Part I of this 3-part series reviewed an article published in the utility industry trade publication Public Utilities Fortnightly in 2007 that is still worth reading. The article is titled, "How to Achieve High Performance, Lessons from the Top 40 Utilities." Many investors focus on the wrong fundamentals by concentrating on dividend yield. According to the information compiled by Public Utilities Fortnightly, there is a substantially higher correlation factor between three-year total stock returns and Return on Invested Capital (ROIC) and Return on Equity (ROE) than a utility's current dividend yield.
ROIC is an important concept for capital-intensive businesses. It measure management's effectiveness in generating shareholder returns based on all the capital at its disposal, including both debt and equity. For example, Company A generates a 10% return on equity with a debt to equity ratio of 0.5. Company B generates the same 10% return on equity with a debt to equity ratio of 1.0. Company A is generating 33% higher returns for each dollar of capital deployed and is creating more shareholder value.
While current dividend yield and long-term dividend growth is important, management's ability to maximize profits based on its capital structure is critical to generating shareholder returns. Maximizing shareholder returns also maximizes the opportunity to sustain dividend increases. Some believe that earnings and dividend growth over the long-term cannot exceed the ability of management to create ROIC. Dividend growth that is not supported by long-term profitability is unsustainable.
Some may scoff at the age of the article, but I believe the correlation remains. In deference to article comments from Part I, ROIC analysis is not a forward-looking statistic but rather a historical evaluation. However, as part of an overall fundamental analysis, ROIC should be at the top of the list for consideration as it trumps all other numbers in the long term. If management is unable to generate returns from its total capital base that is above its peers, share prices and total stock returns will eventually fail to keep up with better, competitive management teams.
Economic conditions change and company profitability changes with it. It is important for investors to conduct their due diligence past a few great looking numbers. For example, Exelon (EXC) has the one of the higher 5-year ROIC averages of 17.25%. However, their 12 month ROIC is 4.46%, reflecting the current depressed state of the merchant power business in the East and Midwest. Weak pricing of merchant power is weighing heavily on EXC's current profitability and is showing up in its lower TTM ROIC numbers. If an investor believes the PJM auction power market will improve, EXC may be able to once again achieve a high ROIC in the future.
Part I reviewed the ROIC numbers for the components of Dow Jones Utility Average. This article will offer the statistics for the S&P Utility Index components not included in Part I. There are 19 companies in the S&P Utility Index that are not components of the DJUI, and are listed below.
The following table lists trailing twelve month ROE, 5-yr average ROE, long-term debt to equity ratios, trailing twelve month ROIC, and 5-yr average ROIC for: Ameren (AEE), CMS Energy (CMS), DTE Energy Holdings (DTE), Equity Corp. (EQT), Entergy (ETR), Nicor (GAS), NRG Energy (NRG), Northeast Utility (NU), Oneok (OKE), Pinnacle West Capital (PNW), Pepco Holdings (POM), PPL (PPL), QEP Resources(QEP), Scana (SCG), Sempra Energy (SRE), Teco Energy (TE), Integrys Energy Group (TEG), Wisconsin Energy (WEC), Xcel Energy (XEL),
LT Debt to Equity
INTEGRYS ENERGY GROUP
PINNACLE WEST CAPITAL
DTE ENERGY HOLDINGS
The table is sorted by each firm's 1-year ROIC with the largest returns listed at the top. Keep in mind the top three utilities in the DJUI were Edison International (EIX) with a TTM ROIC of 9.11%, Public Service Enterprises (PEG) with a TTM ROIC of 6.23%, and Southern Company with a TTM ROIC of 6.07%. From the above list, the top three utilities based on TTM ROIC are Integrys, Pinnacle West and Wisconsin Energy. Management of each of these companies generated higher ROIC over the trailing 12 months than their previous five year averages, which is a great trend for long-term shareholders.
The latest investor presentations for each can be found here:
- Integrys investor presentation
- Pinnacle West investor presentation
- Wisconsin Energy investor presentation
Utility investors should expand their fundamental analysis to include comparisons for Return on Invested Capital. If Public Utility Fortnightly's analysis is correct, investors could be better rewarded by incorporating Returns on Invested Capital into their thought processes.
Author's Note: Please review important disclaimer in author's profile.