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A reader of my articles has requested a review of utility companies based on a cost of capital model. As I do not know of any such model currently available, I thought it might be an interesting topic for discussion along with possible inclusion in future investment analysis and decisions. For specific information, I turned to the industry association Edison Electric Institute (eei.org).

EEI counts 56 publicly traded electric utilities as members and provides an interesting overview of this segment of the utility business. EEI publishes statistics ranging from transmission rate case decisions to total stock market performance from its members. Included in its toolbox is information concerning the current credit ratings of its members along with historical data.

Long-term debt is especially critical in evaluating a utility's balance sheet. The sector is the most capital-intensive of all U.S. industries, both in terms of percentages and real dollars spent. Recently, electric utilities have been on a capital-spending spree. Below is a graph of capital expenditures by shareholder-owned electric utilities from 2003 to 2012:

(click to enlarge)

As shown, capital spending has ballooned over the past 5 year period from the previous 5 year period. Total capital spending increased from $266 billion between 2003 - 2007, or an average annual amount of $53.7 billion to $403 billion between 2008 - 2012, or an average annual amount of $80.7 billion. This represents a staggering 50% increase in capital spending over a short time frame.

The driver of this capital spending increase is not only the need to replace coal-fired generating facilities with other fuel sources and the need to improve/expand the transmission infrastructure but also the regulated nature of the business. A growing regulated asset base usually translates into higher profits over time.

Historically, there have been three ways of financing large capital expenditure budgets: annual operating cash flow, raising equity in the stock market, or issuing long-term debt. As most utility's capital budgets exceed operating cash flow less dividend payments, since 2006, the amount of long-term debt on electric utility balance sheets has grown. Below is a bar graph outlining total long-term debt over the past 10 years:

(click to enlarge)

Between 2003 and 2006, long-term debt for the sector was reduced from $350 billion to just under $325 billion. As capital budgets grew from 2007 to 2012, so did outstanding debt. Long-term debt expansion has mirrored the growth in capital spending, growing by more than $100 billion over the past six years. According to EEI, the percentage of total capitalization represented by long-term debt has remained consistent over the past three years at 56.8%.

This increase in long-term debt has affected the credit ratings of shareholder-owned electric utilities in a negative fashion. Below is a pie chart comparing the percentage of S&P bond ratings by investment grade from 2001 to 2012:

(click to enlarge)

What becomes obvious is the deterioration of the percentage of high-grade ratings as the dollar amount of bond issuance grew. In 2001, 32% of electric utilities earned an A- or higher credit rating. By the end of 2012, only 19% of electric utilities earned a rating of A- or higher. The lower rating of BBB- and below has increased from 19% in 2001 to 29% in 2012.

As of December 31, 2012, the average credit rating for all members of EEI was BBB. However, there was a slight difference between the categories of Fully Regulated, Mostly Regulated and Diversified (meaning not as regulated). The categories had the following average ratings: Regulated = BBB, Mostly Regulated = BBB+ and Diversified = BB.

Since 2005, the spread between 10-yr Treasury yields and new offering of electric utility bonds has maintained its 1% to 2.5% spread, with the exception of the credit crunch from 2008 to 2009. Recently, the spread has declined from a spike of around 2.5% to just under 2%. The chart below outlines the spread from 2005 to the end of 2012:

(click to enlarge)

Early in 2013, approximately 87% of the industry's rating outlooks at the parent level were Stable, 9% were Positive or Watch-Positive and 4% were Negative or Watch-Negative.

The list of the top credit rated EEI member companies and their ratings are below and include Southern Company (SO), Alliant Energy Corporation (LNT), Consolidated Edison, Inc. (ED), Dominion Resources, Inc. (D), Integrys Energy Group, Inc. (TEG), NextEra Energy, Inc. (NEE), Northeast Utilities (NU), Vectren Corporation (VVC), Wisconsin Energy Corporation (WEC), and Xcel Energy Inc. (XEL).

Company Name

Q1 2013

Southern Company

A

Alliant Energy Corporation

A-

Consolidated Edison, Inc.

