(UtiliPoint - Dec. 21)

– By Ken Silverstein Daily IssueAlert 12/21/2004

Free The bloodletting may be over. But the difficulties in the utility industry are not. After the greatest credit collapse in decades, such companies have gotten a breather, although their future generally won’t brighten significantly for another five years.

That’s the message from Standard & Poor’s, which says there is still room for more credit downgrades. Downgrades in the merchant generation and trading sectors have slowed down this year but at the same time, they have outpaced upgrades. The unregulated merchant business model has not changed much and no blueprint has yet to emerge to make those power sales and trades any less risky.

Indeed, UtiliPoint®’s study of 89 investor-owned utilities reveals that the industry generates 37 percent of its revenues from “unregulated” sources. With trading and merchant generation making up more than 50 percent of these unregulated revenue sources, the industry, in general, still has substantial business risks to manage.

“Stable is really the name of the game,” says Peter Rigby, utility analyst for Standard & Poor’s at a UtiliPoint seminar on the industry’s future prospects. “We don’t see things getting any worse or better. But we still believe there is a greater potential for downgrades. The number of companies on ‘credit watch negative’ has fallen though. There were close to 200 downgrades in 2002.”

The mean debt to capitalization ratio for the entire utility industry is 60-40, says S&P. That’s only changed marginally in recent years, it says, because it’s too easy and too cheap to obtain debt financing today. Interest rates are low and banks have loosened their grip on the money, although they enhanced their due diligence efforts. At the same time, companies are selling assets that work to keep such ratios higher.

The total merchant debt is $65 billion, due by 2012. The biggest ones owe $42 billion—a little better but not enough to dig out of the debt hole, says Rigby. There is little capital recovery because the spark spreads—the difference between the prices of natural gas as a feedstock and the market price for electricity—are so low.

In other words, sufficient capital recovery needed to pay off the debt is not there and relief probably won’t happen until at least 2010. That’s because generation capacity margins in most regions of the country are well above the minimum 15 percent. Meantime, demand growth has moderated as evidenced by annual gross domestic product rising 3 percent over the past decade with annual electricity growth increasing only 1.8 percent.

Recent projects undertaken by merchants are widely exposed. Prior to construction, such companies received commitments for only 40-65 percent of the gas-fired power they were to generate. The idea was that the balance would be sold on the spot market for presumably more money than term deals—a model that fell apart as natural gas prices soared and as wholesale electricity prices plummeted because of soft demand and too much generation supply. Basically, the spark spread is so thin that some companies have trouble covering their fixed costs.

“Many utilities have gravitated toward debt because it has been cheap,” says Rigby. “They can therefore tolerate the higher leverage. It concerns us because we are in an environment where risks are likely to grow.”

Previous Forecasts

But Fitch Ratings has a more optimistic take on the utility industry. After the “credit inferno” in 2002, it says “broad signs” exist that both the regulated and unregulated sectors are improving. In its 2005 projections, the credit agency says the near-term outlook for investor-owned electric utilities and affiliated generating companies is “stable” in 2005 while the outlook for diversified energy merchants “has shifted to positive from stable.”

UtiliPoint’s research also suggests that utility earnings are making a slow but definite comeback. When comparing year-to-date 2000 earnings per $1,000 of revenue with year-to-date 2004 results, it finds that the industry’s earnings’ picture has improved from $86 to $105 per thousand dollars of revenue. That's because they have been trimming costs, shedding less profitable enterprises and increasing earnings on certain lines of business.

The better outlook for the merchant sector furthermore "reflects successful re-financings in 2004 that enabled most of these companies to extend debt maturities and eliminate near-term liquidity concerns,” the Fitch report says. It notes that the public power utilities "were largely immune" from the problems and that their ratings outlook remains "stable."

It credits low interest rates and accessible capital with improving liquidity and balance sheets. Such market dynamics were particularly helpful to the merchant utilities, which should see “continued opportunities.” The pace of re-financings among regulated utilities, however, slowed in 2004 when compared to 2003.

Fitch analysts expect capital expenditures overall to increase over the next five years and above current industry projections, with new investments in electric transmission and distribution systems, as well as in natural gas storage and liquefied natural gas terminal facilities. Utilities also will face higher costs to meet new environmental standards for sulfur dioxide, nitrogen, mercury and greenhouse gases, they note.

New Times

Forecasts made in the 1990s as to the future demand for power did not hold true. The result was that many lenders overvalued the assets used as collateral on which they made loans. That allowed unregulated independent power producers to borrow aggressively—expenses that they could not pass through to ratepayers.

Times are different now. While money is cheap, borrowing conditions are stringent. That’s likely to mean that the larger utilities with solid balance sheets will endure and possibly acquire the assets of smaller independents. The credit agencies say the overall goal is to get to a 50-50 debt-to-equity ratio, if companies want to achieve investment grade ratings.

Granted, hindsight is always perfect, but the optimistic projections as to the demand for energy have been costly, as stock values in many cases have plummeted while bond values are 40 percent of their face value at the time of sale. On the other hand, those companies that have managed their growth while maintaining a strong balance sheet have weathered the storm. Specifically, they are staggering debt maturities, negotiating bank loan covenants during good times and maintaining bank lines of credit in excess of anticipated needs.

Business models in the generation business have been varied and no one formula for success is right. Future blueprints, however, need to consider unforeseen circumstances that can erode liquidity and hurt credit ratings. Prudence is therefore the overriding principle for when the next boom hits.

UtiliPoint's IssueAlerts are compiled based on the independent analysis of UtiliPoint consultants. The opinions expressed in UtiliPoint's IssueAlerts are not intended to predict financial performance of companies discussed, or to be the basis for investment decisions of any kind. UtiliPoint's sole purpose in publishing its IssueAlerts is to offer an independent perspective regarding the key events occurring in the energy industry, based on its long-standing reputation as an expert on energy issues.

Copyright 2004. UtiliPoint International, Inc. All rights reserved.

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