The pains and gains of electric utility stock ownership

Michael Foley is the Director of Financial Analysis for the National

Association of Regulatory Utility Commissioners (NARUC) in

Washington, D.C., a position he has held since 1979. Foley holds a B.S.

degree cum laude in Business Administration from the State

University of New York and an M.B.A. in public finance from

Michigan State University. The views expressed here are his own and do not necessarily reflect the position

of the NAR UC.

The Pains and Gains of Electric Utility Stock Ownership Despite the vicissitudes of overbuilding, low natural gas prices, cost overruns, prudence reviews and disallowances, most electric utilities have outperformed their unregulated counterparts by significant margins.

Michael Foley

eyn years of prudence investi- tions, citizen utility boards,

regulatory lag, and intrusive gover- nors and state legislators have wreaked havoc on the widows and orphans who own the common

stock shares of our nation's electric

utility companies. Or have they? In the early 1970s, the Consoli-

dated Edison Company of New York, facing a serious cash flow crunch related to the construction of its Indian Point and Astoria power plants (both of which were later sold to the Power Authority of the State of New York), commit- ted what was at the time considered an heretical act. In April 1974 Con Ed decided to skip one quarterly dividend payment in an

effort to conserve cash. Wall Street was merciless in its reac-

tion. The company's common stock, which had traded as high

as $26 per share the previous year, plunged to $6.

action sent shock waves ughout the utility industry.

Leonard S. Hymml, Merrill Lynch's highly respected utility specialist

noted that, "Con Edison's dividend omission hit the industry with the impact of a wrecking ball. It smashed the keystone of faith for investment in utilities: that the dividend is safe and will be paid. "1

By September of that year, electric utility stock prices had fallen by 36% across the board-- the greatest collapse in any calendar

28 The Electricity Journal

year since 1937. 2 Five years later, in the wake of

the debade surrounding its Three Mile Island project, General Pub- lic Utilities, Inc. witnessed the fall of its common stock from $18 per share to just above $3. The firm suspended all common dividend payments for the next seven years. Gerhard Enge, a 75-year- old shareholder lamented to the Wall Street Journal that he had invested heavily in the company 10 years earlier in the hope of receiving dividend income during his retirement. "I'm losing $3,600 per year of dividends. I hope we can get dividends back before I die. "3

J ust over a year ago, Public Ser- vice Company of New Hamp-

shire, primary owner of the trou- bled Seabrook nudear unit, filed for protection under Chapter 11 of the United States Bankruptcy Code, the first major public utility to do so since the Depression. The firm's common stock trades today for about $4 per share a meager 53% of book value and there are, of course, no dividend payments to speak of.

Within the past four to five years, 23 major electric utility companies have been forced by events to reduce or eliminate alto- gether the payment of common stock dividends. As New York financial consultant Robert Rosen- berg observes, "What had pre- viously been unthinkable, has now become merely unusual. ,,4

In the face of these well publicized investor horror stories and others which space will not per- mit us to mention, utilities and their friends warn that the tradi-

tional regulatory compact has been violated, that many investors will no longer risk capital in this industry, and that the reliabil- ity of future service may be in jeopardy.

The truth lies elsewhere. Look- ing beyond such hysterics, data are beginning to emerge which document that large institutional investors have in recent years been making an aggressive yet lit- tle reported move into electric util-

EEh over the four-year period 1984-87, institutional ownership of electric utility stocks has increased from 22.8% to 34.0%.

ity equities. Edison Electric Insti- tute (EEI) reports, for example, that over the four-year period 1984-87, institutional ownership of electric utility stocks has increased from 22.8% to 34.0%. 5

hY would sophisticated insti- tional investors gobble up

securities in an industry beset with so many well publicized financial problems? Aren't the names "Peach Bottom," "Seabrook," "Shoreham," "Marble Hill" and "Diablo Canyon" so well known now in the financial press that investors categorically reject all utility equities?

