A Ticking Time Bomb in Utility Earnings?
Recession-battered customers have drastically cut power consumption.
With the economy in a tailspin, utility customers have flipped the "off" switch. While lower power consumption bodes ill for all utilities, some will fare worse than others. We think those that depend heavily on industrial users--the most economically sensitive customer class--could see precipitous declines in usage and, consequently, in earnings.
In this piece we'll highlight some of the utilities we think are most at risk in today's economy. We'll also identify those that, thanks to an attractive customer makeup, look better-positioned to weather the storm this quarter and beyond.
Utilities sell power to three customer groups, in order of increasing price sensitivity: residential, commercial, and industrial. Residential customers are the least price-sensitive for three reasons. First, they are highly fragmented and, as such, tend to be less organized. They may exert pressure through consumer advocacy and regulatory bodies, but the vast majority of residential customers are not involved in setting rates. Second, electricity represents both an essential and proportionally small household expenditure, making it a low-profile target for budget cutbacks (in contrast to, say, a family vacation). Third, most homes still lack any mechanism for monitoring power prices, leaving consumers oblivious to the actual cost of power at a given moment. For these reasons, residential accounts are generally a resilient and profitable source of utility income. For every kilowatt-hour of power sold to a residential customer, the average utility collects 12 cents in revenue.
Industrial customers, on the other hand, are organized and vocal when it comes to setting rates. Power consumption is typically a major expense item in their operating budgets. They are more attuned, and hence reactive, to changing power prices. For every kilowatt-hour of power sold to an industrial customer, the average utility collects just 7 cents in revenue. Commercial customers--comprising nonindustrial firms, hospitals, and the like--fall somewhere in the middle, providing 10 cents in revenue for every unit of power sold.
All else equal, we view utilities that rely heavily on industrial sales as less attractive even in a favorable economic environment. This reliance becomes a still-greater liability during a cyclical downturn; manufacturers tend to cut the lights first and keep them off longest. Concentration of demand adds further risk. In some cases, the closure of a single factory can meaningfully impact a utility's bottom line.
Industrial Demand Off a Cliff
As demand for power marched ever-upward over the years, regulated utilities became known for their steady, if not racy, earnings growth. But in recent months they have experienced an abrupt reversal of fortunes. Total volume sales among the utilities we cover plunged an average of 4.3% in the first quarter. Industrial customers led the pack, slashing usage by a staggering 12%. Only on a handful of occasions over the past six decades have we witnessed such a steep drop in demand. Residential customers, conversely, displayed predictable price inelasticity: consumption in this group declined a mere 0.3%. Sales volumes matter greatly to utilities because of their largely fixed cost structure; any decline in revenues is amplified on the bottom line.
Given preliminary data and the absence thus far of an economic turnaround, we suspect that second-quarter numbers, when they are released in the coming weeks, will look every bit as ugly. We also suspect they will vary widely by utility. To sift out those utilities in possible danger, we ranked our coverage universe by customer breakdown. Following are the 10 regulated utilities with the greatest exposure to industrial customers:
By comparison, the average regulated utility in our coverage universe relies on industrial customers for just one quarter of its sales. Assuming industrial sales fall at a similar pace in the second quarter as in the first, total revenues could decline by over 5% among the most industry-reliant utilities. And because of operating leverage, this could translate into a 20% or greater collapse in profit.
We think NiSource (NI) and Vectren (VVC) are among the most vulnerable. While both companies' gas utilities constitute a greater share of operating income than the electric utilities, the recession has hit their Indiana service territories more than almost anywhere else in the nation, with overall usage down over 12% in the first quarter of this year.
A Few Bright Spots
There's good news for the discerning utility investor: A handful of firms are relatively well-positioned from a customer-quality standpoint. Here are the 10 utilities with the greatest residential exposure. For perspective, the average regulated utility sells only 36% of its power to residential customers.
While residential demand may hold up well in slow economic times, it is susceptible to other sources of volatility, such as regional weather. Hot summers and cold winters tend to lift demand, while mild conditions do the opposite. And as we have seen recently with Florida utilities FPL Group (FPL), TECO Energy (TE), and Progress Energy (PGN), housing booms and busts can strongly impact residential demand.
Customer Makeup: One Factor of Many
We emphasize that customer composition is but one piece of the investment puzzle. Other variables, including regulatory structure, management, and growth opportunities, also shape a utility's investment merit. For certain companies, such as Southern Company (SO) and American Electric Power (AEP), we believe such variables compensate for their less-desirable customer profiles. Similarly, we think demand head winds are more than discounted in the current share prices of some firms, notably Exelon (EXC) and Entergy (ETR).
Just as some utilities with high industrial exposure possess offsetting strengths, some of those with high residential exposure are lacking in other respects. Pinnacle West (PNW), for example, has lost millions on ill-conceived real estate ventures, while Portland General Electric (POR) is allowed a lower regulated return on equity than most of its peers.
The Bottom Line
Over time, demand for power should resume its upward trend. And regulators should eventually recompense utilities for their current struggles through higher future rates. Given the momentous severity of today's falloff in demand, however, we think some may be in for a rougher ride than others.
Morningstar analysts Travis Miller and Mark Barnett also contributed to this article.
Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.