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Cap-Ex Conundrum

Does slow and steady still win the race?

Fortnightly Magazine - September 2011

Since Public Utilities Fortnightly first published the first Fortnightly 40 report in 2005 , it’s become a barometer of the U.S. utility industry’s financial performance—or to be more precise, of long-term stock performance for utility shareholders.

We designed the F40 model specifically to measure long-term performance, because utility investors typically don’t expect their shares to produce overnight growth. Instead they want a steady and predictable dividend, and perhaps a little share price growth to provide some hedge against inflation. As AGL Resources CFO Drew Evans told Fortnightly in an interview for this year’s F40 report, “Nobody is looking for double-digit growth from utilities; they’re looking for mild growth in dividends. Slow and steady wins the race.”

It’s no surprise, therefore, that companies with strong positive cash flow and dividends tend to rise to the top of the F40 ranks, while companies with weak or negative cash flow, or small or zero dividends, gravitate toward the bottom. This makes perfect sense, as steady cash flow and dividend yield comprise the historic bedrock of the investor-owned utility value proposition.

But when a capital-intensive industry enters an asset-building cycle, many companies will operate in the red for a few years or more. That’s particularly true when compliance requirements mandate a large slug of investment all at once, and it’s worse in states where regulators are slow or stingy about letting utilities include their new assets in the rate base. Indeed, regulatory lag can be blamed for some companies’ poor showing in the F40 in some years, and their apparently sudden reappearance when costs enter the rate base.

This seems likely to happen for more companies in the coming years—and in fact already has a substantial impact on the rankings. Of the 10 industry companies with the biggest cap-ex budgets in 2010, fully six of them failed to make this year’s top-40 ranking (see “ Fortnightly 40 Best Energy Companies ”). They include some of the best-known names in the U.S. utility industry—such as Duke Energy, the #1 cap-ex spender this year, as well as El Paso Corp., PG&E, the Williams Companies, Progress Energy, Xcel and Con Edison.

Of course cap-ex spending isn’t the whole reason these companies aren’t getting into the top 40, but it’s a big factor and it’s likely to get bigger.

ITC: A Case in Point

This year’s survey offers a new face in the crowd—ITC Holdings, the country’s only publicly traded pure-play electric transmission company (see “ ITC: Riding the Wires ”). ITC just barely missed making it into the top-40, but its solid performance across several metrics raises some interesting questions about how companies in a build-out phase will fare in the F40 model.

ITC is an unusual case. Like other regulated utilities, ITC’s earnings come from rate-regulated assets. But unlike most utilities, ITC carries a high debt load—to finance its ongoing development and other work—and its rates are set by the Federal Energy Regulatory Commission