Indeed, the names are only too well known; but investors have

been acute enough to recognize that there are still plenty of solid opportunities remaining in companies like Duke Power, Potomac Electric, and Wisconsin Public Ser- vice to warrant the aggressive ac- quisition of utility equities. More- over, they recognize that yesterday's "dogs" can be tomorrow's high flyers.

T ~ ' l gege~t° hist°ry tO cOnfirm n, we note that a pru-

dent investor who purchased one share of Consolidated Edison in 1974 for $6 owns two shares today trading for about $47 per share with a rock solid dividend of $3.44 per share. Con Ed has announced that the stock, which split two-for-one in 1982, will split again (two-for-one) effective June of this year. Likewise, General Public Utilities has re- sumed regular quarterly dividends and its stock trades for roughly $38 per share up from about $3 a de- cade ago.

Long Island Lighting (Lilco) may be the next to challenge the notion that utility equities offer unlimited downside risk with only controlled upside potential. Lilco's common stock has doub- led within the past year and trades today for about $15 with no dividend. Prudential-Bache is now running quarter-page "Life After Shoreham" ads in the New York Times touting Lilco as "a unique opportunity to capture significant upside potential for capital gains and positive earnings growth in the years ahead" and projects "future dividends of $2.00 per share by 1991 .,,6

There has never been any doubt that shrewd professional invest-

June 1989 29

ors, equipped with powerful computer models and all the latest financial research, can structure a utility portfolio which provides a fair return. However, this artide goes further in suggesting that an amateur investor, armed with nothing more than a dart board, can select utility stocks which on average provide a more lucrative return at lower risk than the average non-regulated industrial corporation.

J ohn V. Clear~ President and Chief Executive Officer of Green

Mountain Power, made much the same point in a recent trade journal article in which he argued, "... if you had invested $100 in utilities in 1955 and another $100 in a compos- ite of indnstrials and reinvested all the dividends paid on both portfo- lios, the total pretax return in nomi- nal dollars on your utility investment at year end 1986 would have been, you guessed it, greater than the return o n i n d n s t r i a l s . "7

There is today a growing recog- rdtion that electric utility equities have, on average, been a superior investment vehicle when com-

pared side-by-side with equities of the major non-regulated industrial corporations. Or as Forbes

puts it, "Utility stocks have soundly beaten the market since 1975----catching much of the street napping. "8

This conclusion is premised on the notion that after all the ab- stract theories of financial performance have been considered, the ultimate and most meaningful indicator of long-term corporate profitability is total cash return to common stockholders. Volumes have been written about such eso- teric utility financial matters as al- lowance for funds used during construction (AFUDC) as a per- centage of earnings, cash flows due to interperiod tax normaliza- tion, and market-to-book ratios. However, when all is said and done, what really matters is how much cash return the investor has received on his original outla)a

A s PacifiCorp's 1986 annual report to stockholders correctly

instructs, "Total investment return--- the combination of stock price change and dividend payments---is

the most important indicator of how shareholders are faring. "9

artide summarizes the re- of a recent report of the

National Association of Regulatory Utility Commissioners which provides an extensive examination of the common stockholder r e a m performance (cash dividends plus market price increases---i.e., capital gains) of 92 major electric utilities and electric utility holding companies over the 17-year period 1972 through 1988.1°

The time period studied was one of the most tumultuous periods in the industry's history and included the Arab oil embargo and concomitant oil price spikes, several years of double digit infla- tion, oppressive interest rates, doz- ens of prudence investigations, multi-billion dollar cost disallowances, and over 100 plant aban- donments representing some $30 to $40 billion in lost investment. In short, the study period can scarcely be characterized as the halcyon days of electric utility performance.

The study compares utility

Investor returns from utility equities continue to play a merry tune.


stockholder performance with that of the Standard & Poor's (S&P) Index of 400 Industrials and the Value Line Industrial Index (VLIC) of over 900 industrial corporations using two differ- ent measurement techniques (compound average and internal rate-of-return).

