Don Diaz , Contributing Editor
Participation (or lack thereof) from institutional investors to a large extent determines investor-owned utilities’ (IOUs) likelihood of financially thriving or foundering. The most significant forms of this patronage, amid current market conditions, are clearly debt purchase, finance and restructuring or re-finances. Subsequent institutional interest/attractiveness in the sector’s equity issues hinges on IOUs’ abilities to obtain, and more importantly, sustain financing and credit worthiness.
That said, overall sector health appears to be on the rise as firms continue to shore up balance sheets and grow revenue streams. Still, IOUs continue to struggle to regain their sea legs in 2003 in the wake of a sobering loss in total revenue during the fiscal year ended in 2002: off 7.6 percent from 2001-2002 from $423 billion to $391 billion. This drop in revenue (totals are for the entire sector) represented staggering declines in operating and net income, plunging 33.4 percent, and 116.9 percent respectively.
August’s historic blackout in the northeastern U.S. certainly added to the sector’s woes, but a silver lining may emerge from this unfortunate event. As depressed equity prices lure bottom-feeding institutional investors to the table, sector firms will secure much-needed capital investments. Yet another encouraging trend is the S&P 500’s Utility Index’s 6.88 percent year-to-date gain, (as of 8/18/03) representing an index value of 97.76, surging from its 52-week low of 75.87. Market participants believe the index may be on track to retrace its 52-week high of 115.84, if the U.S. economy continues its steady rate of recovery.
Energy companies that have recently become favorites among institutional investors include Calpine (NYSE:CPN), which has recently demonstrated an innovative method of maintaining its debt financing. The firm, with Goldman Sachs acting as its investment banker, incorporated a spark-spread hedge into its $750 million power plant refinancing package. This structure ensures that debt service will be paid to its investors even in the event of deteriorating generation margins. This type of financing is the first of its kind to come to the institutional debt markets, and represents the bleeding edge of sector leverage instruments. The derivative created literally strips out the price risk associated with market fluctuations, employing a spark-spread floor tied to first and second lien term loans and floating rate notes. Look for other sector members to follow Calpine and Goldman’s lead with similar debt offerings and loan structures. Accordingly, institutional investors will likely be very receptive to debt issues such as Calpine’s, which provide additional assurances that debt payments will be made. Of course, alternative credit facilities such as Calpine’s do not come cheap (albeit enhancing their institutional appeal). Calpine is expected to pay LIBOR (London Inter Bank Offering Rate), which was at 1.11 percent as of 8/18/03, plus 6 percent on at least the loan component of its latest financing package.
Still, while unique financing and creative debt instruments are definitely positive developments in the recovering sector, many IOUs remain out of favor with Wall Street analysts and research firms, which guide institutional investment. Clients are often recommended to adopt wait and see strategies. Even as IOUs strive to maintain credit ratings; institutional investor sentiment remains fickle at best. Firms with poor track records have acted to exacerbate the sector’s difficult position within the capital markets. FirstEnergy Corp. (NYSE:FE), the beleaguered Ohio utility, saw Moody’s place its ratings under review for possible downgrade just hours before August’s blackout. S&P has also issued negative comments regarding FirstEnergy’s credit status. Yet, ultimately as FirstEnergy’s bond spreads (its debt’s yield vs. comparable treasuries) widen, institutional investors may be enticed by larger-than-expected yields, which could justify exposure to the event risk associated with this name. Overall, the sector’s pain is for the most part, moderate, with spread-widening likely to spur buying opportunities amid the most liquid institutions.
Despite the current uncertainties in the sector, there are a number of companies that remain favorite holdings among institutional investors. Pinnacle West Capital Corp. (NYSE:PNW), parent company of Arizona-based Pinnacle West Energy claims the largest percentage of institutional investors in relation to its outstanding shares. Pinnacle owns consolidated assets of $9 billon; the bulk of which represent its core energy operations of retail and wholesale delivery of electricity products and services.
