Utilities: The Capex Conundrum

While credit-rating agencies are applauding the first few utilities to reach the end of their multi-billion dollar capital expenditure programs, there is some debate in the industry as to whether this will be a positive for future earnings growth.

Some have argued that those utilities that finish their programs early will have more cash on hand, which will not only help them endure rising costs such as potentially higher taxes, but will also afford greater financial flexibility to take advantage of mergers and other opportunities for investment once interest rates start to rise.

But others have argued that the expected jump in electric power prices in the coming years will make it difficult for utilities to take on new projects, as regulators will be less willing to approve them as rates come under pressure. So those utilities still in the midst of large capital expenditure programs may have the advantage, since they’ll enjoy higher earnings as they complete each project, while those that finished their programs earlier may not be able to find new projects of similar quality with the same attractive terms.

Regardless of the relative timing of such investments, faith in management’s ability to generate shareholder value from capital projects is at an all-time low, based in part on the industry’s experience during the last period of major capital expenditures. As depicted in the chart below, the percentage of firms able to deliver returns on invested capital (ROIC) that exceeded their weighted average cost of capital (WACC) dropped precipitously toward the end of that period.

Chart A: Will Utilities Be Able to Generate Better Shareholder Value This Time?

At the heart of this debate is which situation will provide investors with the best combination of strong growth and sustainable income. Before proceeding, however, it should be noted that this discussion could end up being moot if new regulations on carbon emissions require significantly higher spending levels.

Based on available capital expenditure forecasts, according to an SNL Energy report, “Spending is projected to decline after 2013, with the drop-off due largely to the completion of large generation projects and the finalized installation of environmental projects to comply with Mercury and Air Toxins Standards (MATS) and other standards promulgated by the Environmental Protection Agency (EPA).”

Among those companies that are winding down their spending programs, NextEra Energy Inc (NYSE: NEE) accounts for almost 30 percent of the projected $10 billion decline in annual spending from 2013 to 2015. Other larger-cap companies with projected 2015 budgets that are below their 2013 levels include: CenterPoint Energy Inc (NYSE: CNP), Dominion Resources Inc (NYSE: D), PPL Corp (NYSE: PPL), Public Service Enterprise Group Inc (NYSE: PEG), and Southern Company (NYSE: SO).

Meanwhile, the companies that are projected to be spending more in 2015 than they are presently include The AES Corp (NYSE: AES), Ameren Corp (NYSE: AEE), American Electric Power Co Inc (NYSE: AEP), CMS Energy Corp (NYSE: CMS), and Northeast Utilities (NYSE: NU).

When Cash Is King

The main reason to be concerned about the timing of major capital projects is that there are a number of financial and economic challenges looming ahead. In addition to the potential for higher taxes in the near term if bonus depreciation is not extended, the eventual rise in interest rates will make it costlier to pursue debt-financed deals as well as initiate new capital investment projects. Overcoming these challenges will be more difficult for utilities that are in the midst of capital-intensive investments, and that could lead to dividend cuts.

Below, we survey these headwinds’ potential effects on earnings:

1) Bonus Depreciation and Capital Spending:

According to a report from Moody’s Investors Service, “The US telecommunications and utilities industries could face more than $100 billion in combined federal tax payments in the coming years resulting from accelerated depreciation benefits they have taken since 2008. Assuming the ‘bonus depreciation’ allowance expires as scheduled at the end of 2013, companies will have to adjust capital spending and shareholder dividends to offset higher taxes.”

Though the credit-rating agency asserts that time is on utilities’ side if the bonus depreciation expires, as there are various tax strategies that firms can undertake to offset higher taxes, this could still undermine dividend coverage. Indeed, Moody’s says, “Our projections suggest that the industries’ combined dividends will rise to $52 billion in 2020 from $44 billion in 2013. Such dividend payouts are unsustainable because net income and free cash flow will remain essentially flat, in part owing to higher taxes.”

2) Interest Rates and Merger Deals:

Slower load growth is causing utilities to look beyond their service territories. According to Moody’s, “Growth has been moderating in recent years primarily because of greater energy conservation and efficiency, and increased distributed generation and the 2008-09 economic downturn.”

The rating agency says, “These growth trends have pushed some utilities to look beyond their service territories for additional load growth in areas that are growing faster than the national average. Recent deals have been credit neutral as they have been financed with a balanced mix of debt and equity.”

