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