Teco Energy, Inc.

Copyright 2002 by The Dryden Press. All rights reserved. 101 - 1

TECO Energy, Inc

After graduating from the University of Florida two years ago, Dave Roserio took a job as a financial advisor with Morton Staley & Company, a blue chip diversified investments firm. Dave was recently assigned to the account of Laura Henderson, a 71 year old widow whose regular broker had just retired. Laura's account had been opened 65 years ago when her father, an executive with Tampa Electric Company, gave her some stock on her sixth birthday. Until his death, her father regularly bought Tampa Electric stocks and bonds through the companys employee purchase plan and put them into a trust for her. Tampa Electric, like most other electric utility companies, changed its structure to a holding company that owned a regulated utility plus a number of other unregulated subsidiaries. In this case, Tampa Electric formed a holding company named TECO Energy, Inc, which now owns Tampa Electric plus a gas company and a number of other related businesses. See the press release shown in Table 1 for a more complete description of TECO, and for more data and analysis see the companys annual report and various online sources such as the companys web site, Quicken, and Yahoo Finance.

Through her fathers investments and her own savings from a real estate brokerage business, Laura has developed a substantial portfolio. Her current net worth is approximately $5 million, and her major sources of income are Social Security payments of about $15,000 per year plus income from her investments. When Dave met with her, he learned that Laura was primarily interested in maintaining a stream of real, inflation-adjusted, after-tax cash income sufficient to maintain her current standard of living. Currently, she needs about $100,000 per year. Laura is also interested in helping with her grandchildrens college education, and she want to leave them something, but those are secondary considerations.

When Dave reviewed Ms. Hendersons account, he was immediately struck by the fact that all of her financial assets are held as TECO stock or bonds, with half in stock and half in bonds. Then, when he sat down with her, Dave expressed his concern with the portfolio. He explained that TECO is undergoing a transition from a regulated monopoly to a company exposed to competition. It has been shifting resources away from its core Florida operations and into diversified businesses across the U.S. and around the world. Although the company is doing well, it has been expanding rapidly and increasing its debt, which worries the bond rating agencies. As a result, in 2000 TECOs bonds were downgraded from Aa to A. Dave explained that these events are already factored into the price of the securities, but that investors changing expectations about

Bond and Stock Valuation; Portfolio Selection

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Bond and Stock Valuation

101 - 2 Copyright 2002 by The Dryden Press. All rights reserved.

the company will drive its future stock price. Ms. Henderson understood Daves arguments for a more diversified portfolio, but she replied

that her father had always, even on his deathbed, cautioned her against selling her TECO securities. In his words, TECO is the best managed, safest company in the world. Whatever you do, dont let anyone talk you into selling your TECO stock and bonds. This same message had been passed on to her children and grandchildren. So, she stated that before rebalancing her portfolio, Dave would have to convince her that a rebalancing would truly be beneficial. She also wanted to bring some of her heirs into the discussion, because she felt that they should know more about investments before they inherit her assets. Dave agreed to meet with her and her heirs in two weeks to discuss her investment position.

Dave also discussed Ms. Hendersons tax situation with her. Her income tax rate is 39.6 percent. Also, the tax basis for her TECO common stock is about $5 per share, but the basis for her bonds is close to the bonds current market values. Dave is aware that estate tax rates rise sharply and hit 55 percent on amounts in excess of $1 million. This makes gifts by people with potentially large estates desirable from a tax standpoint, even though potential donors dislike losing control over funds that are given away. Dave notes that Congress recently changed the law relating to the estate tax, or the Death Tax as opponents call it, causing it will be phased out by 2010, but he also knows that many in Congress want to keep it and plan to introduce legislation to reinstate estate taxes. Dave is also aware that the State of Florida, as well as other states and local governments within the various states, issue tax exempt bonds, and currently these munis with the same risk and maturity as her TECO bonds yield about 5 percent.

When Dave told Jorge Escolona, Morton Staleys regional manager, about the meeting, Jorge indicated that he would like to attend the presentation. He also indicated that he would like invite a good friend, a senior TECO engineering executive who had recently been transferred from operations to finance, to the session. (TECO rotates senior executives who might be future candidates for president throughout the company to broaden their backgrounds.) TECOs primary goal is to maximize its stock price, and Jorges friend wants to learn more about how people like Ms. Henderson make investment decisions. The finance group must raise capital from time to time, and the finance staff must also estimate the companys cost of capital, so he wants to become more familiar with investments, capital markets, and how investors like Ms. Henderson think.

Dave wants to use the Capital Asset Pricing Model (CAPM) in his analysis. According to Morton Staleys financial economists, stocks current risk premium over Treasuries is about 5%. Again, though, the economists recognize that others believe the market risk premium to be as high as 7 percent or so. For an approximation to the risk-free rate, he planned to use a U.S. Treasury security, but he was not sure which one. He also wanted information on bonds with TECOs rating, which is single A. To obtain the bond data, he looked at several sources, including Bloomberg (www.bloomberg.com), the Federal Reserve (www.federalreserve.gov/releases), and www.bondsonline.com, and he also got information from Morton Staleys bond traders. From these various sources he obtained the rates shown in Table 1. He planned to use the Table 1 data but to look up more recent interest rate data and have it available in case someone asks him how things have changed lately

Ms. Henderson also told Dave that a stockbroker recommended by her son had suggested that she should invest in preferred stock. Since TECO has no preferred outstanding, he


recommended that she buy some of Carolina Power & Lights 6.84% coupon, quarterly payment, perpetual preferred stock. Like TECO, CP&L has a single A bond rating, and its bonds are about as risky as those of TECO. The CP&L preferred is not actively traded, hence is not reported in the newspaper, but Dave learned from Morton Staleys traders that it currently sells for $106 per share.

TECO and its various subsidiaries also have about 25 different issues of long-term, fixed rate debt, at interest rates ranging from 5.35 to 10.1 percent, plus several variable rate issues that yield about 3.5 percent. Some of the bonds are callable, while others cannot be called prior to their maturity. All of the coupon bonds pay interest semiannually, on January 1 and July 1, and all are rated A. A listing of the bonds in Ms. Hendersons portfolio is shown in Table 2.

For information on TECOs stock, Dave decided to look at Value Line, which provides information about companies betas, along with forecasts of dividend payments, payout ratios, and expected growth rates. Therefore, Dave obtained the Value Line report on TECO dated 9/7/01 as shown in Table 3. He wanted to estimate a fair value for the companys stock. The row labeled decls per share showed that TECO paid dividends of $1.33 in 2000 and is projected to pay $1.37 in 2001. Also, Value Lines projected dividend growth rate from 199800 to 200406 (see left column, middle of the page) is 4%. Dave also noted that while the recent price of the stock as reported by Value Line was $28.99 per share, a still more recent stock price could be obtained from a local newspaper or the Internet. He decided to use the Value Line data for illustrative purposes, but he also obtained more recent stock price data on TECO to see show how much the stock price has changed.

Dave is well aware that the electric utility industry is being deregulated. Originally, each utility was granted a monopoly that gave it the sole legal right to sell power in a specified geographic area, and in exchange for this monopoly, the companys prices were controlled. In effect, prices were set so that the company would earn a fair rate of return on its common equity, with fair generally being defined as its cost of common equity. Now, though, competition is replacing regulation to keep the companies from exploiting the public. Utilities are being permitted to enter one anothers territories and thus to compete, and electricity prices are being set by competition rather than bureaucratic government regulators. High-cost companies located close to low-cost companies are obviously at risk of losing business, whereas low-cost companies have an opportunity to gain profitable business by expanding into other companies territories.

Deregulation has helped some companies but seriously harmed others. In particular, the major California utilities, where deregulation was first introduced, have been stuck charging fixed prices to customers in the face of rapidly rising costs, resulting in huge losses. Indeed, the largest California utility, PG&E, was forced to declare bankruptcy, and the second largest company, SCE, is also in danger of bankruptcy. Bankruptcy leads to the elimination of dividends, and it also seriously erodes stock and bond values, possibly driving them to zero.

Dave decided to estimate TECOs expected DCF return based on the dividend and price reported by Value Line, along with several potential growth rates. One potential growth rate is the 4 percent dividend growth rate Value Line forecasted. However, that rate is only half the projected cash flow growth rate, and also less than the revenues, earnings, and book value growth rates, which made Dave question whether 4% is truly the average investors expected average long-term growth rate. Next, he noted that Value Line forecasted a 64% payout ratio (found as the last entry in the right-hand data column headed 0406 and called All Divds to Net Prof). Value Line also forecasted a 15.5% return on common equity (found above the 64% dividend payout figure). Using those two items, he calculated the retention growth rate as follows:



Retention growth rate = (1 Payout rate)(ROE) = 0.36(15.5%) = 5.58%. Dave also looked up analysts growth rate forecasts on the Internet. He went to Quickens web site (http://www.quicken.com), then clicked Investing, and entered TECOs symbol, TE. He then clicked Analyst Ratings and scrolled down to the section on Growth Rates, where he saw that the consensus 5-year growth rate was 9.2%. Thus, TECOs long-term earnings growth forecast was just over 9 percent. Dave would have preferred a forecasted growth rate for dividends, but he could not find one.

