Yielding to pressure

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The relative safety of regulated utilities appealed to investors during an uncertain economy. But as optimism increases and the industry transforms, US utilities are under pressure to maintain attractive shareholder returns. Dean Maschoff reports.

During recent economic uncertainty, investors turned toward the relatively safe harbor of rate-regulated utilities. In the US, record low interest rates made utilities particularly alluring, offering an average dividend of 4.2% in 2012 that drove price/earnings (P/E) multiples well above historic norms.

But as the US economy began to show signs of recovery, interest rates climbed, confidence returned to investors — and utilities began to appear overvalued.

Now the sector faces losing investors to higher growth opportunities while also dealing with earnings pressure brought by fundamental industry changes.

Forecasted anemic electric demand over the next two decades and significant capital investment requirements will put pressure on utilities’ ability to deliver attractive returns.

A new paradigm

While utilities continue to trade significantly above 10-year averages, these peak valuations are unlikely to be sustainable in the long term. As they prepare for the challenge of maintaining attractive yields, utilities are adopting various strategies.

Almost all companies are striving to improve operations and earn the maximum allowable return on equity (ROE), while at the same time seeking earnings growth through capital investments in their regulated businesses.

In investor presentations, many companies talk less about long-term earnings growth and instead emphasize planned capital expenditure growth, which should translate into an almost one-to-one correlation with earnings. While this model for growth is good, the challenge will be to minimize regulator and customer fatigue with year-after-year rate increases.

Other utilities are looking to reduce risk by either disposing of competitive generation or acquiring additional regulated businesses. Two prominent examples of this strategy are:

  • FirstEnergy’s recent decision to retire about 2,000 megawatts at two facilities, primarily in response to low gas prices
  • Ameren’s selling of its merchant company, Ameren Energy Resources, to Dynegy

This type of consolidation and restructuring, along with M&A activity, will continue to play a major role in reshaping the sector.

Some companies, particularly independent power producers, are pursuing growth through the development of contracted generation and other competitive businesses across a diverse geographic area, while still cutting costs from their existing businesses.

Examples include:

  • NRG Energy, the country’s largest competitive power generator, which has established the spin-off company NRG Yield to operate and acquire contracted conventional and renewable power generation infrastructure
  • NextEra Energy, which has an extensive renewable energy portfolio that is unregulated but largely backed by contracts

Pressure on integrated utilities, potential for LDCs

While integrated utilities have performed well in recent times — their 3.6% total shareholder return (TSR) of 2012 was the sector’s best — such results are unlikely to continue in the long run.

These businesses are increasingly challenged by:

  • Expenditure pressures associated with replacing aging infrastructure and required investment in environmental compliance
  • The impact of the trend toward distributed energy, particularly in California and the US Southwest, which will eventually erode the market share of central power plant generation

Natural gas local distribution companies (LDCs) may be in the best position to make the most of future growth opportunities. LDCs began 2013 with a rebound from the 2012 doldrums, producing a segment TSR of 11.6% — the highest of the sector.

The potential of top LDCs to outperform lies in their ability to take advantage of continuing low natural gas prices to increase capital investment, improve the reliability and safety of their businesses and therefore grow their rate base and rate earnings.

Trouble ahead?

In a rapidly shifting landscape, utilities face several challenges in their quest to maintain attractive shareholder returns. Many companies may plan to mitigate earnings pressure through growth in non-regulated businesses.

However, if these non-regulated businesses do actually grow earnings, rating agencies will likely lower their credit rating. This dilemma has no easy solution, and utilities will need to tread carefully as they navigate a way forward.

Growth amid transition

The period when significant capital inflows helped utilities drive shareholder returns based upon market uncertainty is over.

Utilities’ earnings and cash flow will face increasing stress from:

  • Higher interest rates
  • Pressure on ROEs
  • Depressed energy prices
  • Rate pressure from the combination of lower demand and regulator fatigue 

Companies that can drive positive capital expenditure, build strong relationships with regulators and customers and position themselves for future opportunities stand the best chance of delivering steady dividends and credible growth prospects in the face of industry transition.

How we can help

We are working with leading utilities across all segments as they develop strategies to address the challenges of driving growth amid industry transition. We advise companies on their operating models, cost structures and performance management to make sure they are strongly positioned to fund infrastructure investment, drive future growth and manage their regulatory obligations.

For more information

EY - Yielding to pressure

Read The great yield rush, our analysis of the total shareholder return of the top 50 US utilities.