"Next phase, new wave, dance craze, anyways
It's still rock and roll to me"
Billy Joel, 1980
Do not be lulled into thinking this time it is not different. Investing in electric utilities offers both new challenges and new tools to help navigate through the maze of utility selection. Investors should expand their horizon of analytical tools when evaluating utility investments. While Billy Joel wrote these lyrics in 1980, investors need to remain up to date on new tools and the impact of subtle but pronounced changes in the regulated electric utility field.
Thirty years ago, life was simpler and utilities were easier to segregate between "good" and "bad." However, today investors should factor multiple influences into their thinking. These include the negative impact of alternative power generation on profitability, customer satisfaction surveys, regulatory environments and return on invested capital.
Wind Should Be In the Mix
Many utility investors look at anticipated growth rates, dividend yield and dividend growth to locate the next best investment. However, digging deeper into available data will offer some interesting insights into the selection process.
The negative impact of subsidized wind generated power to existing power producers should not be understated. While it lacks the press spotlight, in my opinion because it goes against the "green energy" grain, the selling of intermittent wind power as a substitute for base load generation is a huge issue going forward. While many look to Europe as the wind power footprint best suited for the US, it is just as important to review the impact on a potential reduction in base load power facility construction.
Some may think the impact of negative power pricing is a figment of my imagination, but it is an issue for the Energy Information Agency (EIA) to comment on in June 2012:
Under certain conditions, electric generators in regional transmission organizations (RTOs) actually pay to produce power as reflected in a price below zero. This situation can arise because some types of generators, such as those providing nuclear, hydroelectric, or wind energy, cannot or prefer not to reduce output for short periods of time when demand is insufficient to absorb their output. RTOs use locational marginal pricing (LMP). Prices are determined at thousands of locations. Prices are also determined hourly and on a 5-minute basis.
Technical and economic factors lead power plant operators to run generators even when power supply outstrips demand. For example:
- For technical and cost recovery reasons, nuclear plant operators try to continuously operate at full power.
- The operation of hydroelectric units reflects factors outside of power demand, for example, compliance with environmental regulations such as controlling water flow to maintain fish populations.
- Eligible renewable generators can take a 2.2 cents/kWh or $22/MWh production tax credit (PTC) on electricity sold. This means that some generators, primarily those operating wind turbines, may be willing to sell their output at negative prices to continue producing power.
- There are maintenance and fuel-cost penalties when operators shut down and start up large steam turbine (usually fossil-fueled) plants as demand varies over a day or a week. These costs may be avoided if the generator sells at a loss when demand is low.
In these situations, generators may seek to maintain output by offering to pay wholesale buyers to take their electricity. While generators will rarely be willing to pay to generate for a whole day to avoid shutting down, many are more willing to do so when they only have to pay for 5 minutes or an hour. Also, the market and operating conditions that give rise to negative prices are more likely to occur for short periods of time.
Negative prices generally occur more often in markets with large amounts of nuclear, hydro, and/or wind generation. The operators of these types of generators may be less willing to ramp up and down for the reasons mentioned above.
Below is a graph from EIA concerning negative pricing in the Pacific Northwest from February to July 2011:
If wind generation is creating a negative pricing environment, and obviously, this is bad for profitability of electric utility companies, how can investors factor this into their investment decisions?
While an expanding and more efficient power grid and electric transmission network will cause wind power generation to be purchased farther from its source, those utilities with the greatest percentage of wind power generated in their states could be seen as having the biggest risk. For instance, the southeast is not as conducive to wind generation as the upper Midwest. The Wind Energy Association has published a table that outlines the states with the largest percentage of wind generation. Listed below are the states with the largest percentage of installed electrical power generated from wind, ranked by percentage of electricity used (from the Wind Energy Association).
% Wind Generation in 2012
A link to an interactive map of current wind farms is here. In addition, below is a map that overlaps current high-voltage transmission networks and wind power potential, from the US Department of Energy, National Renewable Energy Laboratory:
If an investor were seeking service areas that have the potential of lower impact from the disruptive nature of wind generation, it would be areas in white.
However, it is not as cut and dry as this. For example, Massachusetts is attempting to become the first state with a massive offshore wind farm located in Nantucket Sound, off Cape Cod. Cape Wind Co. is looking to place over 120 wind turbines just off the coast. This is a very controversial project with pros and cons. Competing articles can be found here and here.
Customer Satisfaction Surveys
Utility investors are not accustomed to reviewing customer surveys as an investment criteria. However, having great customer service reduces the incidents of negative comments to state regulators, and as all regulated utility investors know, state utility commissioners control the profitability of utilities operating in their states. It should not be a far jump for traditional investors to correlate customer satisfaction with the potential of higher profitability through higher allowed returns.
JD Powers has offered electric customer service surveys for several years. While not including the parent companies, the survey offers interesting insights by region, size and geographical averages. The press release for the 2012 study is located here and a sample of the regional results follows:
It could be assumed that customers of Clark Public Utilities complain less than customers of PNM, and as such may not be as vocal when it comes time for rate reviews.
The advantage of investing in regulated utilities is stability of earnings from an allowed asset base. State utility commissions set electricity rates based on an allowed and predetermined rate of return to the utility. This earnings stability allows utilities to provide stable dividends for income investors. However, not all states offer the same allowed returns and not all states have "utility-friendly" commissioners.
Standard & Poor's credit analysis incorporates these variances into their credit ratings. States that offer higher allowable utility returns and have historically been more conducive to rate increases positively impact the profitability of the utilities under their jurisdiction. S&P factors these into its credit rating decisions, and has produced a map showing its opinion of the friendliness of state utility commissions, with the term "Most Credit Supportive" indicative of a positive environment and "Least Credit Supportive" indicative of negative environment. While the public map below is dated 2008, it is still useful. An updated 2012 version can be purchased here.
Return on Invested Capital (ROIC)
Many investors review current dividend yield, dividend growth and possibly return on return on equity (ROE). However, return on invested capital should trump all these fundamental analysis tools. In capital-intensive sectors like utilities, evaluating management's ability to generate profits from all sources of capital at their disposal is preferable than to just evaluate returns on shareholder equity. I have written several articles about the importance of ROIC and will not recap them here, except to state that some believe a company cannot sustain earnings and dividend growth above management's ability to generate ROIC.
ROIC statistics can be found on several websites such as Reuters.com and Morningstar.com. Reuters.com offers trailing 12-months (TTM) and 5-year averages while Morningstar.com offers annual ROIC going back 10 years. Examples can be found here and here for Southern Company (SO).
I prefer to calculate my own ROIC as I can include only the amount of long-term debt on the balance sheet. While short-term debt and net short-term liabilities are an important consideration in a company's overall balance sheet, they are not usually utilized to finance long-term projects. Short-term liabilities are included in total debt to equity ratios and most ROIC calculations. My calculations include long-term debt only as these are most often used for financing of capital expenditure projects. The ROIC equation I utilize is ROIC = ROE / (1 + long-term debt to equity ratio). In addition, I calculated these on both a 5-yr and TTM basis.
Putting it all Together
Below is a table that incorporates the above information for a few of the more popular utility stocks. I have chosen Southern Company, Wisconsin Energy (WEC), Edison International (EIX) and Exelon (EXC) to compare.
LT Debt to Equity
ROIC 5-yr Avg
Wind Generation Exposure
Low, but increasing
In addition to traditional fundamental analysis, adding these factors may improve an investor's stock selection processes. Utility investing is no longer just about finding dividend growth but also about finding companies that are well positioned for the future.
Author's Note: Please review important disclaimer in author's profile.