Utility Valuation: Shedding Light on the Black Box
April 15, 2002
By Richard Stavros
Experts debate
how energy companies should be valued in the wake of
electric restructuring and Enron.
How
should you value a diversified energy holding company with
regulated and unregulated subsidiaries? How should
you value a pure play merchant generation developer, an electric
utility distribution company, or a stand-alone vertically
integrated utility? Which is the good investment and what's
the ideal energy corporate model?
Furthermore, should
energy companies continue to pursue accelerated growth strategies,
or avoid it by focusing on the regulated (and some say safe)
stable earnings?
Ever since electric
restructuring began in the mid-nineties, industry executives,
mutual fund managers, Wall Street equities analysts, and ratings
agencies have been struggling to find the answers.
Over the last half-decade,
the energy industry has experimented with spinning-off its
generation, or transmission, or distribution, or an entire
subsidiary. Some companies have gone into energy trading,
merchant development, or have taken a more retail focus. Others
diversified into energy technology development, telecommunications
or pursued international holdings. And still others decided
to continue having a hand in all these businesses. Finally,
some companies decided they were happy being vertically integrated
regulated utilities and stayed out of the game altogether
(Please also see Vertical Integration: Necessity or Distraction?,
page 28).
Of course, observers
say that all this wheeling and dealing has turned once very
predictable and transparent companies into black boxes that
some energy executives, financial analysts, and investors
do not fully understand. This, of course, is not a new problem.
Oddly, the current
perceived mess in valuation stems from the previous attempt
to qualify and quantify deregulated utility businesses. As
early as 2000, Wall Street and others were advising utilities
to spin-off or carve-out their unregulated subsidiaries to
give financial transparency to analysts covering the sector
and potential investors.
Those bankers and
analysts, from investment banks J.P. Morgan, Deutsche Bank,
Morgan Stanley and CIBC World Markets, told the Fortnightly
in March 2000, that it was difficult to evaluate the earnings
growth number because it was difficult to evaluate a given
energy trading or merchant subsidiary when paired under a
holding company structure with a regulated utility.
Furthermore, many
bankers complained that energy-trading or merchant operations
results were poorly reported by the holding company. They
explained that's why the holding company received a modest
price-to-earnings (P/E) ratio. The P/E earnings ratio is the
price of a stock divided by its earnings per share.
The P/E ratio, also
known as a multiple, gives investors an idea of how much they
are paying for a company's earnings power. The higher the
P/E, the more investors are paying, and therefore the more
earnings growth they are expecting.
During the 2000-2002
periods, many of the companies that carved-out their merchant
activities did earn higher P/E ratios from investors than
diversified utility holding companies.
Then, the California
crisis and the Enron debacle happened, introducing new wrinkles
to how the market valued these companies. The energy merchants
discovered they were captive to investors' impressions of
the supply picture. The whole industry was penalized for being
involved in the same business as Enron, although their corporate
structures and debt situations, in most cases, were much different
than Enron's in terms of assets, organizational structure,
and culture. Energy merchants and traders like Aquila and
NRG decided they were better off having the considerable balance
sheets of their former parents and carved themselves back
in due to credit concerns prompted by the Enron misadventure.
This has put the industry
back to square one, introducing once again the problem that
bankers first unearthed in early 2000: How do you evaluate
these diversified structures? The current situation has prompted
calls by many in the industry for utilities and analysts to
work on a new framework for reporting and analyzing energy
companies-to shed light on the black box, as it were. But
to date, both the industry and the financial community seem
to be struggling for a common evaluation language.
Building
the Better Valuation Model: Making Sense of the Noise
Dr. J. Robert Malko,
a certified rate of return analyst (CRRA) and professor of
finance at Utah State University College of Business, says
there has been a shift in recent years in the way energy companies
are valued.
"Under traditional
rate-based regulation, a lot of emphasis was on historic cost.
With [electric] restructuring and more sales, there is a logical
shift to looking at an income approach. And in theory, the
income approach is the theoretical correct approach to value
a property. What are the expected cash flows the company is
going to generate?" he asks.
Malko says that relative
emphasis, or weighting, must be determined in evaluating companies
when using the indicators of cost, income, and markets (known
as the comparable sales approach). Certainly, there is still
debate over how much emphasis to put on the indicators, but
the overall weighting has shifted to analyzing cash flows.
For example, he says,
in terms of looking at a company's costs, you have the choice
of using historic, replacement costs, or a trend in historic
cost. When calculating income in estimating the future cash
flows, the challenge is calculating the appropriate discount
rate and then looking at comparables.
"Once a parent holding
company goes into a wide range of business activities and
has a wide-range of subsidiaries, the measurement of risk
on the parent is certainly more complex than if you turn the
clock back and have a more traditional integrated public utility.