Sector firms hoping to attract institutional investors would do well to follow Pinnacle’s business model which first adheres to the company’s benchmark “pipes and wires” function. As a result, institutions own nearly 85 percent of its 91.3 million free-trading shares, with analysts expecting it to outperform the market over the next six months. Its recent lower-than-expected third quarter earnings provided for some institutional selling, but the firm’s outlook remains robust.
Entergy Corp. (NYSE:ETR) is an IOU whose shares are widely held by institutions. Institutional investors own 78.5 percent of the New Orleans-based electric utility’s 226 million outstanding shares. Fidelity Management & Research Co., which holds just fewer than 15 million of Entergy equity issues, is among the largest. Entergy’s 50 percent ownership of Entergy-Koch Trading was the main catalyst behind the firm’s upwardly revised earnings guidance for its fiscal year 2004 to a range of $4.05 to $4.25 per share (some analysts are calling for Entergy to earn as much as $4.65 per share for all of 2004). Cash flow, if expectations are met, that institutions will be hard pressed to ignore. Entergy’s prospects for earnings growth in 2004 make it a good bet to outperform the market over the next six months.
Likewise, Edison International (NYSE:EIX) is another popular IOU with institutional investors who own 62 percent of its 325.6 million outstanding shares. Edison appears on numerous “top sector picks” lists, as analysts and portfolio managers expect it to beat its earnings estimates over the next several quarters. This is due mainly to Edison’s hyper-low price-to-earnings multiple, one of the lowest within the sector. Recent institutional selling should not be viewed as a negative, rather as an overall market trend of limiting exposure to the event risks associated with the sector.
TXU Corp. (NYSE:TXU) also displays the winning characteristics that move institutions to purchase its stock. With 68.4 percent of its 322 million outstanding shares in institutional coffers, TXU is another success story of a sector recommitted to its core business. TXU’s recent venture into wind power in Texas, a huge source of so-called “green” energy is another factor behind its success in courting institutional investment. Environmentally conscious funds such as Mfs Investment Management, which is TXU’s largest institutional holder, are likely to increase their stake in the utility company as a result of its development of clean power initiatives.
Empresa Nacional de Electricidad (ADR, NYSE:EOC), a Chilean-based electric utility, is among the most highly touted non-U.S. sector members. Recently, institutional ownership of Empresa’s stock has increased significantly, the result of several “strong buy” recommendations from a number of Wall Street houses. Empresa’s better-than-expected earnings outlook is the main factor behind its stock’s nascent popularity with institutional investors who currently hold only 3.5 percent of its 273.4 million outstanding shares.
The bulk of Empersa’s generation capacity stems from clean, cost efficient hydroelectric power, which does not require costly fossil fuels to produce; a plus in the ADR’s (American Depository Receipt: a foreign issue which trades on a U.S. stock exchange) allure to institutions which have added eight new positions in Empersa’s stock over the past quarter. Barclays Global Investors fund is majority owner among its institutional peers, holding 1.6 million shares.
Energy companies and IOUs hoping to further their appeal to institutional investors will be required to continue efforts in bolstering balance sheets, paring down or restructuring debt, and renewing commitments to core revenue streams. Business models that adhere to the holy grail of credit worthiness melded with savvy investment banking relationships will remain key elements in any successful IOU campaign for institutional funds.
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Last year’s precipitous plunge in year-over-year revenue, operating and net income throughout the sector must be thwarted in order for the industry to complete its current cycle of recovery.
Recently record-low interest rates appear to be on the rise, making corporate IOU debt issuance all the more urgent with respect to curbing overall sector interest expense. Yet rates remain low enough to effect practical re-packaging of unsavory, or unwanted leverage instruments. However, IOUs should take heed of the sector’s recent past, which is, at least, a cautionary tale of over-dependence on debt financing. Rates will not stay low forever. Hence, facilities with solely floating rate structures that stretch the issuer too far out on the yield curve should be avoided. Except, of course in the direst circumstances, when no other option exists save the protection of bankruptcy court.
Diaz is an independent industry analyst with 15 years experience in the financial and energy markets. He may be contacted at [email protected].
