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 (FERC) rather than by state PUCs. For some of its transmission projects, the company enjoys incentive rates, pursuant to the Energy Policy Act of 2005, to encourage building lines in capacity-constrained areas. For instance, FERC approved a 12.16-percent return on equity (ROE) for nearly $840 million worth of projects being built by subsidiary ITC Great Plains, and also approved the company’s request to include in its rate base costs for construction work in progress.

By most measures, ITC’s stock would be viewed as an outstanding value for shareholders, with low-risk returns that are, in some cases, higher than other utilities are allowed to earn. Plus ITC already has delivered tremendous performance for shareholders—a 22-percent total shareholder return in 2010, and 158 percent over the last five years. And ITC’s profit margin is stellar—the second strongest in the industry, averaging some 19 percent over four years.

Yet, because ITC is plowing so much capital into new transmission projects, it operates with a negative cash flow—one of the deepest in the industry as a percentage of revenues. This factor conspired with the stock’s low dividend yield to keep ITC out of the top 40.

Investing in Attrition

Financial analysts don’t view negative cash flow as a bad thing—if it’s aimed toward the right goal. All things being equal, negative cash flow is a good thing if comes with growth. Clearly it’s good for a company like ITC Holdings, but is cap-ex growth a good thing for slow-and-steady utilities? The simple answer is yes.

“Where there’s a supportive regulatory regime, where companies are allowed to earn a strong ROE, cap-ex investments are a great deal for shareholders,” says Robert Laurens, a partner with Accenture. “It’s a good thing to have negative free cash flow because you’re investing, and stock prices and returns will reflect that. These companies have a good opportunity to invest capital and earn an attractive return with low risk—and that’s a very strong case to make for investors.”

However, the devil is in the details, and in this case the details involve factors that are difficult to control or predict. The biggest factor for regulated utilities is how their investments will be treated—i.e., whether they will be allowed to earn a strong ROE.

A cautionary example involves NextEra Energy, parent company of Florida Power & Light. In early 2010, the Florida Public Service Commission shocked FP&L by slashing its requested $1.3 billion in rates down to $75.5 million. The ruling was highly politicized and spawned a changing of the guard at the Florida PSC—four of five commissioners were replaced. In early 2011, FP&L and the PSC reached a settlement agreement that freezes rates through 2012 but allows the company to pass through certain costs related to storm damage recovery—up to $4 a month on a “typical” residential bill. It also lets FP&L recover the costs of its new, $900-million, West County Unit 3 combined-cycle plant—but only those costs that are offset by projected fuel savings. The carefully worded settlement also reduced FP&L’s allowed ROE from 12.5 percent to 10 percent.

Another example is found in companies with aging coal plants that require clean air retrofits. With environmental mandates looming over so many plants—the factor some critics call the EPA “train wreck”—regulators might ask whether utilities acted prudently in delaying such investments until a crisis emerged. They might decide that, as with FP&L and its new power plant, ratepayers shouldn’t have to pay anything more than the bare minimum to cover basic expenses. But even when regulators do grant a normal rate-base return, such investments might well prove less attractive for shareholders than other projects that would grow revenues.

“Companies would rather be building power plants or transmission systems than spending money on environmental retrofits,” said Jean Reaves-Rollins, managing partner with the C Three Group in Atlanta, in an interview for the Fortnightly 40 report. “If you have to clean up a lot of plants at once, it won’t leave much money left over to pursue other investments.”

And then shareholders might well ask, “Whatever happened to ‘slow and steady’?”