Sub-Primed and Ready


Will the turmoil on Wall Street spur a massive flight to utilities?

Fortnightly Magazine - September 2007

It may seem obvious today that utilities are viewed as the defensive, counter-cyclical investments most favored by investors when the economy takes a downturn. For the great majority of the U.S. utility industry’s history, that is, in fact, how they were regarded.

But during the last economic downturn in the early 2000s, not as many utilities played the cherished role of “widows-and-orphans” investments.

The merchant meltdown left the debt of several utilities downgraded to junk, and their equity valuations at all time lows. Furthermore, even utilities with no merchant exposure suffered as fearful investors, thinking some utilities were on the verge of Enron-like implosion, sold off the sector.

The reason investors lost millions was their failure to understand the different risks involved in the merchant and unregulated sectors. Much like the sub-prime meltdown occurring this summer, many—fairly or unfairly—blamed the equity and bond analysts for not conveying the risks.

Yet the utilities have recovered fully since those dark days, showing double-digit increases in stock prices, while the industry’s credit ratings largely have returned to investment grade.

Yet, there remains a concern that during the next economic downturn investors will pass on utilities again. The reason is that the industry’s risks are still opaque to investors.

For example, Baird analyst David E. Parker, in a July/August 2007 research note, says: “In summary, upside to our previous estimates of substantial energy infrastructure is a good probability most likely fueling attractive earnings-per-share growth for the next decade or longer.” But Parker warns of the unknowns:

“Rising political and regulatory scrutiny due to increasing costs could pressure returns in the wrong state jurisdictions.”

Thus, Parker recommends that investors focus on utility investments with good regulators, solid business strategies, and management that can execute those strategies. And that’s good advice. The industry needs more transparency and a common process to define corporate and financial performance for utilities and for future investors.

Cash No Longer King

Beginning in this issue, Public Utilities Fortnightly presents its highly anticipated independent financial ranking of the 40 best energy companies, known as the Fortnightly 40 (F40). The ranking provides utility execs and investors with a lingua franca, or comprehensive framework, to identify the risk/reward tradeoff for specific utility investments.

This year’s ranking should be of particular interest. That’s because of the current interest among investors in how a specific performance metric can change or become out of step with the true risks and rewards, as was the case in the early 2000s.

A recent analysis as part of the F40 ranking found that total shareholder returns for the highest-performing utilities either were neutral or negatively correlated with free cash flows and dividends. During the merchant meltdown, many investors focused on positive free cash flows at utilities as a way to differentiate from the riskier companies. But today, free cash flow is not as important a financial metric. One analyst believes that the market indirectly still factors credit strength, although it is no longer the issue it was a few years ago. He refutes any suggestion that the negative correlation might mean that the market or investors are not factoring in credit strength to their valuations.

“I just think that we are now at a point in the industry where a lot of those concerns have moved from being the number-one priority to being something that is monitored, as most utilities have addressed the issue of credit risk,” he says.

Given the nature of capital investment in the utilities industry, a longer-term horizon would bring this metric to the fore in a more significant way, he says.

“In a non-capital-intensive industry, free cash flows absolutely is a driver. I think it would be interesting to do the analysis over six and 10 years. I think we’d find more interesting correlations.”

As far as dividends, if you look at the correlation to return to shareholders, as share price decreases the dividend yield increases.

“So, that would explain the negative correlation,” says our analyst. “The other part of the negative correlation is that I would make the assumption [that] the street is seeing sufficient opportunities for strong capital investment in the utilities industry and therefore not rewarding companies that have an above-average dividend yield.”

Understanding why the market is neutral or indifferent to free cash flows may provide insights as to how investors view the industry. But more important, the industry must understand how the change in market conditions, such as the tightening of credit, might or might not affect the billion-dollar infrastructure projects that will be in various stages of financing in the future.

Standard and Poor’s analysts told me that the industry might even benefit from the sub-prime meltdown, because utilities would have more access to capital as more lenders compete for their high credit-quality business.

A Remedy for Risk

Many of these questions are more than academic. Some economists believe the economy may be headed into a possible recession due to the financial turmoil caused by sub-prime loan defaults in the mortgage markets.

That belief notwithstanding, Treasury Secretary Henry Paulson, in his first public comments since the sharp downturn in financial markets in late August, said the turmoil would “extract a penalty on the growth rate” of the U.S. economy, but expressed confidence that “the economy and the markets are strong enough to absorb the losses” without provoking a U.S. recession.

At press time, however, the situation seemed to be getting worse. On Aug. 15, U.S. stocks fell so low as to wipe out the year’s gains for the benchmark S&P 500. On that day, the Dow Jones industrial average lost 167.45 points, or 1.29 percent, to end at 12,861.47—or 8.4 percent below its record close. This marked the Dow’s first close below 13,000 since April 24, and may be the beginning of a wholesale shift in stock and bond portfolios, toward utilities.