S ome assumptions are necessary to compute total returns since in-

vestor actions are so numerous and varied. Both methods used in this study assume that a stock is purchased and sold precisely at mid- year and therefore generates only half of the dividends paid in the years of purchase and sale. Yearly stock prices are estimated by an average of the year's high and low prices. Thus it is assumed that at mid-year a stock's price is the average of that year's high and low price and all trading occurs at that average price. Since all companies are treated the same and a full 17 years of data are examined, the tech- nique provides results which closely approximate actual returns by stockholders.

A total return is calculated only for cases where a stock is held for at least three years and the data in the report have been adjusted for all stock splits. The study con- tains over 3,100 data points and is based on a computer model which performs roughly 20,000 separate electric utility shareholder return calculations. One hundred five distinct hypothetical holding periods are examined for each of the 92 electric companies induded in the study ranging in length from three years to 16 years, u

The Basic Approach: Method I The returns found by Method I

are derived by calculating the yearly compound interest rate necessary for the original purchase price of a stock to grow to the sum of the following four

items: --half the dividends paid in

the year of the stock's purchase;

--half the dividends paid in the year of the stock's sale;

--all the dividends paid during all interim years; and

- - the stock's sale price.

Returns from utility equities clearly dominate those of the non-regulated industrials.

Method I utilizes a standard compound interest formula where the original purchase price is considered to be the present value and the sum of the above four items is considered the future value. The other determin- ing factor is simply the number of years a stock is held.

T he study documents that 48 out of 92 electric utilities in the

study (roughly 52% of the companies) generated average compound rates-of-m0am which exceeded that paid to stockholders in the S&P 400 and that 45 out of the 92 (49%) had

I

returns exceeding those earned by stockholders of the average company in the VLIC.

The average shareholder compound rate-of-return over the 105 possible holding periods for the electric companies was found to be 10.46% compared with a 10.60% return for the S&P 400 and a 10.90% return for the VLIC.

nder this approach, electric fility stockholder re~n'ns are

in virtual parity with returns paid to holders of non-regulated industrial corporations. However, this approach ignores two critical factors which have the practical effect of drastically understating utility performance. The first is that the compound interest approach as- sumes that dividends are not reinvested either into additional shares of utility equities or any other investment opporttmi~ While this may be valid for those stockholders who own utility stocks only to meet current income needs, it dearly is not valid for corporate or institutional investors.

Second135 the compound interest approach ignores the fact that higher dividend payouts (and lower capital gains) from utility equities advance the date when the investor earns his return. Stated more simply, compound interest does not recognize that a dollar of dividend income today is worth more than a dollar of capital gains ten years hence.

As will be shown below, when these factors are considered, returns from utility equities clearly dominate those of the non-regulated industrials.

June 1989 31

The Internal Rate-of-Return (IRR) Approach: Method II

Because various shor tcomings

exist in the average c o m p o u n d

rate-of-return m e t h o d of analyz-

ing inves tment performance, "it is

generally felt that d i scounted

cash-flow me thods provide a more objective basis for evaluat-

ing and selecting inves tment pro-

jects. These me thods take account

of both the magn i tude and t iming

of expected cash flows in each pe-

r iod of a project's life. "12

One of the principal d i scounted

cash-flow me thods is k n o w n as the internal rate-of-re~trn (IRR)

method. The IRR is technically

def ined as "the interest rate that

equates the present value of the expected future cash flows, or re-

ceipts, to the initial c o s t outlay. "13

In short, the IRR is the rate of profit on an inves tment after tak-

ing into considerat ion the t ime

value of money-- i .e . , that a dollar

received today is wor th more

than a dollar received one year

f rom today.

T he importance of a discounted

cash-flow approach is best seen at Table I in the following hypotheti-

cal example of two stocks ("A" and "B") with initial market values of

$100 each. Stock AIS a utility stock

with a not untypical yield of 10%.

Stock B is a nonutility stock with an

assumed yield of 5%. It is assumed

that the investor purchases each

stock at mid-year in Year 1, sells at

mid-year in Year 7, and that he re-

ceives one-half of the dividends

paid during the years of purchase

and sale in addition to the dividends of the intervening years.

