Week 70 - The “Business Case” for Electric Utilities

Situation: You’d like to invest in something that’s as safe as 10-yr US Treasury Notes but pays more than the 1.8% interest you’ll get from owning those. While stocks are 4-5 times as risky (Riskmetrics), companies that need government subsidies to fund huge and ongoing fixed costs are allowed to issue stocks that are then safer than average due to government backing. State-regulated electric utilities are an example. Bankruptcy can’t happen, and Return on Equity is set by the state’s public utility commission (usually in a range of 9-12%). In other words, downside risk is eliminated at the expense of upside returns. Most states also allow their electric utilities to operate an unregulated subsidiary. NextEra Energy (NEE), for example, has a subsidiary that is the top generator of electricity from wind and solar farms in the US, and Dominion Resources (D) has a subsidiary that stores natural gas, the largest such facility in the US.

To filter out less-efficient utilities, we’ve used several accounting tools to assess whether the utility meets a “business case” for sound management, i.e., is likely to double the investor’s investment over the next 10 yrs (for a Total Return of 7.2%/yr). That’s a high bar for regulated utilities to reach, since the goals of public utility commissions are to a) prevent the state’s taxpayers from having to bail out the utility, and b) prevent the utility’s shareholders from reaping windfall profits. In other words, state-regulated electric utilities can neither be a “cost center” nor a “profit center.” The terms “business case” and “profit center” have approximately the same definition so you see the problem. Our job is simple: find the utilities that are so efficient as to almost be profit centers. And we apologize that the attached Table is overly complex but a number of metrics have to be used to assess companies that are on the edge of true profitability.

Bottom Line: Risk is the bane of an investor’s existence (see Week 7 on Risk). So let us find companies that governments have to subsidize and see what investors have to give up in return. To start, let us pick companies that are going to produce the same amount of product in good times as well as bad times, because that eliminates the risk of a business fall-off during recessions. In other words, if windfall profits aren’t possible at least we can stop worrying about more than one risk. By investing in state-regulated electric utilities, we get to stop worrying about the risk of bankruptcy and about the risk of recession. (It’s not quite that simple, since state public utility commissions try not to raise electricity rates during recessions.) The Table shows you 3 good investing choices: NextEra Energy (NEE), Wisconsin Electric (WEC), and Southern Company (SO). We threw in the Vanguard Index 500 Admiral Fund (VFIAX) so that you could compare utility returns to the lowest-cost stock fund that has all 500 of the largest companies.