Risk avoidance drives utility stock performance.
Utility stocks historically have been a safe haven, a stable, long-term investment for widows and orphans. However, with banks collapsing and the economy falling into a recession, utility stocks as a whole recently have performed poorly, with our portfolio of 75 companies1 losing $200 billion in market value in 2008.
While the Dow Jones Utility Index slightly outperformed the Dow Jones Industrial Average, (by 4 percent, -30 percent vs. -34 percent), total shareholder returns (TSRs) were abysmal. Only eight companies in our portfolio produced positive TSRs. Given the impairments in the markets and the significant tightening of credit and cash availability—even for utilities with strong credit ratings—the overriding factor driving individual company performance was perceived risk (i.e., the amount of unregulated, relatively risky, cash-intensive businesses vs. regulated electric and gas utility businesses).
This thinking is reinforced by an analysis of merger and acquisition activity. While two previously-announced deals were completed (Great Plains Energy’s merger with Aquila closed in July; and Iberdrola, S.A.’s acquisition of Energy East closed in September), the only new activity was related to potential acquisitions of companies requiring additional liquidity, whose stock prices had decreased to the point of making them attractive buy-low opportunities. This was the case for Constellation Energy’s proposed sale to MidAmerican Energy, which was terminated (with a breakup fee) in favor of EDF Group’s offer to acquire just under 50 percent of Constellation’s nuclear business. Another example was Exelon’s proposed hostile takeover of NRG Energy, a deal that continued evolving at the time of this writing.
In evaluating TSRs, 75 utility companies were categorized according to their asset mix, business focus, and corporate strategies, into the same sub-segments analyzed in previous years: energy delivery (companies in the regulated “wires and pipes” business, either electric or electric and gas), gas distribution (companies only in the “little pipes” business), integrated gas (companies operating across the natural gas value chain—gas production and marketing, gas processing, interstate pipelines and storage, and gas distribution), power generation (companies primarily focused on developing and operating unregulated power plants), and integrated gas and electric (companies that have power plant assets as well as electric and gas delivery assets and customers).
Also, given the down market in 2008, the analysis evaluated companies based on their market-to-book ratios, to understand how utility value investors performed in 2008 (or can expect to perform in 2009).
Balance Sheets Matter
In the five sub-segments, TSR performance differed substantially from the 2005 through 2007 period compared to 2008 (see Figure 1). The integrated gas and power generation companies, with their greater upside and risk, were the strongest performers in the 2005 through 2007 period and the weakest performers in 2008. Similarly, the gas distribution and energy delivery utilities, with their relatively conservative strategies and balance sheets, were the strongest performers in 2008 and the weakest performers in the 2005 through 2007 period.
The returns and strategic rationale behind integrated gas and electric company performance was more varied. Generally, the poor performing integrated gas and electric companies suffered due to liquidity concerns from significant merchant energy and trading businesses, as well as other unregulated investments (e.g., PSEG, Constellation Energy). On the other hand, stronger performing integrated gas and electric companies maintained their value based on existing acquisition premiums (such as in the Puget Energy acquisition by Macquarie) or the combination of limited unregulated businesses and positive regulatory environments (e.g., Southern Company, Hawaiian Industries and Pacific Gas & Electric).
2008 was a very weak year for both utilities and the broader market. Only eight of the top 10 performing utilities in 2008 posted positive returns, and four of those eight companies posted returns of 5 percent or less (see Figure 2). The top six companies include four gas distribution utilities and two energy delivery utilities, all of which exhibited similar strategies, tied to stable dividends, strong balance sheets, good regulatory relationships, and conservative management philosophies. Additionally, of the top three 2008 performers—Laclede Group, Piedmont Natural Gas, and CH Energy—Laclede and Piedmont had rate increases approved by their respective public utility commissions in 2008, while CH Energy filed a rate case with a likely positive outcome.
Among the bottom 10 companies in 2007 (see Figure 3) were three of the four power generation companies, with the other power generation company (e.g., NRG Energy) coming in as the bottom eleventh company. Also among these bottom performing companies were two integrated gas and electric companies—Constellation Energy and PSEG. These power generation and integrated gas and electric companies all experienced liquidity concerns, which since have resulted in acquisition announcements (e.g., Constellation Energy and NRG Energy), rumors of acquisitions (e.g., Reliant Energy) and asset sales (e.g., PSEG and Constellation Energy).
Given the strong downturn in performance in 2008, it’s not surprising there’s a relationship between 2008 TSR and beginning of year market-to-book ratio (see Figure 4).2 This is particularly evident for companies with relatively high market-to-book ratios. The integrated gas and electric companies in the portfolio with a market-to-book ratio exceeding 1.6 averaged a TSR of -36 percent; and companies with a market-to-book over 2.0 averaged a TSR of -51 percent. The latter group includes many companies that previously experienced a run-up in share price due to strong nuclear performance (e.g., Constellation Energy, PSEG, Exelon and PPL). Interestingly, only a subset of these companies (e.g., Constellation Energy and PSEG) experienced liquidity issues in 2008.
