How to Achieve High Performance

Deck: 

Lessons from the top 40 utilities.

Fortnightly Magazine - September 2007

The Fortnightly 40 ranking celebrates a significant achievement for companies that have delivered superior financial performance on a number of critical balance-sheet and profit and loss (P&L) metrics over the past three years.

While the performance of the top 40 companies is commendable, our analysis of high-performance organizations reveals that less than one in 10 companies outperform their industry peer group over a period of more than 10 years. Given this finding, and the long-term nature of our industry, the question becomes not just what drives high performance in this year’s list, but how to fast forward 10 years and try to predict what characteristics will drive the top 40 list in 2017, as well as what companies need to do to remain or become high performers over the next 10 years.

High Performance

In our analysis of the Fortnightly 40, we broadened the number of financial metrics to further shine light on the attributes of high performers. We looked at items such as return on invested capital (ROIC), and a number of market metrics, including total return to shareholders (TRS), P/E and PEG (price to five-year-earnings-growth ratio). We also ran correlations and tried to distill some of the key drivers of high performance in this year’s ranking.

• Capital markets get it right (for the most part). Cap-ex discipline is key.

Most utilities, and most companies across industries, for that matter, focus on earnings per share (EPS) as a primary metric of business performance. The regulatory compact in most states further encourages a focus on P&L discipline ahead of capital discipline. This year’s data further confirms that return on equity (ROE) and ROIC – WACC (weighted average cost of capital) (i.e., the return on every dollar invested above a company’s cost of capital) are the primary drivers of value. These metrics correlate most highly with TRS; in fact, these metrics have a correlation to TRS that is twice as high as that of profit margin, arguably the core metric for most utilities (see Figure 1). Capital markets do seem to respond to differences in ROIC and ROE, and for all their irrational behavior, share-price performance is most highly correlated to what we believe are the right metrics (see Figure 2).

• Dividend yield inversely correlates to shareholder returns and is an indicator of reduced growth opportunities.

Many utility CEOs and CFOs have been pondering the impact of dividend policy on the attractiveness of their stock, and whether the type of investor interested in utility stocks is biased toward high-dividend yields. The data reveals a strong negative correlation between dividend yield and TRS backed by a significant R squared, confirming that significance. Some of the correlation may be explained by the fact that yields increase as stock prices decline, but a negative correlation also exists between dividend yield and both ROE and expected five-year EPS growth rates. While high dividends often are a sign of strong financial discipline, it appears as though the market believes there are sufficient attractive investment opportunities in our industry that make better use of cash than increased dividends.

• Profit margins have not been a good predictor of returns, but earnings growth potential is key.

Historical profit margins are not a strong indicator of future earnings growth and TRS; however, companies that can demonstrate strong EPS growth potential will be rewarded (as shown by the strong correlation between estimated 5-year EPS growth rates and TRS). The “back-to-basics” strategy, adopted by most regulated utilities has narrowed the number of strategic degrees of freedom and reduced the number of earnings growth levers. As a result, a number of utilities have resorted to more aggressive cost reduction and operational improvement programs, which are starting to create a significant gap in performance. Between 2001 and 2005, the utilities most focused on cost reduction lowered their costs by 4 percent compound annual growth rate (CAGR), while lagging utilities increased their cost-base by 2.9 percent CAGR (see Figure 3). This differential results in a 27-percent delta among these utilities over that period, which dramatically affects EPS growth differentials.

• No single strategy dominates the top 40, but a few strategic capabilities emerge.

At first glance it might appear that exploration and production stocks figure prominently in the top 40, but analysis of the percentage of regulated revenue for each member of the top 40 reveals that the list includes a balance of regulated and unregulated utilities (on average 69 percent of the revenue from the top 40 utilities is regulated). Indeed, the top 10 utilities are slightly more regulated than the top 40 overall. In addition, we found no linkage between size and performance, with the average revenue per company being around $5 billion for the top 10, for the top 40, and for utilities outside the top 40. Below high-level strategic positioning, however, we uncovered a number of strategic capabilities that are present within many of the top 40 utilities, regardless of their position along the value chain.

Step Change Business Transformation: A number of the utilities at the top of this year’s list, including TXU and PG&E, have undertaken a significant transformation of their operations to drive a step change in performance.

