by Brad Kitchens and Greg Litra, ScottMadden Inc.
Even amid signs of economic recovery, the recent collapse of the stock market in the winter of 2008-09 and talk of a new post-recession investment environment has led to concerns about what factors will affect electric utility industry valuations going forward. What will drive stock prices? How should corporate executives preserve shareholder value?
Drivers of Utility Stock Prices
Stock prices can serve as a proxy for the health status of an industry. Industry fundamentals—revenue sources and trends, asset base, reinvestment requirements, operating and overhead costs—remain significant stock cost drivers. And while macroeconomic factors still influence the direction of electric utility stock prices, a few industry-specific fundamentals have helped those valuations avoid some, though not all, of the declines of the broader averages.
The collapse of the merchant power sector in the early 2000s and subsequent downturns in 2001 and 2003 caught merchant generator and electric utility stock prices in the downdraft. Utility stock prices have since slowly climbed back from their falloff as utilities deleveraged their balance sheets, unwound diversification strategies, resized their competitive wholesale businesses and refocused on their core regulated activities. Since then and until mid-2008, electric utility stocks have performed well (or in the case of diversified utilities, roughly the same) compared to broader indexes. (See Figure 1.)
Many attribute the most recent rise in stock performance to a defensive flight by investors to the relative safety of utility returns. That the sector continued to have access to capital, albeit pricey, through the worst of the credit crunch added to its appeal.
While price-to-earnings ratios of various electric sectors had reached some heady heights during 2000-01 and 2007, those valuations might have overshot on the downside their recent historical norms. (See Figure 2.)
But as utility stock prices have weathered the recent downturn with relative resilience, unfavorable trends continue to weigh upon the sector:
Financial consequences of climate change legislation, renewable portfolio standards and implementation of smart grid. Potential constraints on carbon dioxide emissions, new renewable resource requirements and smart grid improvements needed to realize more effective energy efficiency and demand response likely will entail an expansion of assets, many in rate base. The resulting returns likely will be recoverable in rates. Unfortunately, the uncertainty and scale of potential investment and, as a result, the potential for sizeable rate-increase requests is beginning to weigh upon the industry. Cash needed to fund capital expenditures will be significant and potentially burdensome. Regulatory scrutiny almost certainly will be on the rise.
Natural gas price volatility. Natural gas-fired generation has been the predominant form of power generation capacity installed in the past five years and comprises slightly more than 40 percent of the installed capacity and more than 20 percent of net generation in the U.S. Until recently, price volatility has been persistent as natural gas has become a key fuel for the power sector. Suddenly, storage levels are on the rise, particularly in the face of mild temperatures and limited supply disruptions. The recent promise of more economic, unconventional gas sources could lead to abundant gas supplies, which might mute price volatility. As recently as the early 2000s, however, the industry banked on an infinite steady supply of $4-per-million British thermal units of gas, but price escalation through the mid-2000s proved those hopes wrong. Margins remain vulnerable to unfavorable unhedged swings in gas prices, especially for firms with a sizeable wholesale business. Conversely, continued low gas prices threaten companies focused on unhedged coal and other forms of baseload generation. Either factor may blindside the industry and disrupt certain company valuations.
Anemic power sales. Through the first four months of 2009, revenues for the U.S. electric industry were off by more than 4 percent from the same period in 2008 because of flat residential sales and a nearly 13 percent drop in industrial sales. Most industry observers expect these sales levels to return, but concerns surround the timing of the recovery and the possibility that sectors such as automobile manufacturing might never fully regain their pre-recession levels of demand. Given the high fixed-cost nature of the industry and absent a different ratemaking paradigm, a prolonged sag in electric sales revenues will continue to dent the industry’s earnings prospects.
