Gone are the days when investors could buy a utility stock, sock it away and never have to think about the investment ever again.
It’s still true that many utilities are great conservative investments that provide steady dividends, but the slow deregulation of the electricity business is fundamentally changing the nature of the utility investing game.
“There’s no question that’s true,” says David Schanzer, utility analyst at Janney, Montgomery, Scott in Philadelphia. “Most investors are unaware that the industry is much less interested than it ever has been in rewarding shareholders in the form of dividends.”
Last year six major utilities cut their dividends sharply, with virtually all of the companies citing the need to conserve cash in the face of impending deregulation of the power industry.
“This is definitely a trend, and investors who require security of income and steady dividends should be aware that the game has changed,” says Bob Kump, head of investor relations at New York State Electric & Gas Corp.
The National Energy Policy Act, passed in 1992, requires that utilities provide wholesale customers (municipalities, rural electric co-ops, public power agencies, etc.) with open access to transmission grids. Wholesale power users were released from their captive relationship with local utilities.
Following passage of this legislation, many utilties were caught in a bind. On the one hand, investors were demanding higher dividend yields on utility shares because of the perception of increased risk, but many utilities had to slash yields to brace themselves for competition.
NYSE&G’s story is a case in point, having slashed its dividend last October by about 36 percent. Kump cites the “need to prepare for deregulation” as the principal reason behind NYSE&G’s action.
“The industry is fundamentally changing, and management felt the need to rethink our strategy,” Kump says.
NYSE&G’s new strategy is to conserve cash and pay down debt to strengthen its currently highly leveraged balance sheet.
Kump is probably right when he says that NYSE&G shareholders will likely recover lost dividends in the form of a higher stock price. The market is indeed currently rewarding the stocks of utilities with conservative balance sheets. The potential for a capital gains pop, however, is small consolation for investors who bought NYSE&G looking for income.
Kump clearly realizes this. “A good chunk of our investor base could give a damn about capital gains,” he says. “It was a very difficult decision for us to cut the dividend. We maintain that it’s in the best interest of shareholders to reduce the dividend payout from 95 percent of net income to 60 percent.”
Commonwealth Edison, now known as Unicom, is a company Chicagoans are all too familiar with. It’s known here as a company that’s continually asking for huge rate increases and is continually getting turned down by state regulators.
From an investment standpoint, ComEd is also a prototype of the kind of utility that risk-averse investors should avoid at all costs. ComEd slashed its dividend way back in 1992 by 47 percent, sending the company’s shares into a steep nosedive from which it has never recovered.
ComEd’s problems can be summed up in two words: nuclear power. Hindsight is golden, but it is safe to say that ComEd officials made a utility investment gaffe by electing to continue with their huge nuclear power construction program in the early 1990s.
ComEd figured it could pass on the bloated costs to consumers through rate increases, just as it had always done. The Illinois Commerce Commission, which, as a result of its tough ComEd rate decisions, is considered by some to be the harshest regulatory body in the U.S., refused to allow ComEd to pass along the full cost of its nuclear cost overruns.
The upshot, in the words of ComEd President Sam Skinner, is that ComEd shareholders are sitting on a $5 billion investment “on which we are earning no return.”
Despite the ICC’s effort to hold down rate increases, ComEd is one of the highest-cost electricty producers in the country. With deregulation looming, the company is facing the prospect of having lower cost producers in neighboring states poaching on its protected territory.
Wisconsin Electric Power, which can sell power profitably at half ComEd’s cost, has already taken the municipality of Geneva, Ill., from ComEd.
ComEd has only been able to keep Wisconsin Electric at bay by sharply reducing its rates to certain customers, a cost that is borne by the shareholders in the form of lower profits.
Another very dark cloud hanging over ComEd is the possibility, however remote, that it may never recoup any of the $5 billion investment in nuclear power that the ICC has excluded from the utility’s rate base.
While the Federal Energy Regulatory Commission recently strongly recommended that state regulators allow utilities to recover such “stranded” investments, there’s no guarantee the tough ICC will follow Washington’s advice.
If ComEd were forced to write down all its investment, shareholders would be hit hard.
There are a lot of utilities across the U.S. with similar “stranded” investments. What investors clearly need to recognize is that utility stocks are no longer the low-risk investment play they used to be.
Schanzer agrees that, to some extent, utility common stocks can no longer be viewed as a proxy for bonds. “For those who absolutely need safety and steadiness of income, you might want to avoid utility common stock,” Schanzer says.
He points out that utilities are aware that income investors are starting to shy away from their stock and are offering high-yield monthly preferred stock.
“Individual investors love these things. They sell out straight off. I recommend United Illumination Co.’s monthly income preferred, which is yielding 9 5/8 percent versus 8 1/2 percent on the company’s common stock,” says Schanzer.
Dan Rudakas of Kemper Securities has put together a recommended portfolio of utilities that have little or no exposure to nuclear power. For risk-averse investors he recommends Cilcorp in Peoria; DPL in Dayton; IPALCO in Indianapolis; NIPSCO in Hammond; PacifiCorp in Portland, Oregon; TECO Energy in Tampa; and Tucson Electric Power Co.