Strategic Agility and Active Portfolio Management: Many of the utilities at the top of the list actively have rebalanced their portfolio through strategic acquisitions, new build, and divestiture of non-core assets. This includes the ability to respond decisively to the cycles of the utility industry with appropriate asset plays (e.g., seven-year generation cycle). For example:

• TXU’s active portfolio restructuring, including unbundling and outsourcing of capabilities;
• CLECO’s divestiture of CLECO energy gas pipeline organization;
• Duke’s divestment of Spectra;
• PP&L’s shedding parts of its overseas subsidiary;
• Energen’s aggressive E&P investments; and
• Energy South’s aggressive investment in storage assets.|
Differentiated Asset-Management Capabilities: Active portfolio management cannot be carried out effectively without robust asset-management capabilities (advanced O&M and cap-ex investment planning and prioritization). These capabilities are linked directly to the ability to drive ROE and ROIC (which are most highly correlated to TRS) and require the right organization, processes, governance, access to information (not just data), and decision-support tools.
Regulatory Management: Obviously essential in reaching a win-win regulatory compact. We also found a strong correlation between customer satisfaction scores and financial returns, suggesting direct linkage between customer focus and regulatory settlements.

High Performance in 2017

In analyzing EPS growth forecasts for the top 40 utilities, we found that the average fiscal year (FY) 07 to FY08 forecasted EPS growth rate is 8 percent, while the five-year EPS growth rate for the group is 6.6 percent. In an industry where fundamentals grow at 2 to 3 percent, costs continue to increase and regulatory compacts and allowed ROEs are increasingly tight, meeting a long-term 6.6-percent EPS growth target will be extremely difficult without a fundamental transformation in the strategy and operating model. Compounding these aggressive earnings targets are a number of significant and disruptive challenges, such as an aging infrastructure; a maturing workforce; increasing environmental pressure and regulatory uncertainty; entry of private equity; continued commodity volatility; and rising customer expectations (often prompted by other industries).

Over the last two years we have started to explore, with a number of progressive utilities, the defining attributes of the high-performing “utility of the future.” In so doing, we have identified ten key traits that we believe will differentiate high performers 10 years from now (see Table 1).

1. Manufacturing-like Performance Culture

Although the utility industry is focused on benchmarking, application of cross-industry benchmarks and comparisons is limited. When comparing utility performance against cross-industry benchmarks, we identified measurable gaps in operational efficiency. For example:

• Utility crews average just under five hours of productivity per day. Best practice in other industries is close to seven hours per day.
• Call-center self service approaches 70 percent in many industry sectors; utility best practices are in the mid-40-percent range.
• Utility supply chain capabilities do not yet rival those of an Amazon, FedEx, or UPS.
• Asset-management capabilities lag those of many of the oil majors.

We believe that one of the keys to achieving superior operational performance and unlocking the value potential inherent in the utility value chain will be a methodical and intense focus on performance measurement and management, combined with a focus on end-to-end process standardization and optimization. This focus on metrics will apply from the C-suite to the front line, combined with a culture of continuous improvement. Companies like KeySpan and PG&E have started this transition.

Toyota’s production system exemplifies this type of performance mentality. The Harvard Business Review article, “Learning to Lead at Toyota,” highlights how a new trainee sent to one of the established plants in Japan was asked to identify 50 improvements to an established production line in three days, or one every 22 minutes. The example is extreme, but many utilities are uncovering the potential of process orientation and a metrics focus on their bottom line.

While we can debate the root cause of the performance differential (likely a combination of inadequate regulatory incentives, the structure of the industry, company-specific traits, and the nature of a must-serve industry), we believe that this performance gap against cross-industry leaders will close over the next 10 years.

2. Simple on the Inside

Utility operations have evolved gradually over decades, adding capabilities in an incremental manner, often without a fundamental operating model rethink. As a result, many utilities experience significant complexity and unnecessary human intervention across the value chain. Numerous processes are understood often only by long-standing employees who are likely to retire within 10 years. While some employees thrive on this complexity, a simplification of end-to-end processes will be essential to become a leader in the industry and to address the issue of a maturing workforce that will retire within a decade, affecting 50 to 60 percent of a utility’s institutional knowledge.

3. Differentiated on the Outside

The advent of the smart grid and advanced metering infrastructure will allow utilities to differentiate their value proposition further and provide tailored offerings that currently do not exist or are reserved for only the largest of industrial customers. The combination of traits 2 and 3 is illustrated in Figure 4.

4. Proactive Enterprise

By nature, the utilities industry is a reactive one: Utilities react to outages (often after being informed by customers), billing issues, and equipment failures. While most utilities excel in “crisis mode,” the industry will shift to a more proactive form of operations under which utilities can predict and foresee an outage long before it occurs; mine customer behavior; find ways to increase customer satisfaction; and maintain an asset to a predicted failure point as opposed to a pre-defined schedule.

5. Real-Time Information Intensive

The utilities industry is data intensive, and actionable asset information is essential in driving returns on investments. Leading utilities will undergo a significant shift in the quality of the information they store and mine about their assets and customers and the corresponding decision support tools and processes. Over time, utilities will migrate to real-time information through increasingly ubiquitous sensor devices.