But the report notes that once interest rates start to rise, an increase in the cost of capital could slow or impede mergers and acquisitions, or at least those transactions that are heavily financed via debt. Thus, during a rising-rate environment, companies with relatively strong balance sheets should be better positioned to secure low-cost financing than those in the midst of large capital expenditure programs that may have to wait until their credit position improves.

3) Interest Rates and Equity Risk Premiums:

Higher interest rates would not only affect the cost of debt financing, but would also raise the cost of equity issuances. A report from analysts at J.P. Morgan, dating from 2010, examines the cost of equity should Treasury rates revert to a level between 5 percent and 6 percent in the medium term.

Assuming that stocks generate returns consistent with their long-term premium of roughly 6.5 percent above risk-free investments such as Treasuries, the utility industry’s cost of equity would increase to 10 percent to 11 percent.

The implications are significant. “At 11 percent, the regulated utility sector’s cost of equity would outstrip the current industry median allowed return on equity (ROE) of 10.7 percent. Even at 10 percent, the cost of equity would be outside the historical margin of error of what utilities have been able to realize relative to allowed ROEs. Over the past decade, the utility industry has typically under-earned its allowed ROE by approximately 75 basis points,” J.P. Morgan found.

Even more concerning, the banker added, not only have realized industry ROEs compressed since 2004 to a median of 9.6 percent as allowed ROEs have ratcheted down, but the under-earning spread has widened as well, from a median of approximately 60 basis points that prevailed prior to 2005 to 110 basis points since then.

“Thus, if we assume that the industry is likely to continue to under-earn its allowed ROE by approximately 100 basis points, then with a current average allowed ROE of approximately 10.7 percent, the industry is likely only to be able to earn approximately 9.7 percent–below its cost of equity should the 10-year Treasury rate increase to 4.7 percent or higher,” J.P. Morgan concluded.

Trust, but Verify

So how do investors evaluate which utility management teams are most likely to not only skillfully allocate their capital, but also get the timing right on its deployment? Since we can’t see into the future, it all comes down to trust in their decision-making based on their track record (See Chart B).

The big question to ask is whether management is generating a return on invested capital (ROIC) that’s greater than the company’s weighted average cost of capital (WACC). ROIC is a ratio that incorporates shareholder returns from equity and debt to help investors identify managers who maximize profits from all sources of capital at their disposal.

Many investors usually highlight earnings and dividend growth, yet these come with a heavy price for regulated utilities. That heavy price is a growing investment base funded by large and usually increasing long-term liabilities on their respective balance sheets. Earnings growth rates and return on equity do not consider the impact of these higher liabilities. ROIC provides insight into how effectively total capital is deployed, regardless of its origin.

Some have argued that ROIC is not a good metric for the utilities industry since it doesn’t reflect issues such as regulatory lag, while under-collection on capital investments can distort it. But a 2007 study by Accenture found that ROIC was 58 percent correlated to high total shareholder return. Conversely, a high dividend yield had a negative correlation to total shareholder return.

Furthermore, in its own historical analysis, J.P. Morgan found that utility stocks whose underlying companies had higher spreads between ROIC and WACC realized greater returns over the same period.

Chart B: Top ROICs Meant Top Total Shareholder Returns in the Past

At present, when looking at the top five utilities with the largest capital expenditure programs, we found many firms were barely exceeding their cost of capital, while there were a few that weren’t. According to Bloomberg analytics, those that earned above their cost of capital were: Duke Energy Corp (NYSE: DUK) (1.32 percent), American Electric Power (1.12 percent), NextEra (0.64 percent) and Southern Company (2.94 percent), while those firms not earning their cost of capital were Dominion (-2.27 percent) and PG&E Corp (NYSE: PCG) (-0.36 percent).

There may be various reasons why ROICs are low for these firms, such as the effectiveness of management decisions or regulatory lag. According to McKinsey, “Since a company’s continuing value is highly dependent on long-run forecasts of ROIC and growth, this result has important implications for corporate valuation. Basing a continuing value on the economic concept that ROIC will approach WACC is overly conservative for the typical company generating high ROICs.”

Investors should look closely at individual capital expenditure programs and past management effectiveness to determine which firms are the best investments. But if the prospect of examining the spreads between ROIC and WACC makes your head spin, there’s another way that’s even easier.

In the end, we believe the answer to the capex conundrum is the balance sheet. A strong balance sheet is always preferable, as it gives management options against the unknown. Furthermore, strong balance sheets create more value and, therefore, lower the long-term cost of capital.