Dave also talked with Sharon Ferrari, Morton Staleys electric utility analyst, and he asked her for her recommendation as to the proper growth rate for TECO for a DCF valuation. Sharon stated that she was forecasting a long-run growth rate of 6 percent, based on the retention growth rate using a payout of 60 percent and a 15 percent ROE.. She also pointed out that TECOs management was forecasting a growth rate of 10% over the long haul (see Table 4). However, Sharon said that in her experience both managers and many security analysts tend to be biased on the high side, so she is sticking with her 6 percent forecast.1 She does admit, though, that the company might very well hit its 10 percent target, or do even better, but like many companies, it could also miss on the low side.

Jorge Escolona wants Dave to make a good impression on Ms. Henderson and the TECO executive, so he prepared the following questions and asked Dave to use them to help structure his presentation. Jorge noted that stock and bond market data change daily, and for that reason he asked Dave to base his analysis on data as of January 2002 as given in the case. He suggested that Dave look up more recent data, but hold it in reserve and bring in into the discussion only if someone asked how things have changed since January 2002. So, Dave plans to assume that the presentation is being made on January 21, 2000, and to take that date as today.

Questions About the Case 1. Does it appear that Ms. Hendersons portfolio currently generates enough income to support

her lifestyle? Is that situation likely to continue in the future? Note that about half of her bonds are at 8 percent and half at 5.35 percent.

2. A TECO engineering executive was assigned to the finance group to broaden his experience. Why should a senior executive be interested in an investments-oriented seminar such as the one Dave is presenting?

3. What do you think of the brokers recommendation that Ms. Henderson invest in 6.84% preferred stock?

1 Sharon also pointed out that in recent years many companies, including utilities, have been reporting good earnings growth for a number of years, then reporting a large write-off, which indicated that past reported earnings growth was overstated. She thinks that many analysts ignore this factor and therefore are overly optimistic. Similarly, managements could hardly be expected to admit that they may have to take big write-offs before they occur, so they too may be estimating too high a growth rate.


4. What fundamental change has occurred in the electric utility industry in recent years? Has that change affected the wisdom of Ms. Hendersons fathers advice to never sell her TECO securities? How might this change be expected to affect (a) the rate of return that investors require on TECOs debt and equity securities and (b) the companys cost of capital?

5. The term asset allocation refers to the mix of assets in an investors portfolio between bonds, stocks, and cash, and, possibly, foreign investments, real estate, gold, and other types of investments. Financial planners generally recommend somewhat different asset allocations for people of different ages, and for people with different goals, net worth, and tolerances to risk. Should Dave Roserio suggest a change in Ms. Henderson's asset allocation? If so, what stock-bond mix would you recommend?

6. Another aspect of portfolio management is the selection of individual stocks and bonds that are included in the portfolio. What should Dave recommend regarding Ms. Hendersons security holdings: (1) no significant changes, (2) a moderate restructuring, or (3) a massive restructuring? In your answer to this question, be sure to consider transactions costs and taxes.

7. What information shown on the Value Line sheet could be used to help estimate TECOs CAPM cost of equity? What other information would be required to complete this estimate?

8. What information shown on the Value Line sheet could be used to help estimate the DCF cost of equity? Is enough information given to complete the estimate?

Questions Related to Bonds that Require Calculations: (The model would be helpful in answering these questions.) 9. Look over the data given on Treasury and TECO bonds, and then answer the following

questions:

a. Make a graph of the yield curves for Treasury and A rated corporate bonds.

b. Using the spreadsheet model, calculate each bonds exact YTM, YTC, or price, based on the actual time to maturity. Then fill in the blanks for either yield or price, whichever is missing. Assume that today is 1/21/02.

c. Which yield, YTM or YTC, is closest to the yield Ms. Henderson is likely to earn? Explain your answer.

d. Differentiate between interest rate price risk and reinvestment rate risk. Which of the Treasury securities has the most price risk? The most reinvestment rate risk? Do some sensitivity analyses for the 2-year and 30-year bonds to illustrate your answers.

d. What would probably happen to the income from two Treasury bond portfolios, one holding 2-year and one holding 30-year bonds, over a long period, say the next 30 years? Assume that the 2-year bonds are reinvested in new 2-year bonds when they mature.

e. Treasury bonds are not callable, but corporate bonds are callable. If you were asked the same questions about TECOs bonds as in (d) and (e) above, how would call provisions affect your answers?



f. Given Ms. Hendersons situation, what maturity structure would you recommend for her bond portfolio? Should she continue holding only TECO bonds? Should she consider a bond mutual fund or funds?

g. Some U. S. Treasury bonds are indexed to the rate of inflation. Currently, those bonds pay a real rate of from about 1% to about 3.3%, depending on the maturity. (See Bloomberg.com > U.S. Treasuries > Inflation Indexed.) Should Ms. Henderson consider investing in indexed Treasury bonds?

h. The State of Florida has some bonds that yield 5% and have the same risk, maturity, and call features as the TECO bonds of 2032. Should Ms. Henderson consider selling some of her TECO bonds and using the proceeds to buy Florida bonds?

