Business & Money
The Back-to-Basics Valuation Squeeze
An analysis of the strategic implications of the re-basing of power and utility industry valuations.
July 2004
By Ian Connor
Over the past several months, traditional valuation levels have re-emerged in the power and utility industry, with recent premium valuation metrics compressing significantly. This re-basing of industry valuations at levels more supportable by historical benchmarks and fundamental considerations of long-term growth and total return follows a two-year period of significant dislocation in the power and utility industry (and broader financial markets), during which dividend yield emerged as the primary value driver.
As considerations of growth begin to re-emerge in power and utility valuations, the industry again is confronting its historical dilemma: how to achieve long-term earnings growth that outstrips the intrinsic regulated utility growth profile of 1 to 3 percent. Following the collapse of the myriad of non-regulated growth platforms that precipitated recent industry-wide dislocations-most notably merchant energy-many utilities are again focusing on perhaps the most viable, broad-based and credible growth strategy: mergers and acquisitions.
Value-Dislocating Factors
Over the past two years, historical valuation parameters and metrics were dislocated by a unique confluence of economic, market, and industry-specific factors. The recession beginning in 2001, the post-bubble market collapse, and the overhangs of post-9/11 terrorism and war materially affected the general economy and equity markets. These factors triggered a classic "flight-to-safety" phenomenon in the capital markets, with utility securities and their perceived bond-substitute characteristics serving as a specific and traditional beneficiary.
This bond-substitute dynamic was enhanced by several other unique circumstances, further fueling industry valuations. First, the return proposition of utility equities relative to government securities became exceptionally compelling following the decline in interest rates to historic lows, with power and utility industry dividend yields outstripping the benchmark 10-year Treasury yield on an absolute basis over much of the period (see Figure 1). The 2003 dividend tax cut further improved the relative yield proposition of utility dividends to government securities on an after-tax basis. Second, at least initially, the financial difficulties affecting much of the power and utility industry constricted the universe of utilities that had the fundamental "safety" attributes to qualify as viable "bond substitutes." Investment, as a result, was concentrated still further, driving a limited set of high yielding, "safe" utilities to exceptional premium valuation levels.
During this period, utility valuations trended to historical premium levels, with the Lazard Core Utility Index trading between 14x to 15x on a one-year forward P/E basis, markedly in excess of historical trading levels of only 11.5-12.5x and only marginally below the 15.2x P/E median of historical utility acquisitions, which traditionally reflect a 20 to 30 percent premium to public market trading levels (see Figure 2). Select high-yielding, "safe" utilities (i.e., utilities with highly regulated earnings streams and de minimus unregulated exposure) commanded even superior valuations, with such utilities as Ameren, Cinergy, and Southern trading at highs over the period of 16.5x, 16.6x and 17.8x, respectively.
Emergent Valuation Re-basing Factors
Recently, however, traditional economic factors, stabilizing market dynamics, and industry valuation orthodoxies appear to be re-emerging, re-basing the industry's valuations on more fundamental and sustainable principles of long-term growth, yield, and total return. Several factors appear to be driving this. First, Treasury yields have risen sharply recently in anticipation of an increasing interest-rate environment. The strong March 2004 unemployment data were widely viewed as the last signal component of a resurgent economy, triggering one of the largest one-day falls in bond prices (and correlative increase in Treasury yields) since 1996. Utility indexes traded off accordingly, with the relative yield proposition of utilities diminished (see Figure 3). This trend continued with the similarly robust April employment figures and the Federal Reserve chairman's comments further buttressing capital markets sentiment that interest rates will begin to rise, potentially significantly, in 2004.
Second, the broad recovery of the power industry over the past year has expanded the stable investment base in the industry, diluting the recent equity concentration in select, relatively high-yield/low-risk utilities. With this broad-based recovery, investors have begun to again distinguish between utilities based upon their relative growth and total return propositions, even if only crediting those growth strategies that are deemed supportable within a conservative evaluative context, such as favorable regulatory treatment. However, positive equity market sentiment also appears to be forming around non-regulated but strategically adjacent growth strategies that until recently were being heavily discounted by the post-merchant-collapse market. Representative strategies include Sempra's trading and marketing business and Dominion's E&P platform.
Finally, notwithstanding the continued overhangs of terrorism and war, strengthening economic dynamics are revitalizing investment in the equity markets, with investors rotating out of defensive, safe equities such as utilities and once again looking for growth and equity propositions with annual total returns of at least 10 to 15 percent. This rotation towards a growth bias is translating into enhanced scrutiny of the true underlying growth propositions of utilities, a level of discrimination absent in the defensive, heavily yield-biased market of the past two years.
This is not to say that yield in the current market is irrelevant as a driver of value in the industry; rather, it is simply being considered as one component of value, appropriately weighted along with long-term growth considerations within the larger context of a utility's total return proposition.