Rate recovery. Timely, complete recovery of prudently incurred costs is critical for utilities. The expiration of many rate freezes in the early and mid-2000s forced many utilities to apply for rate increases to recover expenses incurred because of escalating fuel prices and investments in grid-reliability upgrades and new generation capacity. The Edison Electric Institute estimates that despite the current recession, investor-owned electric utilities plan to commit some $230 billion for capital projects during 2008-10. Also looming for the industry are new and unknown costs for carbon-control measures and other environmental mandates. With customer resistance to rate increases, a constructive relationship with regulators will be critical to avoid lagging or outright denial of recovery adjustments and to preserve balance sheet strength and utility earnings.
Utility Performance During Past Downturns
History can sometimes be instructive when gauging expectations for industry stock performance. During the Great Depression after the initial stock market crash of 1929, utility stocks performed on par with the broader average. The Dow Jones Utilities Index, created just prior to the crash at the market’s peak, lost more than 88 percent of its value from early September 1929 to mid-1932, roughly paralleling the Dow Jones Industrial Average (DJIA), which fell to less than 11 percent of its early September 1929 value during the same period. The indices diverged in mid-1933, however, as the DJIA recovered to 40 percent of its value while the Dow Utilities languished at levels below 20 percent of its pre-crash value until and beyond the outbreak of World War II. There are similarities and differences between the electric utility industry during that period and today’s Great Recession (see Figure 3).
These are long-lived events. In all, the Dow Jones Utilities Index took about 30 years to return to pre-crash levels.
More worrisome is a repeat of the 1970s through early 1980s. The industry faced challenges similar to those in today’s environment:
- Ambitious, heavily financed capital expansion plans (including nuclear plants) made more expensive by the effects of spiraling inflation on materials, labor and borrowing costs,
- Meaningful cost increases in building and operating power plants driven by new environmental regulations affecting air, water and hazardous waste,
- Escalating prices for all generation fuels and legislative limitations on wider use of certain fuels (natural gas and petroleum),
- Slackened electric demand caused by a sluggish economy and conservation in the 1970s and exacerbated by a recession in the early 1980s, just as new capacity was coming online.
The primary difference between this and these earlier periods is inflation, which today is a nagging concern given the level of government spending but not yet a problem for the U.S. economy.
Implications for Industry Leaders
Earnings growth will not be achieved easily when customers are worried about the continued viability of their businesses and jobs, increasing their savings rates and growing more sensitive to electricity price increases as wages and costs of other goods and services are in decline. Utilities also have some unknown financial exposures to regulatory mandates and fuel prices and must prepare for various scenarios, the outcomes of which could affect the stability, certainty and sustainability of earnings.
Companies must continue to aggressively pursue constructive regulatory relationships, as a primary strategy. This is the cornerstone of revenue consistency and profitability. Given the scale of potential capital expenditures for new energy resources (including new and expensive technologies such as carbon capture and storage, advanced nuclear, renewables and energy efficiency), a regulatory predetermination of prudency will help avoid some of the 1970’s expansion pitfalls.
Second, utilities must hedge their bets on generation fuels. The past has taught us that a diversified portfolio may be marginally more expensive in the near term but could prevent price volatility, public furor and policy intervention later.
Third, a continued focus on wringing costs out of the enterprise and actively managing the risks of potential price inflation—whether administrative or general costs, construction or fuel expenses—will always remain an important driver of shareholder value.
Finally, as the cost-reduction scale declines, utilities must think more creatively about topline growth and create attractive services and products to leverage ever-expanding technological advances in battery and other electric technologies, as well as the public’s continued interest in sustainability and green energy.
The industry has done well historically during uncertainty and adversity. The stabilization of cash flows is evident as a result of recent cost-control actions. An improved economy should assist with longer-term, top-line growth. As these factors develop, higher valuations should result for many utilities.
Brad Kitchens is president and CEO of ScottMadden Inc. He has a bachelor’s degree from Rose-Hulman Institute of Technology and an MBA from Duke University. Reach him at firstname.lastname@example.org.
Greg Litra is a director at ScottMadden Inc. with principal expertise in financial, economic and regulatory analysis, strategic planning, corporate governance, risk management and transaction support. He graduated from the University of South Carolina School of Law and earned an M.S.I.A. from Carnegie Mellon University and a bachelor’s degree from Wofford College. Reach him at email@example.com.