting.