Utilities are a safe haven investment. By dint of the regulatory process, it offers a reasonably pre...
Utilities are a safe haven investment. By dint of the regulatory process, it offers a reasonably predictable earnings stream. Unregulated markets are attractive, as the prospect of M&A activity creates a spur to share prices and cost-cutting efforts boost the bottom lines of the other players.
From their state-owned heritage, there is huge scope for cutting bloated work forces and improving efficiency. The highly cash-generative nature of these mature businesses also generates enough cash to sustain a high dividend yield.
That is the theory anyway. But does any of that apply in the post-Enron world? Has the risk profile of the sector really changed? It will certainly take months to uncover the true cost of the Enron bankruptcy and in the meantime the newsflow will add to the sector's volatility. But Enron was essentially a marketing and trading company and there were few assets to support its burgeoning customer base. Such companies are few and far between in the sector.
Integrated utilities, on the other hand, marry assets to customers and lower their earnings risk by creating a natural hedge in the form of an inherent customer base that can absorb any increased production costs. In the US, most electric utilities can pass on increased fuel costs in the form of higher prices to their customers, which keeps group profits to a minimum.
TXU is a good example, with 11 million customers served by the 335 million megawatts of power it generates each year. It has steadily grown earnings by an average 9%-11% a year. TXU has done this in a fully competitive market. The liberalisation process has driven management to trim fat from their workforce wherever possible. EDP in Portugal has recently announced plans to strip E62m (£38m) from its cost base by 2005, with 15% of its staff costs earmarked for reduction. Scottish & Southern Energy has cut the cost base by £140m since merging Scottish Hydro with Southern Electric, through removing duplicate IT systems and the like.
Seeboard and Wessex Water are up for sale in the UK, Innogy is in takeover talks and the stronger players are poised to mop up the distressed assets of the independent power producers in the US. Even the textbook monopolistic utilities can offer attractive opportunities. The UK water sector provides an average dividend yield in excess of 7%. The proposed balance sheet restructuring that will see capital returned to equity holders as the regulated businesses swap equity for debt to lower their cost of capital should provide a fillip to share prices. This comes about through closing the discount to the regulated asset base at which these companies trade.
So, in a world where many commentators are pointing to lower capital returns from the market and a greater emphasis on total returns, much of the utilities sector is still attractive.
Enron is the exception to the rule but the volatility the ensuing debacle creates, if anything, makes the sector more attractive. It highlights interesting opportunities where those who can see through the noise to pick stocks that are utilities in their truest and most defensive form stand to make the greatest gains.
There are high dividend yields.
Utility firms embarking on cost cutting.
Industry going through restructuring.
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