Table I shows that in both in-

stances the investor was able to

double his initial $100 investment , earning a "profit" of $100. How-

ever, us ing the IRR approach, the

investor is far f rom indifferent as

to which stock provides a higher return. Using the s tandard IRR

formula, TM we see that Utility

Stock A has an IRR of 15.3% while

Nonut i l i ty Stock B has an IRR of

13.62% Thus there is a difference

in the IRR of some 12% in favor of

the utility stock.

The higher IRR earned by Stock

A is obviously attributable to the

advantage of receiving higher dividends du r ing the years of owner-

Dividends (10% yield)

Dividends (5% yield)

Table I : Comparison of Two Hypothetical Stock Plans

Utility Stock A

Year I Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 $5.00 $10.00 $10.00 $10.00 $10.00 $10.00 $5.00

($10 x .5) ($10 x .5)

Initial cash outlay for one share : $100 Selling price of stock at mid-year of the seventh year : $140 Total "profit" (selling price plus all cash dividends received, less initial purchase price):

Market price at time of sale $140 Plus cash dividends received 60 Less initial purchase price (100)

"Profit" $100

Nonu t i l i t y Stock B

Year I Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 $2.50 $5.00 $5.00 $5.00 $5.00 $5.00 $2.50

($5 x .5) ($5 x .5)

Initial cash outlay for one share : $100 Selling price of st~k at mid-year of the seventh year : $170 Total "profit" (selling price plus all cash dividends received less initial purchase price):

Market price at time of sale $170 Plus cash dividends received 30 Less initial purchase price (100)

"Profit" $100


Overall Average

Rank Return

Table 2 : Rank Order of 92 Electric Utilities' Rate of Return

(Method II : The IRR Approach)

Name of Electric Company Rank

Overall Average

Return Name of Electric Company

1 22.62% 2 21.54% 3 18.70% 4 18.66% 5 18.17% 6 17.65% 7 17.40% 8 17.31% 9 17.29%

10 17.28% 11 17.10% 12 17.04% 13 16.63% 14 16.44% 15 16.35% 16 16.29% 17 16.21% 18 16.11% 19 16.08% 20 16.06% 21 16.03% 22 15.82% 23 15.82% 24 15.75% 25 15.73% 26 15.60% 27 15.60% 28 15.58% 29 15.51% 30 15.47% 31 15.25% 32 15.13% 33 15.09% 34 14.82% 35 14.76% 36 14.60% 37 14.57% 38 14.52% 39 14.45% 40 14.36% 41 14.23% 42 14.21% 43 14.19% 44 14.08% 45 13.95% 46 13.94%

Consolidated Edison 47 13.86% Tucson Electric Power 48 13.80% Potomac Electric Power 49 13.78% Southern California Edison 50 13.76% Nevada Power 51 13.72% New England Electric System 52 13.59% Utilicorp United Inc. 53 13.55% Southern Indiana Gas & Electric 54 13.53% Wisconsin Public Service 55 13.51% Wisconsin Energy 56 13.44% Commonwealth Energy System 57 13.40% Iowa-Illinois Gas & Electric 58 13.27% Minnesota Power & Light 59 13.19% Baltimore Gas & Electric 60 12.89% Florida Progress 61 12.88% Orange & Rockland Utilities Inc. 62 12.84% San Diego Gas & Electric 63 12.68% Southwestern Public Service 64 12.57% Hawaiian Electric Industries 65 12.35% Delmarva Power & Light 66 12.30% Wisconsin Power & Light 67 12.12% Allegheny Power System 68 11.83% Kansas Power & Light 69 11.67% MDU Resources Group 70 11.45% Duke Power 71 11.45% St. Joseph Light & Power 72 11.42% Iowa Southern, Inc. 73 11.33% Northern States Power 74 11.21% Northeast Utilities 75 11.19% Public Service Enterprise Group 76 11.13% Teco Energy 77 11.01% Eastern Utilities 78 10.94% Midwest Energy Co. 79 10.81% Otter Tail Power 80 10.67% FPL Group 81 10.25% Dominion Resources 82 10.12% Utah Power And Light 83 9.95% Ipalco Enterprises 84 9.66% Scana Corporation 85 9.57% Union Electric 86 7.63% Pacific Gas & Electric 87 7.59% Empire District Electric 88 7.44% New York State Electric & Gas 89 6.56% Sierra Pacific Resources 90 6.01% Cilcorp Inc. 91 5.50% Atlantic Energy 92 4.56%