The complexity and the type of diversification activities
clearly changes the risk profile," Malko says. In terms of
measuring of risk, if you look at the beta values (coefficient
measuring a stock's relative volatility) on the pure non-regulated
generation companies, they have higher beta values than the
traditional regulated companies.
Malko believes it
is important that a comprehensive assessment of business risk
be made in addition to financial risk in the industry.-business
risk in term of the variability of earnings before interest,
taxes, depreciation, and amortization (EBITDA).
EBITDA can be used
to analyze the profitability between companies and industries
because it eliminates the effects of financing and accounting
decisions. A common misconception is that EBITDA represents
cash earnings. EBITDA is a good metric to evaluate profitability,
but not cash flow.
What contributes to
EBITDA are factors that impact revenues or factors that impact
cost of operation, Malko says.
"Clearly, in this
growingly complex environment more scenario analysis sensitive
to business risk with respect to forward looking cash flows
needs to be done. That is clearly one weighted for potential
buyers and sellers to get a handle on," he says.
Focus On Regulated Utilities:
True Love at UBS
|
|
UBS
Global Asset Management's John D. Quackenbush
won't mind if you call him conservative. As
a utility analyst, his recommendations help
drive the firm's investment decisions for its
equity funds. In fact, UBS Global Asset Management
has $405 billion dollars in assets under management
as of December 31, 2001. UBS Asset Management
is one of four business groups of UBS AG, along
with UBS Warburg, UBS Paine Webber and UBS
Switzerland.
The
firm's outlook on utility companies hasn't
changed in the last decade, he says. They like
regulated businesses, regardless of whether
they are in generation, transmission, or distribution.
"We
take a fundamental long-term investment view
and that hasn't changed. ... We still prefer
the integrated providers because of our long-term
focus."
In
fact, it is this long-term focus that has kept
Quackenbush from investing in highflying energy
trading or merchant generation companies.
He
says that unregulated businesses are not out
of the question, but he looks unfavorably on
companies that would stray away from its core
competence of running a utility.
Quackenbush
says that, although evaluating regulated companies
on a case-by-case basis, he looks to see whether
the utility has incentives for achieving cost
savings that they can keep. "[Furthermore]
I think there are some marketing, trading and
generating opportunities that are far astray.
However, if marketing and trading activities
are focused on trading around assets, or targeting
certain niche customers, that could be a business
we would look on favorably," he says. Quackenbush
also evaluates long-term supply and demand
forecasts. "It still appears to us that there
is plenty of supply to meet demand over the
long-term,... even after considering plant
cancellations, and other plants that haven't
been formally cancelled but are unlikely to
be built. There are exceptions regionally,
but from a national perspective, there seems
to be plenty of supply to meet demand over
the long-term. For specific companies, we determine
the valuation by projecting cash flows and
reach some type of probability assessment of
the likelihood that they could meet those cash
flows."
He
explains that UBS Global Asset Management works
on a globally integrated investment platform
that allows analysts to compare companies on
a global basis. "We have analysts in London
and Tokyo and elsewhere (that work together).
If we decide to compare U.S. utilities to European
utilities, this global platform will permit
us to make those types of comparisons." Furthermore,
UBS Global Asset Management uses techniques
such as internal price projections to come
up with expected cash flows to determine the
current value of companies.
Quackenbush
believes that there can be negative results
when utilities go too far astray from their
core competencies. "I think it is in basically
sticking with something that they know, [that
utility companies] do well." He believes in
companies that generate free cash flow, pay
solid dividends, and even buy back stock from
time to time. "We think that it is [important
to demonstrate] disciplined management rather
than taking excess cash flow or free cash flow
and making investments that are far astray,"
says Quackenbush.
When
evaluating individual companies, he applies
a higher discount rate to take higher risks
into account. "We wouldn't necessarily say
a company has to grow by 5 percent or 10 percent.
Growth would be one factor to take into consideration.
But there could be a very solid company with
a lower growth rate that would be acceptable
compared to another company that is in a completely
different situation."
Quackenbush
measures success by comparing the performance
of the utility stocks within UBS Global Asset
Management's funds against utility benchmarks,
like Standards & Poor's utility index and the
MSCI World Standard Utilities Index. For example,
since year-end 2000, the global utility stocks
owned by UBS Global Asset Management have outperformed
the MSCI World Standard Utilities Index by
1,100 basis points.
—R.S.
|
Of course, Malko believes
the real issue will be how regulations are developed in reaction
to Enron, and how those new regulations affect the future
cash flows of energy companies.
