December 15, 2008
As the economy has lost its footing, utilities have stood relatively strong. But will that fortitude continue throughout 2009?
Even in the worst of times, households and businesses need electricity. But tough times necessitate prudence. Declining demand by both businesses and homeowners will eventually take its toll on income. The duality has meant that utility stocks have performed better than the broad market but they have still lost value this year.
The more imminent concerns are over the effects of tight credit and rising infrastructure needs on the utility business over the next year. The industry has not escaped the turmoil. The Standard & Poor's 500 had been down nearly 40 percent for the year compared with about 30 percent for its utility index. That's still a huge amount for a largely regulated industry that passes through most of its expenses to ratepayers.
The tumult comes at a time when utilities need to access to capital. While Standard & Poor's says that the regulated electric utility sector must spend an estimated $180 billion to upgrade its infrastructure and to install pollution controls, it now says that much of this outlay will have to be deferred until credit eases. It does add a word of caution, pointing to a 2007 Black & Veatch study that says as much as 60 percent of the generation, transmission and distribution infrastructure is at least near the end of its service life.
"These guys really need to step up their level of investment to replace their aging infrastructure," says Richard Rudden, a senior of vice president of Black & Veatch. And they are at a minimum of $75 billion a year." Nevertheless, he says that capital expenditures in 2009 will be 10-15 percent less than in prior years. Still, to pay for planned improvements and to attract investment, industry must boost prices 6-8 percent a year -- increases that Rudden says regulators may opt to phase-in over time.
The regulated utility sector has traditionally been viewed as a safe haven for investors, especially for those on fixed incomes who rely on the predictable revenue streams and the steady dividend payments. That model is still relevant, given that incumbent power companies enjoy market dominance in the areas that they serve and the vast majority of them have said their dividends will remain stable in the coming year.
True to form, utilities earnings have been secure over the previous 12 months. But a prolonged recession could have repercussions. According to National City Bank's Jim Halloran, utilities may typically trade at 14 or 15 times earnings. Now, though, those multiples are at about 12. That means investors think that they will earn less.
"Part of the future growth will come from building generation and transmission projects that add on to load or customer base," says Halloran. "But this will be tough because customers are not using as much power and the power companies may have trouble getting access to the capital markets."
Raising Capital
S&P follows utilities that have a total debt of $505 billion. Of that, roughly $105 billion is due by 2010. As of June 30, 2008, they showed $31 billion in cash and short-term investments. Beyond that existing money, the ratings agency goes on to say that the industry has about $110 billion available to it in the form of revolving credit -- money that was arranged earlier on favorable borrowing terms but which expires by 2012.
It points to Duke Energy, which accessed $1 billion of its $3.2 billion credit line and American Electric Power that borrowed $1.4 billion under its existing line of credit. That's why utilities have such "rainy day funds." But the downpour has forced the companies to borrow to ensure that they have enough liquidity. The fact is that diminished productivity and curtailed consumption will dent earnings.
But none of this obviates the need for utilities to update their infrastructure. To do so, they need access to capital and fair, allowable returns. In the days of strict regulation, utilities would issue debt and equity that was backed by the assets of the parent company. The regulatory pact then ensured reasonable rate of returns on prudent investments. In the wake of restructuring, that contract has evolved. The lack of total guarantees now means that those companies must be more imaginative.
The strongest ones have paid for new ventures out of cash flow and then re-financed them later on. Those with the most growth potential have sold equity while those that have strong financials have added debt. Others, meanwhile, have used project financing that is not backed by the full faith and credit of the holding company. Since the last recession, utilities are careful not to become too highly leveraged. The ratings agencies like to see debt-to-capital ratios of 50 percent, also known as a 1:1 debt to equity.
Utilities have spent five years shaping up. But rocky conditions might shake them next year. As for National City Bank, it is "even weight" with respect to the industry, noting it has a "buy" on some major semi-regulated names but not on others. It's holding back on the unregulated players, saying that the weak economy pushes down power prices and subsequent returns while it's bullish long-term on existing nuclear facilities as their operating costs will look cheap once natural gas prices rebound.
The recession will invariably cut into utility cash flows and earnings. But the industry as a whole has sufficient reserves and existing credit lines to help it maintain liquidity. If the fiscal stimulus packages provided by the federal government rejuvenate the whole economy and lift consumer confidence, the utility sector will replenish its coffers and work to update its infrastructure.
Ken Silverstein
EnergyBiz Insider Editor-in-Chief
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