Electric utilities today look a lot like newspapers in 2000: too much debt in an industry primed for disruption.
- Both had long been considered to be safe businesses with dependable income.
- Both took advantage of the seemingly dependable income to increase leverage (debt).
- Both face pressure from a disruptive technology (the internet, and distributed generation and efficiency) with the potential to undermine their businesses.
Speaking at the Economist's Intelligent Infrastructure Conference, Brad Tirpak, Managing Partner at the private investment fund Locke Partners made the case that electric utilities are as woefully unprepared for the coming disruption of cheap, distributed solar power as newspapers were unprepared for the disruption of the internet in 2000. Mr. Tirpak expects a similar story to play out in utilities as solar becomes cheaper and reaches grid parity.
Case study: The end of the newspaper era
Newspapers have not gone away and both local and national news journalism will always have a place on most people's home pages. However, the business of the traditional newspaper was undermined by changes in distribution channels. As readers and advertisers increasingly migrated to the internet, circulation numbers dropped. When a company is highly leveraged with debt, a small drop in revenue is magnified into a proportionately larger drop in profit. To stay solvent, newspapers had to raise prices. Rising prices drove more readers away, starting the cycle all over again, and eventually leading to insolvency for many papers.
Applied learning: How does this relate to the utility sector
In the present climate of rapidly rising energy costs, utilities such as Duke Energy (NYSE:DUK) must face the prospect that large industrial or commercial customers may choose to satisfy their energy needs independently. Investment in on-site solar projects could result in a negative feedback loop similar to the one experienced by the newspaper industry at the end of the last century.
The basic economic model is that utility companies build large projects over many years and at great upfront capital expense, with the expectation that demand will justify the cost. This leaves the utility company exposed to risk from demand uncertainty and changes in energy costs. As the social agenda continues to adopt both voluntary and mandatory conservation efforts, this could drive demand down (cash-strapped and/or environmentally conscious consumers on the one hand and increased government regulation on the other). Scarcity of traditional energy resources, such as oil and coal, will drive up energy costs in the coming years.
As costs increase in the traditional energy generation sector, solar power will achieve cost parity more quickly. Thus, both cost and conservation concerns could drive businesses to adopt on-site solar power generation. If more customers are able to satisfy their own energy needs, utilities will have to increase prices to earn back their cost of capital, thus potentially creating a self-sustaining loop like the one experienced by the newspaper industry.
There are several important factors to take into consideration regarding any similarities between the utility industry and the newspaper industry. First and foremost, utility customers are captive in a way that newspaper customers never were. The option of installing solar photovoltaic cells will most certainly change the way we pay for electricity, but the technology lacks the scalability necessary to free us from the grid.
Second, regulators and state budget makers have an extremely vested interest in insuring that utilities earn back their invested capital. Utility regulators are charged both with ensuring that utility customers get service at a reasonable cost, and also that utility investors will continue to be willing to provide capital for necessary utility investments. If the rapid adoption of photovoltaic cells were to threaten utility solvency, regulators would be forced to take action.
Regulated utilities should be able to handle the imminent changes to the industry brought about by the implementation of solar energy and other renewable sources, but at the cost of their profit margins, as they must be willing to accept lower returns on capital to remain competitive with new energy sources. Traditional utilities like Southern Company (NYSE:SO) will see lower rates of return on invested capital and thus most likely a contraction in P/E multiples. Independent power producers like NRG Energy (NYSE:NRG) and GenOn (NYSE:GEN) could face severe headwinds trying to sell their energy into a newly competitive spot market.
I would be particularly bearish of coal power producers, primarily due to the threat of regulatory action. Furthermore, I would be reluctant to view this demographic trend as necessarily implying that solar module manufacturers like First Solar (NASDAQ:FSLR) are a safe play based on implications of rising demand. The solar industry is highly commoditized and the increase in demand for product may not translate into higher profits across the board. The real winner in this may ultimately be the consumer, who will have more options for realizing his or her energy needs at competitive prices, while reducing the aggregrate demand for fossil fuels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.