"Until some of this
stuff settles, you'll have that uncertainty. If you look at
business risk, competition, weather, regulation, [and] availability
of power supply are [will be] the drivers of valuation."
In a nutshell, Malko
says the problem you get into is the qualification and quantification
of all these business risk components, the changing of those
components. The way these factors impact cash flows is certainly
more complex today than it was 10 years ago.
"So, that's really
what analysts are trying to get a handle on. We do have indicators
based on actual sales that we didn't have 10 years ago that
gives us some direction. But on the other hand, we have complexities
and uncertainties about what kind of regulation we are going
to have. What is going to happen to the holding company act
and what kind of new accounting standard will come in play?
Then, there is the state vs. federal issue. These are business
risk factors that make the forecasting of these forward looking
cash flows much more complex," he says.
"What has gone on
in the past year or so is raising flags that analysts have
to be sensitive to what assumptions companies are making regarding
these earnings projections and how sensitive they are to changes
in the business risk climate."
Meanwhile, with a
possible increase in interest rates on the horizon, analysts
are already looking at how valuations might possibly change.
"Everything else being
equal, if treasury rates are going up, the rational investor
is going to want more for an expected cost of common equity.
In terms of the utilities cost-of-capital going up, it depends
on the debt position and whether the company needs new debt."
John D. Quackenbush,
a certified financial analyst (CFA) and analyst with UBS Global
Asset Management, sees different aspects to a possible interest
rate jump. "One, the discount rate would increase as the cost
of capital increases. Corresponding with an interest rate
increase would be a general pickup in the economy, so perhaps
there would be greater revenue growth or economic activity
associated as well. Perhaps they would be offsetting. But
for specific companies, there might be some netting one way
or the other," he explains.
The
Earnings Schizophrenia: Regulated and Unregulated, Same P/E?
Jeff Bodington, president
of Bodington & Company, a financial and consulting boutique,
believes that the financial markets are at a loss for how
to analyze and evaluate energy companies in the electric restructuring
era, especially after Enron. "I think that many analysts are
getting it wrong and focusing too much on the downside risk
and being overly conservative. They are damaging valuations
as a result of things like Enron," he says.
Because the differences
between most diversified utility companies and Enron have
not been widely appreciated, "the stock values of these other
companies have been hammered. ... If you look at what has
happened to those stocks since Enron's announcement, they
have gone down, down, down. Whereas, there is really no new
information," he says.
In fact, many so-called
growth companies found their P/E ratios in January and February
2002 below even those of traditionally vertically integrated
utilities. For example, Calpine's P/E has been under four,
AES has been under six, and Reliant's has been under eight.
Bodington attributed
the stock drop to nervousness about companies that have been
associated with Enron. The result of this nervous reaction
by Wall Street and investors is to increase the debt/equity
ratios of these companies as the market value of the equity
in the company falls and the debt in proportion to total capital
rises, he says.
"As a result, the
lenders which for years have financed the asset-heavies' expansion
programs, are not only saying we won't lend you anymore, but
we think you should sell assets and use the cash to pay down
some of the debt to bring your debt/equity ratio back into
comfortable relationships," says Bodington.
Mark Ciolek, a partner
in PwC Consulting's energy industry practice, a business arm
of PricewaterhouseCoopers, is also puzzled by the lack of
distinction between very different businesses in the energy
industry. If you look at a wires model, a merchant generation
company, or a vertically integrated utility, the P/E ratios,
in the early part of the year, were all relatively the same,
he says.
"Of course, I think
that whole market sector has really been unfairly punished,
and maybe it is the flip side of being overly valued for the
last two years that now they are seeing the crunch from Wall
Street. On the other hand, some of the turn downs in valuations
for some of the pure IPPs like Calpine and NRG and Mirant
probably reflect the fact that they have been over-leveraged
and people have been paying too much to get assets in the
generation sector.
"[Moreover], a year
ago, the P/E ratios for the generation companies were significantly
higher. I have a hard time believing that the P/E ratios for
all these different business models can remain the same. I
think we'll see a movement back to the generation side. But
not generation like Calpine where you are just constantly
adding new capacity and increasing your leverage. But a carefully
managed model like an AEP or Duke," he says (Note: merchant
generator P/E ratios did rebound slightly at press time).
Going forward, Ciolek
says that he believes that generation-focused companies are
going to have higher earnings and growth than just a regulated
transmission company (transco) or a regulated distribution
regional company.
"I have to believe
that the P/E ratios and the earnings potential of the merchant
will be larger than what we see in the regulated wires business,
and then likely you will see the integrated utilities somewhere
in between there," Ciolek says.
