This Week, Industry Snapshot Looks at
Electric Utilities

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This Week's Industry Snapshot

In recent years, the electric utility industry has been described as both grim and fascinating. Grim as a result of severe underperformance, and fascinating as a result of deregulation (or as some cynics describe it, "re-regulation"). Notoriously sleepy utility executives are being asked to oversee the transition from a monopoly to full competition in some segments of their business, to invest in other lines of business with superior earnings growth, to usher in mergers that will supercharge a once indifferent market, and to continue their ongoing battles on the regulatory front. A tall order for even the most progressive of industries, and much more of a challenge for an industry that has historically been characterized as dull and predictable.

The once dominant image of electric utilities was that of a business that generated steady dividends, was a haven for widows and orphans, and experienced modest earnings increases. This image is now being undermined by a new competitive dynamic. Payout ratios are dropping as executives realize that strong balance sheets are needed as armor for the coming conflict, and as one anonymous observer quipped, "The industry can be divided into two camps, companies that have cut their dividend and those that are going to cut their dividend."

On the consumer front, thanks to futurist hype, electricity consumers have visions of electrons dancing in their heads. Different power grades, "smart homes," and new appliances that are electronically regulated by the power company have all been grist for the visionary mill. However, the average Jo-Ann just wants a reduction in her monthly bill, which ostensibly is what deregulation is all about. We've already journeyed down that primrose path, and the results have yet to be as rosy as the predictions. The kind of competition that lowers prices only occurs in mature markets, and as we have observed with the recent telecommunications overhaul, growing up seems to take longer than it used to.

With growth projections in the neighborhood of 3% annually, the overall investment climate for electric utilities looks about as appealing as a blackout. However, investors can capitalize on the mistakes that utilities are going to make in the new competitive environment. Most companies, regardless of their size, will aggressively defend their existing market share. As Edward Tirello of NatWest Securities observes, "[T]hey aren't smart enough to realize that if they don't merge, and they don't become big quickly, they're not going to be able to survive in the long run."

The potential ill effects of buying companies in a "bad" industry that operates under a cloud of regulatory uncertainty can be mitigated by focusing upon companies that have a clearly articulated strategy for growth. Investing in the 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.

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