Kentucky Utilities Pinnacle West IE Industries Pennsylvania Power & Light Southern Company Central Hudson Gas & Electric Kansas City Power & Light Boston Edison Central Illinois Public Service Niagara Mohawk Power Carolina Power & Light Puget Sound Power & Light Central And South West Corp. Rochester Gas & Electric Philadelphia Electric Interstate Power Public Service Co. of New Mexico Pacificorp E1 Paso Electric Portland General Electric DPL, Inc. Detroit Edison Washington Water Power Co. Houston Industries Cincinnati Gas & Electric Public Service Co. of Colorado American Electric Power Ohio Edison Louisville Gas & Electric Oklahoma Gas & Electric Commonwealth Edison United Illuminating Central Maine Power Kansas Gas & Electric Co. Illinois Power Texas Utilities Bangor Hydro-Electric Co. Montana Power Duquesne Light Middle South Utilities Gulf States Utilities CMS Energy General Public Utilities Long Island Lighting Northern Indiana Public Service Public Service Co. of Indiana

June 1989 33

Figure 1: Internal Rate of Return Holding Periods Ending in 1988 (Method II)

I I Electric D S&P 400 I I VLIC

20.0%

c a,. ~s

" 15.0%

m

cc 1 0 . 0 %

c

5.0°/°

0.0% Stock Purchased In:

Electric S&P 400

VLIC

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

8.7% 10.4% 14.6% 15.5% 13.4% 16.4% 14.3% 16.8% 20.3% 21.3% 20.1% 17.8% 20.6% 15.9% 9.1% 9.9% 13.3%14.0%12.9%14.1%15.7%16.0%14.9%15.9%18.8%15.6%18.1%17.0% 8.2% 9.8% 13.6%14.6%13.2%15.0%16.1%16.5%17.0%16.9%17.9%14.3%17.0%15.1%

ship, which more than offsets a

lower market price at the time of sale. In the case of Stock B, the in-

vestor earns lower dividends but a substantially higher capital gain, due to a higher market sales price.

Nonetheless, Stock A returns the profit faster and is therefore more valuable.

U sing the IRR approach, the study documents that 67 out

of 92 utilities in the study (roughly 73% of the companies) generated average internal rates-of-return

which exceeded those paid to stock-

holders in the S&P 400 and that 66 out of the 92 had ~ exceeding those earned by stockholders of the average company in the VLIC (see

Table 2, previous page). The average shareholder inter-

nal rate-of-return for the electric companies over the 105 possible

holding periods was found to be 13.39% compared with an 11.89%

return for the S&P 400 and a

12.24% return for the VLIC.

T he reader will note that the

companies listed at the bottom of the rankings all have nudear-re-

lated financial difficulties. For example, Public Service of Indiana,

owner of the abandoned Marble Hill project, ranked last out of 92

companies; Northern Indiana Pub- lic Service Co. (ranked second to

last) owns the abandoned Bailly nudear project; Long Island Lighting

Co. (third from the bottom) owns the Shoreham plant, soon to be sold

to the New York Power Authority for $1.00.

The breadth of the electric utility performance can be seen in Figure 1, which displays the 14 holding periods which end in 1988. In 11 of the 14 periods, the electrics outperformed both the S & P and the VLIC indices. Over- all, out of the total 105 possible

holding periods, the electrics out-

performed the S & P Index about 70% of the time and out-

performed the VLIC Index about 80% of the time.

The Salomon Brothers Model

This article expresses the view that individual investors have earned returns from electric utility common stock which ex-

ceeded those of non-regulated industrial corporations over the 17-year period 1972-1988. But what of institutional investors with access to better market infor- marion?