Responding to Challenges
Previewing the stock portfolio’s performance in 2009, questions must focus on how to define future winners and losers. An analysis might seek value from several different perspectives, given the sharp market downturn in 2008, the potential for a continued recession, and a new presidential administration with its focus on clean energy and energy independence:
• Potential recovery stories: By the end of 2008, there were approximately 17 companies in the portfolio with market-to-book ratios under 1.0,3 the bellwether mark describing whether companies are creating or destroying value. This list includes a variety of company types—power generation companies such as Reliant Energy, Dynegy, and NRG Energy; integrated gas and electric companies such as Ameren, Duke Energy, CMS Energy, and DTE; and integrated gas companies such as Williams and Southern Union Gas.
These companies all might bounce back on their own, depending on the focus of their management teams and their ability to grow earnings and improve balance sheets and income statements; or they might be acquisition targets by companies that maintained higher market-to-book ratios (e.g., Exelon with its 2.0 end-of-year market-to-book, targeting NRG Energy with its 1.0 market-to-book).
• Companies with strong balance sheets: The gas distribution and energy delivery success stories of 2008 might continue on into 2009. Given low interest rates and the potential for a continued recession, these companies—with their stable income streams and conservative management philosophies—might look attractive to investors and even provide growth opportunities if they choose to leverage their balance sheets through mergers or acquisitions.
• Beneficiaries of new energy policy: The Obama administration has indicated energy policy will rank among its top priorities, with a focus on clean energy and energy independence. So the question then becomes, which utilities are best positioned to take advantage of changes in policy?
A national renewable portfolio standard (RPS) will have little impact on many utilities in California and the Northeast, as their existing state RPS requirements likely will exceed any national RPS requirements. However, utility affiliates with strong renewable development capabilities—e.g., FPL, with its focus on unregulated wind and solar development—could benefit through the additional requirements thrust upon utilities in many states.
While the creation of a national carbon policy is expected, the requirements inherent to such a policy are much less clear, other than that a cap-and-trade system likely will be implemented. Companies with significant coal-fired generating assets and carbon emissions (e.g., AEP and Southern Company) will be impacted by: (1) the timing of any carbon-policy implementation, (2) whether existing coal-plant owners receive (or must pay for) their initial allocation of allowances, and (3) the associated regulatory recovery constructs for carbon control investments on regulated generation assets. Additionally, once a carbon policy is instituted, companies with coal-heavy generation portfolios operating in competitive generation markets (e.g., Reliant and Allegheny) may be less profitable as their costs increase, or their units are displaced with lower carbon-emitting (and thus cheaper) generation.
Companies with large nuclear portfolios (such as Exelon and Entergy) may be able to leverage their clean energy focus. In the medium term, carbon policy may result in a higher marginal cost for energy in competitive markets, resulting in increased profitability (higher prices at the same cost) for those companies owning unregulated nuclear assets. In the longer term, the administration’s stance on new nuclear development will be important, as the industry will need to add new, clean base-load resources.
• Companies with strong regulatory relationships: Any discussion of future winners and losers must include a regulatory review, as regulatory relationships drive the performance for companies that generate the majority of their income from regulated operations. In 2008, some of the strongest performers included several gas distribution and energy delivery utilities that were able to recover their infrastructure investments. Winning utilities will continue demonstrating an ability to recover their infrastructure investments associated with clean energy (e.g., renewable generation and transmission to support it, energy efficiency, smart grid and AMI), as well as traditional infrastructure investments in reliability. A constant in this industry is that utilities must maintain a focus on satisfying their customers and regulators, particularly given the tightening of credit and the potential for companies to increase capital investments in infrastructure.
While 2008 was a year when TSRs strongly were tied to the strength of utility balance sheets, a variety of issues will impact future utility TSRs. The question now is how utility management teams respond to the challenges set before them, particularly regarding the business opportunities, risks, and cost recovery associated with clean energy in this capital-constrained environment. The winners and losers in 2009 likely will be determined by their ability to leverage their balance sheets and regulatory relationships, as well as to capitalize on continued growth in clean energy, spurred by both the government and end-use customers.
1. To be included in this analysis, a company had to be publicly traded during the period 1/1/2008 to 12/31/2008 and be in one of the five industry sub-segments listed. The analysis excluded companies with less than $700 million in market capitalization.
2. Market-to-book ratios were computed based on end of 2007 year values for debt and equity. Analysis was performed on the integrated gas and electric segment.
3. Estimated, based on the market value of equity at the end of 2008, the market value of debt as of 3Q 2008, and the book values of debt and equity as of 3Q 2008.