6. Shaping the Energy Future

Leading utilities will be at the forefront of the environmental agenda. A European survey of public attitudes revealed that less than 3 percent of the population trusted corporations on environmental issues. Clearly, many utilities, such as Sempra, Duke, PG&E, KeySpan, PSEG, National Grid, Pepco Holdings, and others already are pursuing an aggressive environmental agenda.

7. Operations Technical Mastery

An analysis of R&D spending shows that while utilities represent 5.23 percent of U.S. capital spending, the industry only represents 0.067 percent of U.S. R&D spending. We do not advocate that utilities should build fully fledged R&D capabilities and recognize that much of the R&D is performed by equipment manufacturers and academic centers. Utilities will, however, need to take greater control over the evolution of technology. This is especially challenging in light of the fragmentation of the industry, but it is necessary if utilities are to move toward a “smart grid” requiring standards and interoperability. Utilities will need to pick a few select areas that are tied to their core strategic intent and become deep specialists in that domain to steer the direction of R&D investments and standards.

8. Information Technology Fast Follower

For the most part, the industry has under-invested in its information technology (IT) architecture. At most utilities, the IT architecture and applications have evolved in a limited way over the past 10 years, and many of the core IT systems are lagging that of other industries. Technology evolution now appears to be at a tipping point, with the advent of smart meters, sensors, communications technology, service-oriented architectures, field-force automation technology, asset-management applications, and work-management applications.

Whereas over the past 10 years the impact of technology on utilities’ performance was debatable, we believe that successful adoption of technology going forward will, if implemented in the right way, drive superior levels of performance. Transforming an IT platform to support utility-of-the-future requirements will require five to seven years. The long lead time makes this a “here and now” issue, which many utilities have started to address in the last two to three years.

9. Diversified & Skilled Workforce

Although the challenge of a maturing workforce is not fully explored in this article, it is one leaders will need to confront. With large workforce retirements pending in the next decade, and with an even higher percentage of institutional knowledge departing, the leaders of tomorrow will need to combine a number of innovative solutions to address the issue. These include greater linkage with education; offshore skills building; outsourcing; process simplification; and creative knowledge management solutions. Winning the “war for talent” will require a proactive and multi-pronged approach (see Figure 5).

10. Mastering the Basics

In addition to the nine traits discussed here, today’s drivers of high performance—asset management, regulatory management, and strategic agility—will continue to be critical drivers of performance in the future. These core capabilities will stand the test of time in a regulated, asset-intensive industry.

Transforming to Get There

It is unlikely that the journey to become a high-performing utility in 2017 will be carried out in an incremental manner. In a recent cross-industry study of company transformations and response to disruptive change, we found that successful companies transform in a series of major step-level changes as opposed to a linear and gradual improvement in capabilities.

The term “business transformation” has become one of the latest management buzzwords over the last three to four years, but it is a fitting term for what utilities need to do to achieve a leadership position in the industry. Business transformation, as we see it, is a program through which a company can drive a step change in performance that is differentiated from traditional process improvement or re-engineering along the following dimensions. Business transformation:

• Addresses all levers of change; i.e., people, culture, organization and governance, process and technology, in unison;
• Requires strong and hands-on support and sponsorship from the C-suite;
• Is not a siloed effort and addresses changes and accountability end to end;
• Is not aimed at incremental improvement (3 to 5 percent) but at a step-change improvement (15 percent plus);
• Is linked to a quantified business case and set of metrics, which are tracked and “monetized” through the effort;
• Does not just focus on cost reduction; it also works to enhance service levels, create a long-term strategic advantage and drive growth;
• Is not a “quick fix” project, but rather a medium- to long-term (two years plus) fundamental change in operations. The business transformation roadmap, however, includes quick wins to demonstrate early wins and help self-fund the overall transformation effort; and
• Creates change that is sustainable over the long term, such that companies do not revert back to “old” processes and behaviors.

Our research shows that more than 50 percent of transformations are not successful, making these programs high-risk/high-reward propositions for a management team. In our research on high-performance transformation, we reviewed more than 50 transformation efforts across industry sectors, to distill what differentiated the successful transformations from the failures. The 10 key success factors are outlined in Figure 6.

So when is the right time to undertake a transformation? It is very much a function of a company’s cultural DNA. The easiest time to transform is, in some ways, when performance degrades and external factors create the inevitable burning platform that forces alignment within the C-suite.

The best time to transform, however, is when times are good. Companies that sustain their leadership position over time have an ability to change while they are at the top, before their performance starts to stall or decline. This is particularly germane to utilities that stand at defining crossroads around infrastructure integrity, technology/innovation, environment, people, and leadership. Key decisions are required in the near term that will set the course for years to come.

Many utilities in North America already have started their transformations, which suggest the performance spread in the 2017 top 40 list will be more significant than it is today, as tomorrow’s leaders chart their journey toward the high-performance utility of the future.