A-

Dominion Resources, Inc.

A-

Integrys Energy Group, Inc.

A-

NextEra Energy, Inc.

A-

Northeast Utilities

A-

Vectren Corporation

A-

Wisconsin Energy Corporation

A-

Xcel Energy Inc.

A-

Source: eei.org

A firm's credit rating can greatly affect its cost of capital. Below is a table of median yields for non-financial corporate bonds categorized by credit rating as of June 9, 2013. Bond Desk Group LLC supplies the table.

(click to enlarge)

Source: bonddesk.com

The table suggests firms with BBB credit ratings pay upwards of 38% higher interest expense on bonds with maturities of 10-yr and longer than those with credit ratings of A. This difference would show up as higher interest expense on the same dollar amount of long-term liabilities for those utilities with lower credit ratings. Higher interest expense translates into lower earnings for shareholders.

More information on credit ratings for electric utilities can be found at the EEI website here and as a downloadable excel spreadsheet here. An interesting article dated October 2012 from Public Utilities Fortnightly titled Views from the Bond Side: How Fixed Income Investors View the Utilities Sector is found here.

Investors looking for alternative matrix of stock and company analysis should include a column titled "Credit Rating". Those firms with higher credit ratings should be considered as better managed. As utility investors are usually longer-term shareholders, quality of management should be a consideration. Evaluating credit ratings may help separate the best from the balance.

Below is the complete list of EEI member firm's S&P credit ratings, as of March 31, 2013:

Company Name

Q1 2013

Southern Company

A

Alliant Energy Corporation

A-

Consolidated Edison, Inc.

A-

Dominion Resources, Inc.

A-

Integrys Energy Group, Inc.

A-

NextEra Energy, Inc.

A-

Northeast Utilities

A-

Vectren Corporation

A-

Wisconsin Energy Corporation

A-

Xcel Energy Inc.

A-

ALLETE, Inc.

BBB+

CenterPoint Energy, Inc.

BBB+

DTE Energy Company

BBB+

Duke Energy Corporation

BBB+

MDU Resources Group, Inc.

BBB+

MidAmerican Energy Holdings Company

BBB+

OGE Energy Corp.

BBB+

Pepco Holdings, Inc.

BBB+

Pinnacle West Capital Corporation

BBB+

SCANA Corporation

BBB+

Sempra Energy

BBB+

TECO Energy, Inc.

BBB+

Ameren Corporation

BBB

American Electric Power Company, Inc.

BBB

Avista Corporation

BBB

Cleco Corporation

BBB

CMS Energy Corporation

BBB

El Paso Electric Company

BBB

Empire District Electric Company

BBB

Energy East Corporation

BBB

Entergy Corporation

BBB

Exelon Corporation

BBB

Great Plains Energy Inc.

BBB

IDACORP, Inc.

BBB

NorthWestern Corporation

BBB

PG&E Corporation

BBB

Portland General Electric Company

BBB

PPL Corporation

BBB

Public Service Enterprise Group Incorporated

BBB

UIL Holdings Corporation

BBB

Westar Energy, Inc.

BBB

Black Hills Corporation

BBB-

Edison International

BBB-

FirstEnergy Corp.

BBB-

Hawaiian Electric Industries, Inc.

BBB-

IPALCO Enterprises, Inc.

BBB-

NiSource Inc.

BBB-

NV Energy, Inc.

BBB-

Otter Tail Corporation

BBB-

PNM Resources, Inc.

BBB-

Puget Energy, Inc.

BB+

DPL Inc.

BB

Energy Future Holdings Corp.

CCC

Source:eei.org

EEI Table Notes: CH Energy Group: Using Central Hudson Gas & Electric Corp: A .; CH Energy Group long-term issuer credit rating not available. MGE Energy: Using Madison Gas and Electric Co AAA-.; MGE Energy long-term issuer credit rating not available.

Author's Note: Please review important disclaimer in author's profile.

Source: Electric Utility Credit Ratings Are Deteriorating