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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Why Utilities Have To Decrease Dividends

Utilities

Electric companies, at least the ones trading on the U.S. stock exchanges, are either fully regulated, partly regulated/partly competitive or fully competitive entities. Most of the old line, investor-owned utilities, whatever their business mix, belong to the Edison Electric Institute (EEI). Aggregating the earnings of EEI members provides a good representation of industry profitability.

But how to measure profitability? In many industries, analysts judge profitability by profit margin, how much of revenue falls to the bottom line and gets translated into profit. Electric companies, requiring heavy capital investment, judge profitability in terms of return on investment (ROI). Shareholders put their emphasis on the earned return on equity (ROE) as do regulators whose job is to ensure that companies are not earning “excessive” profits.

The EEI does not specifically break out profitability of the unregulated component of the business. However, we do know that many of the largest competitive electric businesses have either done poorly or gone bankrupt in recent years. The largest ones earn single digit equity returns when they show any profit at all. So it is likely that the competitive subsidiaries of EEI members have had the same kind of rough going as their peers.

Overall, though, EEI members from 2001 to 2015 reported an average annual return on equity (excluding extraordinary items) of 11.2 percent. That’s not bad for still largely regulated businesses. Risk averse investors who might look at U.S. Treasury bonds as an alternative would be impressed. The average bond yield over the same period was 6.3 percent. In addition, the industry raised its dividend payments over the previous year in 13 of those 15 years. So despite lackluster sales growth and poorly performing competitive businesses, the industry has managed to do well.

But there's a catch. Reported net income--including all extraordinary items--was substantially lower (by 21 percent on average) because in 14 of the 15 years most companies had significant nonrecurring charges. In fact these non-recurring and extraordinary items appear with alarming regularity. This "all in" return on equity figure for 2001-2015 was only 8.8 percent. Related: Oil Drillers On Thin Ice As Banks Tighten Credit

Now notice the difference. The reported equity return was 2.6 percent above the period's bond yields while the "adjusted" equity returns, which omitted all those recurring non-recurring items, exceeded bond yields by a more substantial 4.9 percent. Investors might consider the excess over bond yields as the equity risk premium. But the gap between 2.6 percent and 4.9 percent is a big one in an investment world where somewhat risk averse investors can only expect mid-single digit equity returns at best.

We believe the regularity with which extraordinary items appear reflect a habitual tendency toward business misjudgments. This can manifest itself in a number of ways: paying too much for assets and having to subsequently write them down or the use of inadequate depreciation rates. The latter often do not adequately reflect competitive factors or technological or environmental obsolescence (as an example coal-fired power plants needing to be prematurely retired long before the end of their economically useful lives).

The frequent use of mostly downward earnings adjustments conveys that prior period earnings were overstated and the write downs just an accumulation of previous misstatements. Depreciation charges should have been roughly one fifth higher during the fifteen years. That is, by our reckoning, U.S. electric companies really did earn less than 9 percent on their equity. With regulated returns declining and competitive business lines under severe pressure, it is difficult to expect improvement in actual earned equity returns unless electric companies change their way of doing business. The one bit of good news here is that in an environment of ultra-low or negative interest rates, many investors would be glad to earn even 9 percent equity returns on a steady basis.

Most retail and certain institutional investors buy utility stocks for their above average dividend yield. But depreciation rates are low and probably need to go higher (with adverse effects on net income. The industry also needs more equity financing to lower already high debt ratios. Over time as business risk increases it's likely that the electrics will rely more heavily on internally generated funds becoming more like typical, non-regulated industrial companies that self-finance. Under these circumstances is it likely, or even desirable, to maintain the current level of dividends?

Figure 1 shows dividends against reported and adjusted earnings. The industry paid out only 56 percent of adjusted earnings (higher than most industries but not unreasonable) but 70 percent of reported earnings (a high payout ratio for an industry with an increasingly erratic earnings record) as shown in 2001-2015.

Figure 1. Earnings and Dividends of EEI Members ($ billions)

We propose two changes that would go a long way towards restoring the industry's financial ratios. First, raise depreciation rates. The new levels should reflect potential write-offs (which have averaged $6 billion per year in 2001-2015) as well the increasing threat of asset obsolescence due to rapid changes in policy, technology and climate. Related: Amazon’s New Bizzare HQ Pushes Clean Tech Boundaries

Second, and more painfully, reduce the common stock dividend. We suggest initially a maximum common stock payout ratio of 50 percent. We would also like to see stronger balance sheets with an equity percentage of capitalization of well over 50 percent. This would begin to reflect the numerous competitive challenges the industry faces.

On a worst case basis, regulators may not allow additional revenues or rate increases to cover the new, higher depreciation rates. And the new equity, raised either internally or via stock sales, may only be used to retire debt associated with no longer productive assets. In these circumstances the dividend payout ratio would rise to over 70 percent this year and earnings per share would fall roughly 20 percent. But the dividend could remain uncut.

In terms of utility finance it seems that we are experiencing the best of both worlds. Stock multiples are high while interest rates remain absurdly low. But there are storm clouds on the horizon. However, current market conditions afford the electricity industry the financial flexibility to prepare for the future without meaningfully altering dividends or depreciation rates. Our question to managements is simple. Would you rather prepare for inevitable storms in good times or bad?

By Leonard Hyman and William Tilles

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