The third panel discussion at the Edison Electric Institute's Spring Financial Conference was held on Friday morning, May 20th, 2005. The title of that panel was: "Value Creation or Destruction." Its topics that were supposed to be covered included: a) Regulatory recovery options; b) Returns at what risks; and c) What will be the customers' reactions.
This panel had 4 participants: a) Vic Khaitan of Deutsche Asset Management (an equity investor); b) Ron Barone of Standard and Poors (the credit agency side of the business); c) Ave Bie of Quarles & Brady (ex-Chairwoman of the Public Service Commission of Wisconsin); and d) Keith Masten of JC Penny.
In a not entirely unexpected occurrence, the prepared remarks were fairly ... uninformative (with the exception of Barone's comments, as he nearly always has something worth listening to when he talks at these conferences). And like the other patterns, the Q&A offered some deeper insights than the prepared remarks.
Vic Khaitan, in his prepared remarks, basically just gave a simple primer, offering some very basic areas for investors to examine when evaluating stocks: M&A, Excess cash, Diversification, Management issues, and Risk control. And basically he said that in each area the key was not what the companies might be saying, or how good it all sounds, but how was the company able to EXECUTE its goals in each area. So ... forget about all the vision and even the specifics a company may offer. Focus primarily on the company's ability to EXECUTE its strategy and tactics.
Ron Barone offered a window on S&P's issues of the day. As a credit agency, S&P is focused on credit quality issues, not equity value, though he (and I) believe that credit quality is important to equity value (sometimes it is lockstep, like from 2001-2003, but sometimes it is more indirect). And Barone highlighted some of the important current credit quality trends:
- Despite improvements, 35% of electric utilities still have a negative outlook according to S&P.
- S&P sees the utility industry as having a middle BBB ratings profile, but with a reasonably stable outlook for the sector as a whole.
- Leverage for the sector has finally dropped to below 60% (from over 63% in 2000). And other credit metrics have shown a similar improvement.
- Utilities are moving closer to their core competencies: Regulated businesses, filing rate increase requests to shore up credit quality, etc. but since earned ROEs (return on equity) are high, that bears its own risk.
- He sees a possible acceleration of M&A. This could lead to competition for capital, and therefore leading to more aggressive growth strategies (bad for credit quality). And he expects regulatory approvals to take longer than in the recent past, and for any cost savings from synergies to be retained less for the shareholders, and increasingly sent back to the customer.
The other panelists offered little of importance in their prepared remarks, in my opinion.
In the Q&A, other interesting points were made, however. These included:
- Khaitan raised an interesting point about power plant regulatory recovery being granted for the 1st 4-5 years of the life of the plant only, despite the plants lasting more than 30 years, leaving the shareholders potentially exposed after the 1st 5 year period. And Barone pointed out that regulatory recovery that took too long to phase in was bad for credit quality.
- Ave Bie raised a fascinating point about how STATE regulatory policy must increasingly take into account the strongly increased cross border (i.e. across State lines) nature of the utility business -- the utility business is now truly regional, more than local, and that regulatory commission must begin to incorporate regulatory changes to reflect that (that would be positive for shareholders, in my opinion, should State regulators successfully accomplish that). She highlighted how important dialogue between State regulators was therefore increasingly important.
- The panelists were uniformly unenthusiastic about merger activity between utilities. Barone thought that, despite the promises by the companies, generally the gains do not offset the risks, at least from a credit standpoint. I would add that in my opinion, while certain utility mergers do make sense strategically (such as the Exelon and PSEG merger), most do not make sense -- after all, if you take one pile of crap, and combine it with another pile of crap, what do you end up with? A larger pile of crap (this is my wording, not the panelists' wording).
- Barone felt that the appropriate capital structure for merchant generators who wish to be investment-grade should be at least 60% equity, and less than 40% debt (similar to Oil and Gas Sector), as opposed to the average regulated utility that now has 40% equity and 60% debt.
There was another interesting point made in the discussion. The panel also made a point regarding an important changing of the landscape coming for the industry: The expiration of rate caps.
When the electric utility industry was partially deregulated in the late 1990's, only a part of its markets were fully deregulated -- the wholesale markets. The retail markets (electricity sold directly to residential and smaller commercial customers) remained regulated, mostly. the retail market had price caps put into place to "protect" the customers from a deregulated marketplace ... but those rate caps were to be phased out. The caps have begun to expire, and oil, gas and coal prices (the primary fuel sources for the generation of electricity) are much higher than they were at the time of the implementation of the price caps.
Many customers may be about to face sizable increases in prices they must pay for electricity as these caps roll off. the panelists warned that there is the real possibility of regulators trying to roll back deregulation (likely to be unsuccessful, in my opinion). With few market structures in place to assist in a smooth transition to deregulated retail markets, there will certainly be confusion. There is also likely to be pain for the ultimate customers, in my opinion. And if the state regulators try to reregulate the marketplace, not only will they likely fail, in my view, but they will almost certainly make things even worse ... as nearly always happens when the regulators keep changing their minds.