Insights: Finance

Published in: October 1, 1999

Published September/October 1999

FINANCE These Are Not Your Father's Utility Stocks Investing in today's utilities calls for a fresh approach by Mario Gabelli The Good Old Days In the glory days of the 1950s, utilities were growth monopolies. To satisfy the needs of a rapidly expanding postwar America, utilities companies poured money into new plants and equipment. This new investment was baked into the rate base--the prices utilities were allowed to charge their customers. Due to economies of scale, operating costs were coming down rapidly. Eventually, rates were adjusted lower, but the lag time allowed utilities to increase earnings and dividends substantially while still pleasing consumers and regulators who saw rates trending down. This was the best of all possible worlds for utilities companies and utilities stock investors.   The Bad Old Days Beginning in the mid-1960s, the industry began encountering problems. A newly environmentally sensitive America forced utilities to invest heavily in pollution control equipment, and rates started to creep up. The oil embargo hit in 1973, and rates went through the roof. Just when things looked as if they couldn't get worse, the Three Mile Island nuclear plant disaster aborted investment in nuclear facilities, stranding costs and leading to a further round of substantial rate increases. Utilities were still increasing earnings per share, but the quality of those earnings was deteriorating. Most utilities were still increasing dividends every year, but had to borrow money to do so. For most of the 1970s utilities stocks greatly underperformed the broad market averages.   Utilities stocks regained momentum in the 1980s, but it was declining interest rates rather than improving industry fundamentals that buoyed the group. In fact, annual earnings and dividend growth for utilities declined on average to 0 to 2 percent over the decade. Many utilities had to cut dividends, because payouts were too high relative to flagging earnings, and troubled utilities (mostly nuclear) frequently had to omit dividends for a time. As we entered the 1990s, utilities had gone from being legitimate growth stocks, to "safe haven" yield plays, to a group that no longer offered growth or even secure yields.   The New Era In the early '90s, the utilities industry started to change once again. As U.S. industrial companies became more competitive in global markets, they put pressure on suppliers to cut costs. Industrial customers came to view electric and gas utilities as just another supplier, and started agitating for change. Residential customers, forced to pay high and rising prices to mismanaged monopolies, were screaming for relief. State governments responded by changing the regulatory rules. Utility rates, which historically had been set based on costs, were now often frozen or capped. Utilities could no longer invest at will and be guaranteed a respectable rate of return. They were forced to cut costs. In return, they would be compensated by being allowed to keep a portion of the cost savings rather than rebating them immediately to customers in the form of lower rates.   Leaner Is Better The overhead of a typical utility has a lot of fat, a legacy of cost-based rate regulation, and this fat can be cut over time. However, a faster way to cut costs significantly is to increase the size of the utility via mergers and acquisitions. A merged utility needs only one headquarters, one CEO, one CFO, and so on. Two utilities operating in the same state can eliminate one regulatory department. There can also be some savings in managing plant assets more efficiently. As each consolidation occurs and the merged companies cut their cost of service, it raises the bar for all the other utilities and puts them under more pressure to improve their rates by cutting costs.   Some consultants and investment bankers active in utilities mergers believe the optimal size for a utilities company is 5 million to 6 million customers. If this is the ideal size, then the ideal number of electric utilities in the United States is about 30. Yet, there are well over 80 investor-owned utilities in the United States today, plus a large number of gas distribution companies and a few interstate gas pipelines and water companies. In addition, many electric utilities own or are anxious to buy gas companies in order to be full energy service providers. Buying a gas company that overlaps the electric utility's service territory is particularly attractive to the electric company, since even more costs can be cut.   Takeout Utilities Investors can play "new era" utilities stocks in two ways. They can invest in the likely consolidators--those companies committed to cutting costs and growing earnings and dividends through acquisition. Or, they invest along with us in their most likely targets--what we call "takeout" utilities.   How do you separate the hunters from the hunted? Size is a big factor. If the optimum size is 5 million to 6 million customers, utilities with sound balance sheets that have 2 million to 3 million customers can realistically acquire another 2 million or 3 million over time to attain critical mass. For the small-cap and mid-cap utilities with a million customers or less, however, it's just too late. Utility mergers take a long time to close and then a long time to digest, and there isn't enough time to consolidate your way into the top tier unless you are already halfway there. A small- or mid-size utility may acquire a smaller utility or do a merger of equals along the way. Ultimately, however, most of the small- and medium-size utilities are destined to be acquired by bigger companies.   The type of market a utilities company serves may also help investors identify takeout utilities. One might assume that small utilities serving faster growth markets would be the most likely targets. However, these stocks are already fairly fully valued. We believe the best takeout opportunities are small companies in more mature markets that are priced much more reasonably, allowing bigger companies to pay a nice premium and still make the acquisition accretive to earnings.   Orange & Rockland: Case in Point We are not speculating on consolidation in the utilities industry. It is already happening. We have seen more than a dozen deals in recent years, including several European companies acquiring American utilities. Consolidated Edison's recent purchase of Orange & Rockland Utilities illustrates both the regulatory catalyst for deals and the most common kind of acquisitions we are likely to see in the future.   As part of a sweeping regulatory overhaul, the New York Public Service Commission is requiring utilities to divest power supply assets, hold rates at current levels and eventually open their markets to competition. The sale of generating assets is providing capital for deals, and the rate freeze and prospect of future competition is putting pressure on utilities to cut costs. Financed largely through the sale of its generating assets, Con Ed, one of the biggest utilities in the state, is acquiring its little neighbor, Orange & Rockland Utilities. Cost savings from combining the companies are estimated at $50 million in the first year and more than $550 million over 10 years. Con Ed is predicting the acquisition will be accretive to earnings in the second year. The acquisition price represented a 38 percent premium over Orange & Rockland's stock price prior to the announcement of the deal. (We understand there were four other bidders for O & R.)   The average utilities stock trades at 14 to 16 times earnings and at about 1.6 times book value. Recent deals are being done at 19 to 21 times earnings and 2.5 to 3 times book value. This makes small utilities trading at discounted or market average price/earnings and price/book multiples quite attractive.   Our Strategy Our strategy is to own shares of fundamentally sound, reasonably valued mid-cap and small-cap utilities and then wait for the buyers to come calling. One utility that fits our criteria is DPL, the parent of Dayton Power and Light (NYSE-DPL-$19). DPL is a "bite sized" mid-cap utility trading at about 14 times earnings and 2.25 times book value, which includes about $5 per share in cash equivalents. If the Public Utility Commission of Ohio implements legislatively approved regulatory changes, DPL could become very attractive to a strategic buyer at as high as $30 per share.   Another likely consolidation candidate over time is BEC Energy, the parent company of Boston Edison (NYSE-BSE $42). BEC will be acquiring Commonwealth Energy Systems later this year, which will increase the customer count to 1.3 million. BEC's young and capable management team is interested in further growth via acquisition, but is a likely target itself in time as even larger companies seek to broaden their footprints. Taking BEC's telephone assets (a 49 percent share in RCN Communications) out of the mix, the stock is trading at less than 12 times earnings and about two times book value. We think the utility assets would go for at least $54 per share in a takeover, with the telecommunication assets worth an additional $6 per share. Mario Gabelli is founder and chairman of Gabelli Funds, Inc., a Rye, New York-based financial services company. Mr. Gabelli appears regularly on CNN and CNBC, and is a regular panelist on Barron's Year-End Round Table.