September 3, 1998

An Investment Opinion
by Alex Schay

Power Play

Doomsday forecasts about deregulation, dividend cuts, and the verisimilar notion that greener pastures lie elsewhere have sent investors fleeing the electric utility segment. Even with the market's recent drop, the traditional haven for widows and orphans has been shunned. Electric utilites are still in a kind of a limbo on the regulatory front (despite the April '96 Federal Energy Regulatory Commission guidelines for opening transmission systems and subsequent actions by various states), and tense electric utility executives have elected to limit their infrastructure investments given the lack of state-by-state visibility.

Don't misunderstand, competition is inevitable, and smart companies have thrown themselves into the fray with strategic plans in place -- it's just that even a basic policy groundwork for how competitve markets will be regulated on a regional basis (hence, industry use of the word "reregulation" rather than deregulation) has yet to materialize. Despite this, how bad has the segment performed over the last year?

         Simple Apprec.  Div. Reinvested in Index 
 S&P500            5.86%              7.52% 
 Dow 30           -2.69%            -.9884% 
 Nasdaq Comp      -2.86%                 NA 
 Wilshire 5000    .8803%                 NA 
 S&P Utility      15.02%              20.29% 
 DJ Utility       14.94%              19.64% 
 Phil. Utility    24.54%              30.73% 
 NYSE Utility     23.58%              27.50%
Hey, hang on a second, those returns aren't so bad! In fact, at this point it would seem that airlines, railroads, and electric utilities have kicked the tar out of their competitors in other industries over the last year. Ok, Ok, so the case may be overstated a little bit. Since many other segments other than the electric utility business are represented in the utility indexes, it would be specious reasoning to make any conclusions about the power industry from these results. However, let's take a look at the performance of some of the bigger and better names in the electricity business over the last year to get another perspective:
           Simple Apprec.   Div. Reinvested in Index 
 Duke Energy    21.91%               26.92% 
 Southern Co.   23.47%               30.20%   
 FPL Group      35.67%               40.25% 
 CMS Energy     15.02%               18.50%
The reason for trotting out the returns of some of these companies today is not to proselytize on behalf of the industry, but to remind investors of the potential inherent in a business that has a strong stigma associated with it and that is on the cusp of real change. It is almost a misnomer to speak of an "electric company" in today's environment. Deregulation has prompted an unbundling of services formerly part of highly vertically integrated organizations. This holds out the prospect of "creating" as many as 50 new businesses. Most electric companies generate electricity, transport it to population centers over high-voltage transmission lines, deliver it to customers over low-voltage distribution lines, and then set up all the ancillary billing and meter-reading services required to cover the costs of delivering the energy. These services also include hidden costs, like maintaining excess capacity to insure reliability. (Energy reserves have diminished from rates of 20%-30% to the low teens.)

With the pace of industry development in the current environment proceeding at considerably less than "ramming speed," the potential ill effects of buying companies in a "bad" industry that operate under a cloud of regulatory uncertainty can be mitigated by focusing on firms that have a clearly articulated strategy for growth. Investing in electric utilities doesn't have to be reduced to betting on the horse that will endure the shakeout, but rather on the business that has a low cost structure, low rates, a strong balance sheet, and that has already transitioned to new lines of business. This narrows the investment universe considerably.