Re-basing Implications
The re-basing of industry valuations to reflect fundamental considerations of growth and total return has important implications for utilities, suggesting significant value compression from recent elevated levels. Historical trading levels for the industry imply a sustainable trading range of 11.5x to 12.5x on a one-year forward P/E basis (see Figure 2). Allowing for the after-tax yield benefits of the 2003 dividend tax cut, and attributing some discount associated with its existing time horizon, these historical valuation levels should arguably be adjusted upward approximately 10 percent, potentially implying an adjusted one-year forward P/E value range of 12.5x to 13.5x.
As a further indicator of intrinsic, sustainable industry value levels, a dividend perpetuity analysis assuming 2 to 3 percent organic growth and a 60 to 70 percent payout ratio implies a one-year forward P/E value range of approximately 9x to 12x for the industry. By comparison, to sustain recent forward P/E trading multiples of 14x to 15x for the industry, utilities would have to achieve long-term earnings growth of approximately 4.5 to 6 percent, or significantly in excess of the organic 1 to 3 percent long-term earnings growth profile of a utility's regulated operations (see Figure 4).
Much of this re-basing of industry valuations recently has become manifest. The April 2, 2004, announcement of March 2004's strong employment figures marked the inflection point in this regard, with the Lazard Core Utility In-dex since declining 10 percent on a one-year forward P/E basis, from 13.9x to 12.6x (see Figure 3). At current levels, utility valuation metrics are now argu-ably significantly re-based at levels consistent with historical trading levels and fundamental considerations of value.
Further underscoring this re-basing of industry valuations away from largely yield, bond-substitute considerations and toward a more balanced valuation environment that encompasses growth, the higher-dividend but generally lower-growth utilities that commanded significant premiums over the past two years have compressed more than the lower-dividend but generally higher-growth utilities, which have relatively maintained their value at more supportable trading levels. Since January 2004, a composite index of lower-dividend/higher-growth utilities has declined only 4.6 percent as compared to the Lazard Core Utility Index and a higher-dividend/lower growth utility index, which declined 6.6 percent and 8.6 percent, respectively (see Figure 5, p. 28).
Strategic Implications
The re-basing of power and utility industry valuations also has important strategic implications for utilities. As fundamental and more balanced considerations of value emerge, only those utilities that can present to a still wary equity investor community credible growth strategies that exceed the organic long-term growth profiles of regulated utilities will be able to garner and sustain premium valuations in the current market environment. This is a particularly vital issue for those low-growth, high-dividend utilities that until recently commanded significant valuation premiums. The compression of these values translates into not only lost shareholder value but also diminished strategic leverage and flexibility to pursue growth, either through acquisition or investment.
Nor does a review of current industry growth strategies present a credible, broad-based solution to this issue.
Non-regulated Growth Strategies. The collapse of most of the utility industry's non-regulated growth platforms has made such strategies largely non-viable. While there may be opportunistic, large-scale plays in merchant generation, such aggressive strategies are likely limited to non-industry, better-capitalized players, or to creditors conglomerating distressed assets to glean the derivative benefits of scale and market power to enhance financial performance and create a viable, nearer-term exit vehicle.
Back-to-Basics Strategies. Back-to-basics strategies emerged in reaction to the recent dislocating phenomena following the collapse of non-regulated platforms. Such strategies were both appropriate (utilities that wished to un-derscore their relative safety and stability) and necessary (utilities whose financial and operational profiles were distressed by such non-regulated strategies). However, a "back-to-basics" strategy, even if well executed, is not a viable long-term strategy to deliver growth in excess of 1 to 3 percent. Even aggressive cost-cutting measures implemented to augment organic regulated earnings growth (while always advisable) will yield increasingly diminished returns over time.
Specialized Growth Strategies. Specialized growth strategies (e.g., LNG and conservative merchant strategies predicated on such initiatives as balanced origination and marketing businesses) are potentially viable growth strategies. However, these growth strategies are generally either too limited in scale, too competitive, or too niche in nature to serve as broad-based, long-term solutions to the industry's growth imperative.
Regulated Growth Strategies. Regulated growth strategies appear to be the only long-term growth strategies currently recognized by the market. Regulated initiatives seek incremental growth principally through investment in rate base, asset re-regulation, affiliate generation contracts, and/or other strategies that generally depend on favorable regulatory treatment. Such regulated growth strategies are strongly credited by the market, as they generally provide predictable and visible future earnings. However, such strategies are by definition dependent upon receiving supportive regulatory treatment, both at the federal and state levels. As a result, they carry a quotient of risk and uncertainty in their execution. The Federal Energy Regulatory Commission, in particular, through its policy statements and actions, has signaled that it will disallow, or at least severely scrutinize, certain attractive transactions based on market power concerns or affiliate transaction issues. More critically, the policies and regulatory treatment afforded utilities varies significantly from state to state, with some states being supportive of investment and growth and others reticent to provide the necessary rate structures. Consequently, such regulated strategies do not provide a certain or even necessarily accessible path to growth for many utilities.
