Fortnightly
Utility Finance After the Transition
October 15, 1995By James T. Doudiet, John Higley, and Patricia Eckert
DOUDIET:
Stranded investment has overshadowed other financial issues in the transition to a competitive electric utility industry. For example, what will post-transitional companies look like? Will they attract growth-oriented investors?
Utilities as monopolies enjoyed unparalleled access to the capital markets because price was based on cost. That structure assured the ability to raise funds under any and all circumstances, but it created an atypical industry. Utilities embraced financial strategies (see sidebar) that one doesn't find among unregulated firms. Prices and costs are unrelated in competitive markets; customers are not locked in.
Allow me to propose a financial objective for the post-transitional era: sustainable earnings growth. That idea is getting lost with so much attention paid to transition-period issues. Sustainable earnings growth eventually will drive valuation for utilities, just as in all other businesses. So how does financial strategy translate into value?
In the future, utility managers will find less demand for the skills they've developed (raising capital, investor relations, and the like) in the regulatory era. Other skills will take on greater importance: budgeting, activity-based cost accounting, and cash management.
ECKERT:
On the regulatory side the concept of incentive regulation offers a road to sustainable earnings growth, but only if utilities don't lose sight of market share. Incentive regulation rewards business innovation and yet blends in regulatory oversight. It moves away from rewarding a company for a growing investment base \(em and toward cost control. The addition of price caps or tolerance bands further distances regulatory oversight from the traditional concept of price based on cost.
I also think we will see a much greater emphasis on outsourcing. In the past, utilities were vertically integrated in more ways than in capital structure. They wanted to do it all themselves. But that desire stifled innovation. Few new ideas arise in monolithic organizations. To compete well demands a constant flow of new ideas from as many sources as possible. Supplier chains can add creativity to any organization.
On the financial side, debt creates an unwelcome fixed cost. So, we might expect tomorrow's electric industry to exhibit a smaller proportion of debt capital. Cash flow will be highly valued, but you need a strategy to use cash wisely. Various uses of cash will complete for management's attention. For example, should managers elect to pay dividends while postponing fixed-cost reduction? Dividend payments should fall as a percentage of earnings only if there emerges a better use for the cash. Such a strategy would appeal to new investors looking for sustainable earnings growth instead of dividends.
In telecommunications, we saw a separation of the business into high-growth and low-growth business segments. Cellular communications are a high-growth example. Almost before cellular had become a business, telephone companies spun off these operations to give aggressive investors a vehicle for rapid growth. We might infer from this that investor preference will influence restructuring in the electric business.
HIGLEY:
The traditional way utilities have achieved financial growth in the past \(em earning a return on a growing asset base \(em is just about done. And while cost reduction is essential for the transition, you cannot sustain earnings growth through cost reductions alone.
Utility operations will change into commodity service businesses. Key concepts will emerge, such as market share and product differentiation, but with little brand loyalty among large users, for whom price will govern.
If you already have reduced the costs that are relatively easy and made essential productivity improvements that emphasize profitability, what do you do next? I believe that cost substitution is the next step. By this I mean substituting variable for fixed costs wherever possible. That way, if you lose a customer, most of the costs vanish, too; if you gain a customer, you do so because it is profitable and covers both fixed and variable costs. Outsource suppliers will be asked to share the business risk. Low fixed costs mean greater leverage for profitability.
Moreover, instead of delaying recognition of expenses, advantage will come from accounting methods that expense costs immediately. (Earnings will not come from return on capital, so writing off assets quickly will be desirable.) Here's one possible scenario: Don't own capital equipment.
Some lessons to follow: First, protect your current customer base. We know it is much easier to generate revenues from current customers than to develop revenues from new customers. Second, understand which customers are profitable. Third, make your current customers more profitable by increasing revenue per customer. Emulate consumer product companies, who understand which products are the most profitable and in what mix. Fourth, pinpoint the optimum size needed to economically serve your market.
Lastly, utilities must revamp their financial systems, which were designed heretofore only to justify decisions to regulators. It is not too early to work on the systems and skills necessary to manage in such an environment. t
Jim Doudiet represents J.T. Doudiet Associates, Inc., financial, strategic & regulatory consultants, Minneapolis, MN. Previously he served as an investment banker and as chief financial officer of Northern States Power Co. John Higley is managing director, Energy & Utility Industry Services, at Deloitte & Touche. Patricia Eckert, director of competitive issues, telecommunications & utilities at Deloitte & Touche, previously served as president of the California Public Utilities Commission.
What Monopolies Did Yesterday
. Relied on external sources of capital, not internal cash flow
. Maintained high debt ratio in capital structure
. Paid a large proportion of earnings in cash dividends (even when cash was not available from operations)
. Delayed expense recognition with deferred accounting, pending cost recovery from customers
. Downplayed internal cash flow
. Built asset base to achieve financial growth
. Crafted long-term, fixed-priced contracts to reduce supply risk
. Coveted capital-raising and investor-relations skills; neglected budgeting, pricing, cost accounting, and cash management.
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