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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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Is The U.S. Utility Industry Breaking Free From Its Death Spiral?

Utility Poles

The U.S. investor owned electric utility industry raked in the money in 2016. According numbers just re-leased by industry trade group the Edison Electric Institute (EEI), pretax operating income (operating mar-gin) rose a solid 3 percent and net income for common stock (excluding extraordinary items) increased a resounding 17 percent despite essentially flat kilowatt hour sales.

The industry's balance sheet and debt coverage metrics improved, too. These results might not impress investors in high growth, tech company like Apple or Google. But for a staid industry whose sales have been stagnant for a decade they are spectacular.

From 2012 to 2016, electricity generation rose less than 1 percent but industry pretax operating income increased 12 percent over the period and earnings before interest, taxes, depreciation and amortization (EBITDA) rose by 16 percent.

Over the same five-year period, industry investment in electric utility plant increased considerably. Invested capital rose 23 percent and net plant, 27 percent.

These numbers are not exactly what we'd expect from a sector whose executives fret among themselves about an industry in potential death spiral. Nor for an industry whose stock prices have hit stratospheric levels based on historic valuation measures.

These solid financials demonstrate a formidable ability to squeeze profits out of a stagnant business, in the absence of meaningful sales growth.

There's little question that the electric utility industry has had the wind at its back so to speak. Fuel and natural gas costs declined substantially while interest rates remained at relatively benign levels. Cost of, and access to, capital remained at extremely attractive levels.

But let's look at what industry management can rightly take credit for, expense control. As an example, operations and maintenance expense increased a modest 2.7 percent year over year.

The fortunate result was higher operating income despite flat sales. (See Figure 1.)

Utility financial managers kept the financial ratios stable while industry credit metrics improved to BBB+ range. Much of the new industry debt was acquisitions related. But industry capital expenditures are only about two thirds internally funded which also tends to increase leverage, assuming only partial equity fund-ing of this cash flow deficit. (See Figure 2.) Related: Big Oil's Pivot To Renewables Has Begun

In search of earnings growth, managers have pursued two mostly regulated paths: invest in regulated utili-ty rate base because of favorable returns granted by regulators or grow by acquiring smaller but still regu-lated utilities. The downside of the latter strategy is that because the buyers pay a substantial premium to either market prices or book values of the acquired companies, the newly acquired assets have to perform that much better to achieve the desired return. (See Figure 3.)

Figure 1. Operating profits— still rising ($ billions)

(Click to enlarge)

Figure 2. Debt coverage— keeps steady (x)

(Click to enlarge)

Figure 3. Investment— keeps expanding ($ billions)

(Click to enlarge)

But getting bigger and becoming more profitable are two different things. Sometimes the way the num-bers are reported mask business "reality". For instance, in seven of the past ten years, the U.S. investor owned electric utility industry has incurred substantial asset write offs. These are supposedly “non-recurring” or “extraordinary” events.

Serious investors, though, know that events labeled "non-recurring" or "extraordinary" are seldom either. We know this for the simple reason that these so-called triggering events recur frequently and in some in-dustries with surprising regularity. Our modest proposal? Only look at earnings-in all their lumpy glory-after all the so called "extraordinary" stuff.

Creating a non-recurring item is the way that financial executives and accountants deal with big mistakes such as writing down overpayments on assets or inadequate past depreciation.

They accumulate the errors into a lump sum and then make believe that the losses had nothing to do with the ordinary course of business so should not count when investors judge current or past performance. Of course, when these “non-recurring” events occur on a regular basis, maybe investors should consider them as a regular cost of doing business, not a one-off event. In this case, those losses can be attributed, large-ly, to unregulated operations. The utility operations make good returns. Related: The Fourth Industrial Revolution Is Fueled By Oil

In the days after the breakup of the Bell System, the telephone companies constantly wrote off plant that they had not previously depreciated at the right rate. Enron was also a master of turning mistakes into ex-traordinary events. In 2012-2016, the electric industry reported roughly $200 billion of net profit for com-mon shareholders but only $145 billion in net income, that is, after accounting for all the write offs. (See Figure 4.) To put it another way, the industry reported a roughly 10 percent annual return on shareholder equity from operations but in reality, netted only 7 percent. (See Figure 5.)

Figure 4. Earnings before and after "nonrecurring” charges— a sorry record ($ billions)

(Click to enlarge)

Figure 5. Return on equity before and after nonrecurring charges—from good to so-so (percent)

(Click to enlarge)

Overall, the industry’s return on net plant has declined only modesty, meaning that all the new money go-ing into the industry despite a lack of growing demand for its output, has earned its keep. Although, having so concluded, it also appears that lower taxes have helped, and on a pretax basis, return has declined more markedly. Figure 6.)

Figure 6. Pretax and aftertax return on net plant — low tax payment boosts return (percent)

(Click to enlarge)

Putting it all together, the U.S. electric utility industry in 2016 earned healthy returns and solid profits on its regulated business. On the other hand, unregulated power operations suffered a collapse in power prices due in part to weakness in demand for conventional generation.

Accounting rules require that the books reflect substantial devaluation of assets, and that is what hap-pened.

Existing nuclear facilities, in states where power is priced competitively, could experience further write asset downs. But the zero emission based subsidies provided for these plants by state regulators appears to have postponed the day of financial reckoning.

If power prices finally stabilize and economic growth leads to higher demand, those extraordinary losses derived from competitive activities could diminish. That's the good news.

The bad news is that another competitive "shoe" might drop. If owners of distributed resources begin to compete directly with the now monopoly-regulated electric grid that could lead to another series of asset write downs. This time distribution assets would bear the brunt of competitive pressures as did generation assets years ago. But these financial and competitive worries are not likely to affect the industry soon, at least not this year or the next. So relax.

By Leonard Hyman and William Tilles for Oilprice.com

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  • JOhn Scior on June 17 2017 said:
    These are mature industries that have no competition and have become "cozy" with politicians. They are guaranteed to make a profit and although not extra-ordinary profit, a profit margin nonethe less that insurance companies, state pensions, and large institional investors count on as assured steady income to even out other holdings in their portfolios. COnceptionally smart meters and their selling point sounds good but does anyone really think you would see a "reduced" rate at off peak hours. I'm sure in reality the set price you pay today would be the new minimum price and peak times you would be charged a higher price. Would anyone really pay that much attention to when you use your electricity ? Its easy to tell if you go to a matinee to save money as an entertainment expense but are people really going to stay awake at night to do their laundry or wash their dishes ? Meanwhile the utility company avoids having to build a new generating facility with all those nasty environmental rules to follow whilst forcing all the customers to pay for the "new and improved" Smart meter. Think you can save money generating your own electricity using solar, wind or other sources. Note the Utilities getting ahead by passing legislation that allows them to charge maintenance fees for grid maintenance and transmission services. Don't try to beat them, join them and invest in a mutual fund consisting of electric utilities.

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