Marginal Utilities

What does it profit a utility company to have stringent price regulations, short fuel supplies, high interest costs, and dull management?

July 1974By Comments

When Consolidated Edison, which had paid dividends for 85 years, omitted its quarterly dividend on April 23, mil­lions of investors in utility stocks hit their knees to pray:

“Oh, Lord of Investments, grant to us, widows and orphans, all, that the shoe dropped by our beloved Con Ed be not the first from a centipede; that this totally unnatural behavior for a utility be considered an aberration by investors everywhere; and that this action by Con Ed may be forgiven by money manag­ers, who should find it in their hearts to welcome back into institutional portfo­lios the securities of the nation’s utilities, even as the fatted calf was prepared for the prodigal son.”

Or something like that.

Utilities have been in big trouble in the stock market for a year or more, but investors “ain’t seen nothin’ yet.” American electric utilities produce most of the world’s electricity, but right now they’re about as welcome in a portfolio as Jane Fonda at a meeting of the D.A.R.

Con Ed’s dividend omission was the capper, the eruption of the boil, a true “gotcha” on all conservative investors. The electric utility serving New York City may have peculiar problems. Busi­nesses have been leaving New York in recent years, and office space sits empty. The environmentalist cry is a powerful one and it has kept nuclear power plant plans inactive for the last ten years. And the city’s political atmosphere has often been anti-business. Yet some of the problems afflicting Con Ed are trou­bling the whole electric utility industry.

Up until the current spate of lower earnings comparisons, utility stocks have actually outperformed most of their industrial counterparts in return on equity, dividend increases, expand­ing sales, and other criteria that would warm the heart of an analyst if he had one. But the stock market refuses to recognize these accomplishments, and the prices of electric utility shares have been stable, at best, for the last several years.

Flat or lower prices of its stock are bad for any company, but they can be fatal to a utility, which has a highly leveraged capitalization of about 35 per cent equity to 65 per cent debt. When its equity securities advance in price, a utility can sell some more, using the money for capital improvements. The larger equity base allows the company to sell more bonds, the proceeds of which are also invested in capital im­provements that enhance the value of the common stock, which then advances in price, allowing the sale of more equity, which leads to the sale of more bonds, etc.

The pyramid has worked admirably for many utilities for many years. But it has begun to crumble in the Seventies under a multiple onslaught from sky­rocketing interest costs, growth too fast to accommodate, pollution control costs, nuclear plant fears, fuel costs, bad regulation, and poor management.

As long as utilities could borrow money in the bond market at a reasona­ble cost, they could use the money prof­itably, making the leverage pay off. But the cost of borrowed money has in­creased rapidly in the last several years as the Federal Reserve Board has tried to control Inflation. Gulf States Utili­ties, for instance, sold an issue of bonds in 1966 at an interest rate of five per cent. This year the same utility sold ad­ditional bonds at an interest rate of 8% per cent.

Increased costs from servicing debt depressed earnings, and the price of util­ities’ common stock stabilized or de­clined, making it harder to sell; and when equity prices declined below book value, utility management was faced with a diamond-hard bullet to bite.

In many areas growth in demand for electricity was so great that the servic­ing utility had a hard time coping with it. The increased demand was partly caused by regulations which held prices down, which in turn encouraged con­sumption (not to mention that regulated prices made it impossible to pass on in­creased costs to the customer). Utilities themselves encouraged excessive con­sumption—abetted by more regulations which made electrical energy cheaper the more consumed—and got locked into a growth syndrome which caused severe problems when the energy crisis forced conservation.

Then there is the problem of future demand: a multi-million dollar power plant must be built well in advance of the demand, so the utility must finance the project for several years before it is completed (yet no revenues are forth­coming until it is). And miscalculations of demand can cause horrendous losses.

During the last few years, utilities have been faced with two new and un­foreseen complications: pollution con­trol and nuclear power plant fears. “No More Dumping” and “Don’t Encourage a Nuclear Holocaust” are commendable slogans, but they don’t help a utility pro­duce all the electricity people need as profitably as possible. The delayed in­troduction of nuclear power in many areas has contributed greatly to elec­tricity shortages and the high cost of power.

Pollution control was inevitable but late. Old generating facilities probably will never be acceptably clean, but the environmentalists have accomplished one advance, and they deserve kudos for it: pollution control will be an inte­gral consideration in the design of any new power plants.

The cost of fuel has been the most immediate headache for utilities. Fed­eral regulation kept natural gas cheap, so most utilities planned new facilities to burn that pollution-free fuel. When gas supplies proved inadequate, they had to fall back on fuel oil or coal. When the Arabs put the stopper in oil supplies, fuel costs began to double and triple. What was cheap yesterday is very ex­pensive today and may not be here to­morrow. Utilities are, by nature, long-term planners. Imagine their chagrin when the amount budgeted for fuel costs in 1984 had to be used ten years sooner.

And since utilities are legalized mo­nopolies, each one must depend on some governmental agency to raise prices. Regulators have never been keen to allow rate increases for utilities, but as long as such requests weren’t too frequent, they’d generally “work some­thing out.” But as costs increase faster than revenues, such rate relief has been sought more frequently, and the regula­tors are squeezed between a constituency who generally sees utility rate increases as another prime cause of inflation and the companies that see rate increases as a life-sustaining transfusion. Compro­mises on rate relief began to penalize the utilities with a corresponding decline in return on equity and the breakdown in leveraging.

Many critics of utility regulation in Texas point out that Texas is one of only two states without a state power commission. Each utility negotiates sep­arately with a myriad of local govern­ments. In the past this arrangement has resulted in premium multiples for such local utilities as Houston Lighting and Power and Texas Utilities. It must be noted, however, that the stocks of both these companies are currently selling near their ten-year lows, and that all of the utilities having trouble making enough to cover their dividends operate in states with power commissions.

Many analysts feel that the problems between utilities and regulators might have been the target of Con Ed’s divi­dend omission. The company normally pays 45 cents a quarter, but it omitted the dividend completely even though it earned 48 cents for the quarter. Al­though the company’s problems are real, the dividend omission might have been a drastic attention-getter.

There’s one other factor in the cur­rent plight of the utilities that many analysts don’t like to talk about. In general, utility management in recent years has been uninspired. For all the truly admirable long-term planning they’re so proud of, utility management seemed completely surprised by the se­verity of today’s adversity. And their power has caused a certain arrogance, making them often insensitive to cus­tomer requests. “Go ahead,” they seem to say, “do business with the other light company.” Utility management far­sightedness also stopped short of pollu­tion controls—show me a utility that did anything about pollution control be­fore it was forced to, and I’ll show you a figment.

What happens to the utilities from here will touch the lives of each and every American. Some have even advo­cated nationalization of utilities—so the government can apply the same man­agement that has given us such federal programs as those in agriculture and welfare.

What the utilities need to make them healthy again is not government inter­vention. It’s really just a few simple things like reasonable regulation, lower fuel costs, better management, lower in­terest costs, stabilized growth, and in­vestor patience.

Without at least two or three of these developments, we could be on the verge of the biggest blackout of them all. 

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