Ultimately, then, with ambitious non-regulated growth strategies discredited, and back-to-basics, specialized, and regulatory-based strategies failing to provide a sufficiently broad-based and/or long-term solution to the industry's growth imperative, strategic momentum is again beginning to coalesce around the one strategic alternative that demonstrably does: mergers and acquisitions.
The Merger & Acquisition Proposition
The value proposition of merger and acquisition strategies is manifest. Cost savings and synergies, derived principally from operations and management (O&M) savings, but also variously from the benefits of scale and the transfer of best practices, among others, form the core of this value proposition. Scale alone provides operational and financial efficiencies as well as increases a utility's strategic flexibility to aggressively pursue attractive growth initiatives and investment. Even defined within the narrow parameters of O&M savings, the value is significant, often in excess of 10 to 15 percent of the target's non-fuel O&M. For example, a merger or acquisition with a strategic partner with $1 billion in annual non-fuel O&M expenses would yield approximately $600 million in incremental shareholder value, even assuming that 50 percent of cost savings and synergies are shared with ratepayers. Mergers and acquisitions also provide other less quantifiable, but no less critical, benefits, including diversification of market and regulatory risk as well as the financial scale and resources to withstand significant adverse operational and financial events.
Even those transactions retrospectively deemed unsuccessful were in fact generally able to realize significant synergy and cost-savings value, often in excess of the targets set at each transaction's public announcement. Where mergers and acquisitions in the utility sector have generally foundered is either in the failure to achieve broader strategic objectives, such as convergence (leverage multi-energy platform to derive synergies) and channel leverage (leverage cross-selling and bundling opportunities across multi-energy channels), or in regulatory miscalculation and strategic misadventure, such as pursuing acquisitions with attenuated strategic logic.
These latter two failings reflect the particular imperative of perfection in executing merger and acquisition strategies in the industry. Successful mergers and acquisitions demand rigor and discipline, not only in selecting an appropriate target, but also in properly gauging the regulatory landscape. And while the broader strategic objectives may have proven illusory, the embedded shareholder value propositions of cost-savings, synergies, and scale remain compelling.
M&A: The Public Policy Rationale. Nor is the strategic rationale of merger and acquisitions in the industry limited to addressing the growth deficiencies and value propositions of specific utilities. Consolidation should arguably be a public policy imperative, with supportive regulatory regimes structured to harvest and channel the substantial value embedded in the inefficiencies of a fragmented industry toward the public good. The industry's current fractured state owes more to historical accident and regional prejudices than strategic coherence. And while such fragmentation was perhaps supportable in the past, the present and future potential costs of such deficiencies of scale are freighted with significant economic risk for the United States.
The 2003 blackout brought to the public's attention the significant U.S. infrastructure investment required to improve reliability-by some estimates as much as $100 billion. Investment in infrastructure requires that a fair return be available that someone-i.e., ratepayers-must fund. In an economic and general rate environment with many factors that will otherwise create rate pressures, additional rate increases to fund investment may be politically unpalatable. If regulatory policies were instead adjusted to allow utilities to retain all of the derived merger cost savings and synergies-provided that a significant portion was channeled toward infrastructure investment upon which they could earn a timely and economic return-it would ease the financial burdens on ratepayers and enhance system reliability.
Such a supportive regulatory treatment of mergers and acquisitions would serve the interests of both the public and the shareholders of the nation's utilities. While the regulatory will to implement such beneficial policies is still largely unformed, the industry should continue to move forward on this regulatory proposition, either through public debate or, more directly, through transaction-based negotiations.
The Northeast blackout also framed, though perhaps less perceptibly, a larger critical issue: the degree to which the fragmentation of the sector may be undermining the integrity and strength of the U.S. power system. In the case of the blackout, the degree to which the nation's electricity infrastructure, and by extension its reliability, is dependent upon, and affected by numerous independent entities was in many respects the most important story. This fragmented operational control of the U.S. electric infrastructure necessarily increases system complexity, interstitial deficiencies, and operating inefficiencies, none of which serve the public policy objective of reliability. This relative lack of scale and consolidation in an industry marked by exceptional capital intensity will continue to have important implications as utilities confront the significant investment requirements of the near future. Utilities of significantly enhanced scale would be better positioned from an efficiency and financial strength perspective to meet these increasing multi-dimensional challenges and, thereby, to serve the public interest.
A Fundamentally Consolidating Industry
The power and utility industry is, by nature, fundamentally consolidating. As valuations re-base and traditional growth pressures re-emerge, the strategic imperative appears to be again coalescing around consolidation. Mergers and acquisitions present a viable, broad-based industry solution to providing superior shareholder value over the long-term. Combined with supportive regulatory policies, the derived consolidation values of scale, cost-savings and synergies can be leveraged to benefit the public interest as well. Industry participants should accordingly position themselves either as prime movers in the likely coming consolidation or, at a minimum, to be effectively reactive to the potential initiatives of others. Considerations of shareholder value and public policy require it.
Ian Connor is a director in the Global Power and Utilities Group of Lazard in New York. Contact Connor at ian.connor@lazard.com.
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