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-- Posted Tuesday, 22 June 2010 | | Source: GoldSeek.com
Big American utilities pay big dividends, some as high as 8% among regulated utilities, and right now they're as cheap, relative to the bond market, as they've been in about a quarter century. If you like investments as income, few people who know the utilities equities better than Morgan Stanley Analyst Greg Gordon. In this exclusive two-part interview with The Energy Report, Greg eloquently and frankly explains the utilities market. The Energy Report: Greg, please give our readers an overview of the market for big utilities in the U.S.
Greg Gordon: First of all, in looking at utilities in the U.S., they're a little bit complicated because they're not all homogeneous in terms of business models. In certain regions of the country, state regulators have liberalized the power markets; in other regions they have not. So when you look at the market capitalization of the utility sector, about 45% of the market cap is traditionally regulated utilities that operate regulated businesses where the state government regulator mandates the prices they can charge and gives them a fixed return on their equity investment in the company. They become basically big cyclical energy companies where their margins rise and fall based on their ability to profit from power market dynamics. Generally speaking, power prices go up when natural gas is rising because natural gas is the marginal fuel for power in the U.S. in most markets. Power prices go up when demand is rising because as demand rises, less-efficient plants have to serve the load and that drives up power.
So the profit margins of the diversified utilities cycle, whereas the profit margins on the regulated side tend to be much more stable and predictable and are set by regulators, not by markets.
TER: What about dividends?
GG: The regulated utilities also tend, because they have more predictable earnings and cash flow, to be higher paying dividend entities. The average regulated utility in the U.S. dividends about 65% of its income to its shareholders. The average diversified utility only dividends about 45% of its net income to shareholders, and that makes sense because the diversified utilities in our coverage universe have a riskier cash flow stream. The dividend has to be lower to reflect the fact that the cash flow fluctuates more.
TER: So regulated utilities tend to be better long-term investments whereas diversified utilities have more upside and more risk?
GG: Let's talk about the regulated investment profile and diversified needs separately because really you would own them for separate reasons. Regulated utilities are perceived sort of as income first, growth second, investment vehicles and they're perceived really to be an alternative to other income-bearing instruments like bonds by most equity investors. They tend to behave in a defensive fashion relative to market dynamics; they tend to be less correlated to what's going on in the market in terms of the S&P. And they tend to be much more positively correlated to what's going on in the bond market.
Right now, the average regulated utility in the U.S. is investing capital in things like transmission lines and distribution grid enhancements like smart meters and putting environmental equipment on their power plants and building renewable energy facilities—more than 30 states in the U.S. have renewables mandates. Through these investments, they're growing their rate base, which is the capital investment on which they're allowed to earn by about 5% per year. When you grow your rate base, you have an opportunity to grow your earnings because you earn on the capital you invest. You actually have to spend money to make money. The risk is that they're periodically going into the regulator to ask for the revenues they need to pay for the investments that they're making.
TER: These are the base rate case rulings?
GG: Yes, you're constantly seeing this kind of activity and it pertains to their ability to earn a return on the capital that they're spending. The two drivers that really differentiate a good utility investment story are demographics and regulation. How much capital are you being asked to invest to keep up with trends in your local service region? And, is the regulator giving you a healthy return over your cost of equity or a skinny return on your cost of equity? I said the average rate-based growth was around 5%, but it varies. In California, the utilities are spending well in excess of that; and, in places like the Midwest, they're spending less because there's less demand growth.
The return on equity that these companies actually earn is mandated by the regulator, and the last 12 months the authorized return on equity was 10.5%–11%, but the authorized returns have been as high as 12% and as low as 9%. Again, if you go from state to state, some regulators are more magnanimous than others. As a utility analyst and a utility investor, you try to identify the companies that have the best opportunity for rate-based growth; with the best opportunity to earn healthy returns over their cost of equity. The best opportunities to make investments are in places where there's change taking place, where a state regulator has been historically maybe a little bit tight on the returns that they authorize and we think they're going to start to be a little bit more magnanimous or where a company had not been spending a lot of capital and we think it's capital spending is going to increase, and they'll get an opportunity to earn a decent return on that.
TER: What about regulated utilities?
GG: Again, we think the most money is made in regulated utilities when you invest in positive change; and frankly, the most money is lost when investors fail to perceive the change in dynamics the other way.
TER: A lot of the profitability of these companies seems to hinge on positive outcomes in base rate case rulings. It seems like shareholder success is directly tied to the regulator, no?
GG: Well, you can never say with certainty that a regulator is going to act in any particular way, but you can look at the history of their decision making and look at the mosaic of activity in any particular state to gauge the level of risk.
TER: It seems like the regulator is all-powerful in some cases. What are some jurisdictions, as some of the top jurisdictions as far as regulators go in the U.S.?
GG: That's a good question. Many of the utilities that are perceived to be very stable and well-regulated companies don't look like interesting investment opportunities to me because that's appreciated already. As a value investor by training, I am always looking to invest in something that's underappreciated or misperceived. Those were three examples of regulatory jurisdictions that may be perceived as being more difficult than they really are. If you look at a jurisdiction like California, I think some of the utilities in California are trading a bit cheap to where their fair value is. But that is a jurisdiction that since the California Power Crisis in the early part of the decade has demonstrated itself to be highly constructive in the way it regulates its utilities. Those stocks are trading almost like there is this sovereign risk discount being applied to some of those companies.
I think the regulatory environment in the U.S. is actually pretty good. If you look at the regulatory activity over the past 18 months and you think about what's happened as we've gone through the depths of this recession, the vast majority of utilities that asked their regulators for revenue increases got some meaningful amount of the money that they asked for despite how difficult the economy was.
I am a little bit concerned that it's going to be more difficult as we start getting into an inflationary cycle because when interest rates start to go up, cost of capital starts to rise, the operating costs start to go up, and the physical cost of capital expenditures start to go up. Then the rate increases that become needed start to stress the ability of the regulator to be dispassionate. Then they start to cap the amount they raise rates and that can cause problems.
TER: Thanks so much for your time today, Greg.
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-- Posted Tuesday, 22 June 2010 | Digg This Article | Source: GoldSeek.com
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