Utilities as Seen Through a Global Lens

May 16, 2011
Baird Brings a Broad Perspective to Sector Analysis.
Global events in 2011 – including the earthquake and tsunami in Japan and continued political unrest in the Middle East – have had significant implications for the energy sector and utilities. This spring, Baird Senior Analyst David Parker had the opportunity to meet and speak with utility company managers and investors from around the world at Baird’s fourth-annual Utility & Infrastructure Symposium in Zurich. Perspectives gained from this experience and David’s continued monitoring of world and U.S. dynamics are represented in the outlook below.

Uncertainty Breeds Near-term Neutrality.
Discussions with U.S. and European investors confirm that most remain on the sidelines, waiting for a more predictable future for infrastructure investment opportunities to tip the expected risk/reward ratio in their favor.

Events following the recent tragedy in Japan solidified concerns that a lack of direction for U.S. energy policy could keep domestic infrastructure investment stalled for the next few years, most likely limiting utilities’ appeal in the near term.

While a close evaluation of domestic nuclear emergency preparedness might actually improve consumer sentiment over the long term, it is reasonable to expect that the anticipated nuclear renaissance will be slowed and likely manifest offshore before impacting the United States.

Meanwhile, mounting geopolitical uncertainties and rising oil prices have many investors shifting to defensive postures. Fully 80% of investors at this year’s Symposium were looking for “an investment I can own and sleep easy at night.”

Signs of Stability Ahead?
Authorized ROEs (equity ratios) have declined over the past 24 months; however, it appears that trend could be reversing. Comments from state regulators remain largely constructive, though most appear hesitant to support new accelerated infrastructure spending programs until the economy materially improves.

Maintenance expenditures, on the other hand, appear to be recovering to pre-recession levels. With margins on the rise due to improved economic conditions and/or rate relief, utilities appear to be boosting maintenance budgets to ensure system reliability doesn’t decline. While maintenance expense typically isn’t capitalized and therefore does not grow earnings per share, the benefactors of this trend are likely to be machinery/manufacturing companies that provide services to utilities.

Gas Gets a Boost.
In addition to utilities servicers, natural gas stands to reap some near-term benefits from the current global environment. Japan’s nuclear crisis has elevated safety concerns while supply and demand continues to be the drumbeat for increasing oil prices. In addition to being plentiful, natural gas seems to provide a lower-risk, lower-cost option for future electricity-generating additions. Recently proposed EPA rules provide incentive to switch from coal generation to natural gas – something several companies are already in the process of doing – but regulators’ focus on keeping bills flat in the near term will likely limit new project approvals. Natural gas as a transportation fuel is also a trend investors are interested in.

M&A Rumors Accelerate.
Recent premiums paid have muted investor excitement over the potential for accelerated M&A activity, but rumors of potential utility combinations persist. If the historical trend repeats itself, M&A premiums should improve, supporting increased sector valuations. Assuming the regulatory merger approval process remains constructive, M&A activity could continue to accelerate in 2011. Under such conditions, the potential sweet spot for merger targets would be mid-cap utilities, where the regulatory hurdles are less onerous.

Water on the Rise.
Water utilities continue to invest in infrastructure, helping to drive solid EPS growth and therefore attractive returns. These more predictable infrastructure investment opportunities and improved regulatory recovery mechanisms are boosting valuations. And it appears that investors believe this subsector is much less sensitive to political pressure and therefore a better defensive investment.

Looking Down the Road
Persistent unemployment, significant new natural gas supply in North America, an old and capacity-stretched infrastructure system and pending environmental regulations could refuel efforts to establish federal policy for U.S. infrastructure in 2011. Grasping this unique set of challenges and uncertainties, stakeholders could be catalyzed to reaccelerate infrastructure investment. Baird’s expected timeline:
    • Near term (now through 2012) — EPS growth is expected to remain subdued except for water utility companies that continue to invest in infrastructure. With significant federal policy uncertainties, electric and natural gas infrastructure investment will likely remain curtailed. Similar to past cycles, potential EPA action by next spring could get infrastructure investment rolling by 2012, helping to once again provide an investable sector theme.
    • Long term (post-2012) — accelerating electric and NG infrastructure investment is expected to boost EPS growth to attractive levels. Over the next 10 years, EPS growth averaging 5–8% should fuel attractive total returns as utility companies accelerate infrastructure investment. Pending EPA environmental rulings could prompt the retirement of 40–60 GWs of U.S. coal-fired generation. An estimated $1 trillion in infrastructure investment is needed to improve and maintain reliability, meet customer needs and comply with increased environmental standards in the next 10 years. Estimated water infrastructure needs total $100 billion, natural gas $100 billion and electric infrastructure more than $700 billion.
    • Convergence of water, natural gas and electric infrastructure investment could provide an uplift to capital expenditure forecasts. Similar to the increased interdependence of the natural gas and electric sectors once natural gas became an important fuel source for electric generation, we expect water supply concerns and challenges to fuel additional infrastructure investment opportunities in the future for water, electric and natural gas utilities. This convergence could expand infrastructure investment needs as stakeholders evaluate total system solutions, including supply, storage, efficiency, conservation, recycling, and improved system reliability and optionality.