Understanding Public Electric Company FCF

[nickenumbers]

All,

 

I have been nosing around in a couple public electric company like Duke and NextEra.  Their FCF just sucks, but I suspect that they are playing by a different set of rules in their industry.

 

Their CapEx is enormous relative to their Operating Cash.

 

They fund it all with Debt and Equity.  What is going on here?

 

Can someone give me the basics of FCF for this industry.  Thanks.

[JRM]

I'm curious what attracts you to utilities which, as a sector, are trading near all time highs.  The P/E ratios are ridiculous compared to historical averages.  This at time when energy demand is declining and long term trends are towards decentralized power generation.

 

Back to your question.  I'm not an accounting expert, but here is how your average regulated utility operates:

 

Utilities operate on margin because the amount of capital required to build an asset base (power plants, transmission lines, etc) would be extremely inefficient from a capital management standpoint.  One of the side effects of regulated utilities operating on margin is the sensitivity to interest rates.  Many times it can take multiple years to complete a large scale project and the projects are funded, at least in part or in whole, by floating rate debt.  If interest rates increase the operating profits will be negatively impacted, and vice versa with falling interest rates.  This effect is termed "regulatory lag". You can probably find a better definition on Google. 

 

Something else unique to utilities is they pay very little in taxes.  They maximize depreciation expenses by capitalizing as much operating expense as possible.  This isn't necessarily a bad thing because in general taxes are just passed onto the consumer.

 

Typically return on equity will be in the high single digit range for a well run regulated utility.  They can be higher for an unregulated utility in a decreasing rate environment. 

 

I think shares of utility companies have been bid up by pensions funds seeking yield.  If interest rates rise it will be a double whammy for utility company stocks due to the regulatory lag issue and competing yield from lower risk investment options. 

[nickenumbers]

JRM,

 

Thanks for the background.  I was guessing at some of the things that you described and confirmed, but even your brief background is very helpful.

 

I have never analyzed electric utility financials before. 

 

Your original question of "why are you even interested in them, Nick?"  I figured out that I was not interested in them, but I know enough to suspect when I don't know, and perhaps don't know that I don't know.  So, I was asking to make sure that I wasn't missing the boat here.  For me, they look like low return highly regulated business.  I am going to pass and put them in the too hard pile at the same time.

 

Thanks for the background!

[Cigarbutt]

The traditional model of the regulated return on investment for electric utilities is transforming because 1-electric demand has basically flat-lined and decoupled from GDP growth for the last 20 years and 2-the role of the grid is being redefined.

 

To grow in the context of a stable electricity demand, investor-owned utilities have differed in their strategies but have tended to expand their customer base, to widen their product portfolio and to develop a services component, which means that CFO is typically not enough to fund the dividend and the new ways to grow.

 

I agree with JRM that PEs are high but that's mainly due to persistently low interest rates. Low rates have caused to increase leverage, to increase the ROE and to drive the valuations up because of the yield-chasing behavior so that there may be more cyclicality in future.

 

Duke has a relatively higher yield and seems to be perceived as a more stable and slow growing utility (it has invested mostly in grid upgrades and NG infrastructure) but has performed relatively poorly, especially in the last few years.

 

NextEra is more of a market darling with a lower yield but expected higher growth due to significant investments in renewable energy.

 

So, some potential headwinds and execution risks and each utility has an increasingly different playbook. A potential advantage to look for in the future may be to have a lower cost of capital and to be able to elaborate and apply an efficient cost cutting program that does not affect reliability, customer satisfaction and safety.

[DooDiligence]

The history  of BHE is interesting.

 

The fact that they can invest more heavily than dividend paying competitors should make them a powerhouse (pun intended.)

 

https://berkshirebuffettandbeyond.com/2019/01/28/outsized-returns-in-a-regulated-industry/

[gfp]

Thanks for that link DD - a great summary of BHE and it's always nice to relive the "failed" Constellation Energy deal.  So BHE can get enormous and so far has accomplished 16% for their owners.  Charlie seems happy with it

 

The history  of BHE is interesting.

 

The fact that they can invest more heavily than dividend paying competitors should make them a powerhouse (pun intended.)

 

https://berkshirebuffettandbeyond.com/2019/01/28/outsized-returns-in-a-regulated-industry/

[nickenumbers]

I agree with GFP.  Thanks DD and CigarButt on your inputs.

 

BHE does seem to have a virtuous snowball going with its ability to reinvest the FCF that others [DUK, NextEra] have to send out as dividends.

 

I continue to be the grasshopper sitting at the feet of the Masters.

[DooDiligence]

I agree with GFP.  Thanks DD and CigarButt on your inputs.

 

BHE does seem to have a virtuous snowball going with its ability to reinvest the FCF that others [DUK, NextEra] have to send out as dividends.

 

I continue to be the grasshopper sitting at the feet of the Masters.

 

I too am but a lowly weedhopper, reliably providing dubious color commentary.

 

GFP & CB are the one's who can really make sense of complicated financial / operational situations.

 

Now if you want to talk about music, that's another story.