10. Suppose TECO decided to issue a new zero coupon, non-callable, 30-year bond.

a. At about what price could such a bond be issued? This will require some estimates on your part. Be reasonable, and provide a range of prices.

b. Ms. Hendersons marginal tax rate is 39.6%. Would this fact influence her preference for a zero coupon bond versus a coupon bond that sells at par, assuming that the same YTM exists for both bonds.

c. If TECO wanted to be able to call the zero after say 10 years, how might the terms be structured to make a call feasible? How would the call feature affect the bonds issue price and required rate of return?

Questions that Require Calculations Related to Common Stock

11. What is TECOs required rate of return on common equity as estimated by the CAPM? How does that return compare to the returns on TECOs bonds? How sensitive is the CAPM cost of equity to changes in beta and the market risk premium? How accurate are your estimates of beta and the market risk premium, and hence your CAPM cost of equity estimate?

12. According to Value Line, TECOs annualized next dividend (for 2002) is $1.41, and its expected dividend growth rate is 4% from 98-00 (midpoint 1999) to 2004-06 (midpoint 2005). However, security analysts as reported by Quicken (Zacks) expect the long-run growth rate to be 9.2%, while TECOs management forecasts a long-run growth rate of 10%. Based on the constant growth model ks = D1/P0 + g, what is TECOs DCF cost of equity? How does your DCF estimate compare to your CAPM estimate in Question 11? How would you reconcile any differences, or, put another way, how much weight would you give to each estimate?

13. Based on Value Lines forecasted data and the constant growth model, P = D1/(k-g), what is a fair price for TECO?


14. The upper left corner of the Value Line report, under 2004-06 Projections, shows a projected price range of $35 to $40 per share, and Annl Total Return estimates of from 14% to 9%, which average 11.5%. Thus, this part of the Value Line report suggests that an investor who buys TECO stock at the current price of $28.99 and holds it until somewhere in the period 2004-2006 will realize a return of about 11.5% per year. Is this 11.5% return consistent with your DCF and CAPM required rate of return estimates? Does this imply that Value Line thinks that TECOs stock is fairly valued, i.e., that it is in equilibrium? What are Value Lines verbal conclusions about whether or not TECO is fairly valued?

15. Conclude your analysis by recommending a specific portfolio for Ms. Henderson. Specify your recommended mix of individual stocks, bonds, and mutual funds, and explain what characteristics the specific securities or funds should have. What are the pros and cons of holding individual securities versus holding mutual funds? What would her annual investment income be under your recommended portfolio? How risky would the portfolio be, giving consideration to how different potential interest rate and stock market changes might affect the value of the portfolio and its expected dollar return. How are capital gains and estate tax considerations reflected in your portfolio recommendations?



Table 1. T-Bond Yields and A-Rated Corporate Yield Spreads, January 2002 Treasury securities: A-rated bonds Spread over Treasuries 3-month bills 1.82% 2.53% 0.71% 2-year notes 2.38% 3.81% 1.43% 5-year bonds 3.55% 5.36% 1.81% 10-year bonds 4.26% 6.56% 2.30% 20-year bonds 4.60% 7.28% 2.68% 30-year bonds 4.84% 7.66% 2.82%

Table 2. Bonds in Ms. Hendersons Portfolio Coupon Maturity 1st Call Call Price Market Price Yield 8% 12/31/32 12/31/07 105 108 8% 12/31/32 12/31/04 Par 8%, 12/31/32 not callable 5.35% 12/31/32 not callable 5.35% 12/31/32 12/31/04 Par 0% 12/31/32 12/31/07 105% of accreted value 0% 12/31/32 not callable Notes: 1. Price data are available on some of the bonds, while yield data are available on others. If the price is given, determine the yield, and vice versa.

2. The zeros accrue interest on a semiannual basis. 3. The pricing is as of 1/1/02. 4. The bonds shown here are somewhat different from the bonds TECO actually has

outstanding. We changed the data for pedagogic purposes, to simplify the analysis and to show different situations. Note, though, that the listed bonds were actually issued by other A-rated utilities, and the prices and yields are close to what would exist on similar bonds for TECO.

