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Investing in utilities is like any other sector with the key to success being finding the right mix of management talent and assets that reward long-term shareholders. Many utility investors focus on price-to-earnings ratios, current dividend yield, dividend growth and return on equity. However, these investors are missing out on an important management evaluation tool that will have a greater impact on the returns of their investment over time - Return on Invested Capital ROIC.

The commonly used Return on Equity [ROE] falls short as a primary management effectiveness tool in capital intensive industries, such as utilities. ROE evaluates management returns based on equity deployed, but utilities have a much higher deployment of total capital when long-term debt is added to equity. ROIC gives a clearer picture of utility management effectiveness than ROE as it includes returns on debt capital as well as equity capital.

However, ROIC calculations are usually not very user friendly and most financial websites don't publish ROIC numbers in their financial statics. The easiest formula I have found is RIOC = ROE / (1+Debt to Equity). These numbers are usually easily available online, such as from finance.yahoo.

Keep in mind that different industrial sectors have different levels of capital intensity. While utilities historically use large amounts of debt capital, other sectors, such as technology and pharmaceuticals, do not. This means that while an 8% ROIC may be great for a utility firm, it may not be so hot for a technology firm.

Screening the 15 mainly large-cap utility stocks in the Dow Jones Utility Index (DJUI), NextEra Inc (NEE) and Williams (WMB) generated 14% ROE during the trailing twelve months (TTM). This would imply that each management team generated about the same amount of returns for each dollar of equity capital deployed. However, NEE has a debt-to-equity ratio of 1.36 whereas WMB has a debt-to-equity ratio of 3.05. WMB deploys far more total capital than NEE but generated about the same return. When calculated, NEE generated a TTM ROIC of 5.92% vs WMB's TTM ROIC of 3.48%. NextEra management generated a higher shareholder return than Williams for every dollar of total capital deployed.

The following table outlines the 15 companies of the DJUI, their debt-to-equity ratios, ROE TTM, ROE 5-yr average, ROIC TTM, ROIC 5-yr average, dividend growth rates and payout ratios:

Symbol

Name

Debt to Equity

ROE TTM

ROE 5-yr

ROIC TTM

ROIC 5-yr

Div Grow 5-yr

Payout Ratio TTM

PEG

Public Service Enterprise Group

0.69

12.81

16.19

7.58

9.58

3.74

53.10

CNP

CenterPoint Energy, Inc.

1.98

20.30

19.32

6.81

6.48

5.66

43.99

SO

Southern Company

1.01

12.35

13.01

6.14

6.47

4.05

76.30

NEE

NextEra Energy, Inc.

1.36

13.96

13.56

5.92

5.75

7.96

45.06

AEP

American Electric Power Co., Inc.

1.05

11.15

11.17

5.44

5.45

4.28

56.13

EXC

Exelon Corporation

0.82

9.37

22.13

5.15

12.16

3.86

110.00

ED

Consolidated Edison Inc.

0.85

9.32

9.55

5.04

5.16

0.85

66.50

D

Dominion Resources, Inc.

1.39

11.55

18.20

4.83

7.62

7.38

85.50

FE

FirstEnergy Corp.

1.12

8.60

11.21

4.06

5.29

1.92

80.20

DUK

Duke Energy Corporation

0.82

6.65

6.21

3.65

3.41

-4.71

90.50

WMB

Williams Companies, Inc.

3.05

14.09

9.92

3.48

2.45

17.23

80.80

PCG

PG&E Corp.

0.95

6.11

10.61

3.13

5.44

6.63

100.00

NI

NiSource Inc.

1.33

6.40

6.08

2.75

2.61

0.00

81.40

AES

The AES Corporation

3.17

6.83

14.86

1.64

3.56

0.00

0.00

EIX

Edison International

1.16

-0.27

9.21

-0.13

4.26

3.19

100.00

Average

1.38

9.95

12.75

4.37

5.71

4.25

71.30

Source: Reuters

It seems profitability in the utility sector has been tough over the past 12 months. The average TTM ROIC is down from its 5-yr average by a sizable 19%. However, four of the top five TTM ROIC generators were also close to their 5-yr averages, implying greater stability for these companies - CNP, SO, NEE, AEP. These companies also offer above-average 5-yr dividend growth, below-average payout ratios, and at or below-average debt-to-equity ratios (except CNP).

A basic description from their respective websites:

Centerpoint Energy -

We're a company with more than 5 million metered customers and a long history of service. CenterPoint Energy is composed of an electric transmission and distribution utility serving the Houston metropolitan area, local natural gas distribution businesses in six states, a competitive natural gas sales and service business serving customers in the eastern half of the U.S., interstate pipeline operations with two natural gas pipelines in the mid-continent region, and a field services business with natural gas gathering operations, also in the mid-continent region.

Southern Company -

A leading U.S. producer of electricity, Southern Company businesses include electric utilities in four states and a growing competitive generation company, as well as fiber optics and wireless communications. Southern Company brands are known for excellent customer service, high reliability and retail electric prices that are below the national average.

NextEra -

NextEra Energy, Inc. is a leading clean-energy company with revenues of more than $15.3 billion, more than 41,000 megawatts (MW) of generating capacity, and approximately 15,000 employees in 24 states and Canada as of year-end 2011. More than 11,000 of NextEra Energy's employees are based in Florida. Headquartered in Juno Beach, Fla., NextEra Energy's principal subsidiaries are Florida Power & Light Company, which serves approximately 4.6 million customer accounts in Florida and is one of the largest rate-regulated electric utilities in the country, and NextEra Energy Resources, LL C, which together with affiliated entities is the largest generator in the United States of renewable energy from the wind and sun. Through its subsidiaries, NextEra Energy operates the third largest number of commercial nuclear power units in the United States. NextEra Energy has the second largest fleet of power plants in the United States, capable of producing the electricity needed to power more than 17 million homes.

American Electric Power -

AEP ranks among the nation's largest generators of electricity, owning nearly 38,000 megawatts of generating capacity in the U.S. AEP also owns the nation's largest electricity transmission system, a nearly 39,000-mile network that includes more 765 kilovolt extra-high voltage transmission lines than all other U.S. transmission systems combined. AEP's transmission system directly or indirectly serves about 10 percent of the electricity demand in the Eastern Interconnection, the interconnected transmission system that covers 38 eastern and central U.S. states and eastern Canada, and approximately 11 percent of the electricity demand in ERCOT, the transmission system that covers much of Texas.

Adding a review of Return on Invested Capital should help investors uncover management teams that have outperformed their competitors in a very important matrix - generating returns on the total capital at their disposal.

Author's note: See important disclaimer in Mr. Parepoynt's profile

Source: Don't Forget ROIC When Evaluating Utility Managers