But Ciolek believes
that European utilities and oil majors, which have been rumored
to be on the hunt for U.S. power and gas acquisitions, will
impact such valuations. If you look at a company like Shell,
they have more cash than long-term debt. In addition, the
Europeans have enormous market capitalization and can come
in and swallow most domestic utilities pretty easily.
The
Corporate Structure Debate: Pure Play vs. Diversified
Ciolek calls it the
$64,000 question. What is the ultimate corporate structure
that can adequately bring value to shareholders and withstand
economic downturns and the uncertainty and risk involved in
deregulated markets?
Being in that part
of the value chain-the generation and the merchant side-you
have to have a sizeable balance sheet. "It is pretty comparable
to the upstream on the petroleum side, where they have such
enormous balance sheets and have such diversification of risk
through different projects over the world that they are able
to weather the booms and the busts much better than what we
have seen in the utilities or the energy sector because of
the fact that most of these guys are relatively small from
a market capitalization perspective," he says.
So, the model of the
Dukes, the Exelons, and now that NRG is brought back into
Xcel, "I think the added balance sheet capabilities from a
credit and cash perspective is the model that will be the
dominant model at least for the next to the three to five
years," he says.
Ciolek believes that
the diversified holding structure also provides better protection
than say a vertically integrated utility possibly merging
with other vertically integrated utilities in the interest
of gaining size and scope. For example, a few years ago when
oil prices hit all time lows the oil majors took such a defensive
tactic.
PwC recently completed
an analysis of all the mergers since 1996 in the energy sector
and tried to classify them. It looked at the stock performance
for the 14 days before the announcement and the 14 days after
the announcement to see what the market thought of the strategy
and then looked over the past year since close (see Repeatable
M&A: Creating a Value Chain Reaction, p. 46). The findings
showed that the mergers that were strictly vertically integrated
utilities matching up with one another for the purposes of
obtaining scale have not been very effective from the market's
perspective.
Ciolek says the lessons
of Enron and California were that it is very difficult to
be a pure play merchant. Going forward, he believes there
still might be some companies that want to brave the pure
play business model.
But it is a high-risk
business with boom-bust commodity driven cycles, which would
expose those entities to a great deal of risk, he says. The
corollary would be an upstream oil company. When oil prices
are going up, things are like gangbusters, but when power
prices drop they bear the brunt of it.
Certainly, energy
merchants like Calpine and Mirant could benefit from a pairing
with an oil major because of its strong balance sheet. Bodington
also agrees with this idea. He says that if he had to choose
between the diversified utility model or a merchant developer
owned by an oil major, he would choose the oil major as the
ideal corporate structure.
Take, for instance,
Shell trading. Here we have a company that is not involved
in vertically integrated utility operations but is a very
big trader and they have a AAA credit rating, he says.
"If you want to be
a trader, you have to have a AAA credit rating. If it is supported
by a vertically integrated utility, great, but if it is supported
by a global energy business that involves oil that is fine
too. I don't see any reason that trading needs to be restricted
to somebody supported by a vertically integrated utility.
I think what you have to do if you want to be an effective
trader is of course know what you are doing and have a good
credit rating, and how you get that is really not very important.
You can do that by owning a utility or the Shell model.
"I would have Shell
at the top of the list. One of the good reasons for deregulation
is that the industry was moribund and had ossified and badly
needed to become more aggressive and more dynamic. In a corporate
structure where there are subsidiaries that do different things,
the approach of having one unrelated businesses has been largely
discredited. The approach that involves businesses that can
take advantage of each other's skills is proven," says Bodington.
He says the trading
organization benefits more from an entrepreneurial culture
involved in all kinds of risk management activities than from
a highly regulated culture. "I think the skills and the mindset
of the entire Shell organization are better suited to supporting
a trading company than those of a Duke-like entity."
Trading companies
can be very useful and don't need to have hard iron or assets,
he says. What any trading organization has to have is a focus
on risk management, whether you manage risks through owning
iron or power plants or manage risks through financial instruments
really don't matter that much. You have to just manage the
risks. That is why he doesn't necessarily agree with the recent
industry convention that energy-trading companies have to
have assets, and cannot be a pure play.
"In a perfect world,"
he says, "I don't see any difference. In today's market, trading
organizations are being devalued more because investors are
skeptical over how good the risks are really hedged. Enron
showed that it really wasn't hedging its risks but hiding
deals gone badly.
"[A trading organization
is viable] to the extent that you can give investors confidence
that you can manage risks. In the long-term, I don't really
see any difference between owning a contract and owning a
power plant as long as the contact is with a credit worthy
owner of a power plant. So, I'm not sure accounting changes
are necessary. I think better judgment is necessary."
Richard Stavros
is the executive editor of Public Utilities Fortnightly.
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