5. Ms. Henderson has only a small amount of the zeros. Most of her bond portfolio is divided equally between the 8% and 5.35% issues.


Table 4. Press Release: TECO Energy updates earnings outlook for 2002 and beyond for investors New Orleans, October 30, 2001 In its presentation at the Edison Electric Institute's annual financial conference today, TECO Energy is updating its earnings growth outlook for 2002 and beyond. The company is expanding the information provided in its third quarter earnings statement, including reaffirming the company's 15 percent earnings growth target for 2001. TECO Energy Chairman, President and CEO Robert Fagan said, "TECO Energy is committed to 10 percent average annual earnings growth over the long term, despite the fact that economic and energy market conditions will make 2002 a challenging year. Even so, I see TECO Energy as different from many others in the current environment. We expect good growth in our regulated businesses in Florida, we expect improved results at TECO Power Services and in our portfolio of other unregulated businesses, we see the opportunity to deliver real earnings growth of 5 to 10 percent next year." "The year 2002 will be a transition year for us, as we focus on construction of major generating projects and bring them into commercial service. The year 2003 should be a breakout year for us with the commercial operation of the four major power plants that TECO Power Services is now building, and the first phase of the Bayside repowering coming on line, " added Fagan. Florida Operations: The Florida operations are expected to produce good growth from customer additions and increased per customer energy usage. Historically Florida's service-based economy has been less sensitive to economic downturns than other areas of the country. In 2002, Tampa Electric expects more than 2.5 percent customer growth and 3 percent energy sales growth, with summer peak demand expected to rise more than 100 megawatts. Earnings are expected to grow at a rate greater than customer growth due to a significant rise in AFUDC earnings from 2001's expected level of more than $8 million to almost $30 million in 2002. In 2002, Tampa Electric will continue its repowering at the Gannon Station. The additional capital cost to complete the repowering is expected to be about $450 million. The completed repowering will provide an additional 1,050 megawatts of highly efficient natural gas-fired capacity to Tampa Electric's generating mix and is on schedule to be in-service by the middle of 2004. Peoples Gas expects to grow its customer base by 5 percent with net income growing at a faster rate due to a favorable customer mix and higher per customer use. Over the past three years, Peoples Gas has made significant investments in system expansion throughout Florida to open untapped markets to natural gas, and the company is now connecting increasing numbers of customers to the system.



TECO Solutions, the energy services and gas marketing subsidiary, expects to grow net income from increased demand for energy engineering, design and construction services and from gas management services for a growing number of large commercial customers taking advantage of Florida's unbundled gas market. TECO Power Services expects to produce significant growth next year from a complete year of operation of the full capacity of the Commonwealth Chesapeake Power Station in Virginia, the Frontera Power Station in Texas, and the initial operations of the first two phases of the Union Power Station in Arkansas late in the year. At the other unregulated companies, TECO Coal expects increased earnings from higher steam coal prices. TECO Transport expects to produce earnings at or above the 2001 level, from a more normal pattern of government grain shipments, a modest improvement in phosphate shipments and better utilization of covered barges in southbound river business. Based on current gas price futures, TECO Coalbed Methane is expected to record lower earnings due to lower natural gas prices and normal production declines. Cash Flow: Capital expenditures for the 2001 through 2004 time frame are expected to total almost $4.2 billion, including $1.9 billion for the announced projects at TECO Power Services and more than $1.1 billion for the repowering of the four units at the Bayside Power Station. Cash flow from operations is expected to be $2.7 billion during this period. Dividends during the period are expected to be $0.8 billion with the current policy. The company expects external financing requirements to be $2.3 billion in the 2001 through 2004 period. The external financings are expected to be achieved through roughly equal amounts of debt and equity or equity-like products. In 2001, TECO Energy has already raised $325 million of equity through the sale of 12 million shares of common stock. Beyond 2002: In 2003, TECO Energy expects double-digit growth primarily from the continued good growth in the Florida operations, including higher equity AFUDC earnings at Tampa Electric, and the major new generating projects entering service in the first half of the year at TECO Power Services. The increased earnings from TECO Power Services is expected to more than offset the elimination of the Section 29 tax credits after 2002 at TECO Coalbed Methane. TECO Energy (NYSE:TE) is a diversified, energy-related holding company headquartered in Tampa. Its principal businesses are Tampa Electric, Peoples Gas, TECO Power Services, TECO Transport, TECO Coal, TECO Coalbed Methane, TECO Propane Ventures and TECO Solutions.

Teco Energy, Inc.

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