S alomon Brothers utility wizard Mark Luftig has constructed a

computer model which identifies electric utility stocks as either undervalued or overvalued. For the 12- year period 1977-1988, the stocks se-

lected as undervalued re0amed 756% compmed with 278% for the


S & P 500. is The results are even

more impressive when dividend re-

investment possibilities are consid-

ered.

W h a t A b o u t F e d e r a l I n c o m e

T a x C o n s i d e r a t i o n s ?

Some of the return advantage in

the past has arguably been lost in

Federal taxes due to the nature of

the earnings (i.e., d ividends vs.

capital gains). Corporate stock-

holders, of course, can take advan-

tage of the dividends received de-

duction which under current law

allows exdus ion of 70% (85%

under old law) of dividends re-

ceived from holdings in corporate equities. 16

F p o r individual taxpayers, it is im- rtant not to overlook the spe-

cial provision contained in the Eco-

nomic Recovery Tax Act of 1981

which provided tax deferrals for

dividends reinvested in qualifying

electric utility equiV.17 Though this

provision has expired, it did pro-

vide individual investors with an

opportunity to shelter significant

sums of dividend income from cur-

rent Federal taxation. In addition,

Section 116 of the Internal Revenue

Code (repealed in 1986) allowed in-

dividual investors to exdude $100

($200 on a joint return) of dividend

income received from domestic cor-

porationsY 8 On a prospective basis

all dividend income is treated on an

equal footing with capital gains

under the terms of the 1986 Tax Re-

form Act. 19 President Bush's pro-

posal to restore the tax preference

for capital gains is not given a

strong chance of passage.

C o n c l u s i o n s

In light of the superior earnings

of the utilities and the impact of

the new Federal tax law changes,

it is clear that the argument often

advanced by utility representa-

tives regarding the " inadequacy"

of al lowed earnings to utility in-

vestors is un founded and wi thout

merit. Moreover, these results---

presented above and in the

NARUC report2°--challenge the

notion that investors will be un-

willing to risk capital when the

day arrives for financing the next

generation of power plants. •

Footnotes:

1. L. S. HYMAN, AMERICA'S ELEC- TRIC UTILITIES: PAST, PRESENT, AND FUTURE 109 (1988).

2. Id.

3. GPU Financial Picture Improves but Obstacles Remain, Chief Says, Wall St. J., May 5, 1983, at 24.

4. R. Rosenberg, The Dividend Cutting Experience of Electric Utilities: When the Unthinkable Becomes Merely the Un- usual, PUB. UTIL. FORT., April 28, 1988, at 12.

5. EEI Finance Committee, Financial Info, January 5, 1989, at 2.

6. Life After Shoreham (Advertise- ment), N.Y. Times, April 27, 1989, at D- 15.

7. J.V. Cleary, Jr., The Long Term Value of Utility Stock, PUB. UTIL. FORT., June 9, 1988, at 92.

8. Hit "em where they ain't, FORBES, Nov. 3, 1986, at 92.

9. PACIFICORP, 1986 ANNUAL REPT. TO SHAREHOLDERS 28.

10. M. FOLEY, M. LEHMAN, UTIL- ITY STOCKHOLDER RETURNS: 1972- 1988, (NARUC, May 1989).

11. The data points include 17 years of high and low market prices and annual dividend payments for each of

the 92 electric utilities included in the study as well as the S & P and VLIC indices. A "holding period" is defined as the number of years the investor owns the stock. The study calculates returns under each of the two methods for 105 distinct holding periods for each company ranging in length from 3 years to 16 years. There are, for example, 14 possible holding periods which end in 1988 as shown on the chart at Figure 1.

12. J.C. VAN HORNE, FINANCIAL MANAGEMENT AND POLICY 73 (1974).

13. J.F. WESTON, E.F. BRIGHAM, MANAGERIAL FINANCE 295 (1978).

14. The IRR Formula:

F = Cash flows (e.g; dividends and selling price) I = Initial purchase price of stock r = Internal rate-of-return t and N = Time Periods (years)

F1 F1 FN - - ....÷ - - I=0

(1 + r) 1 + (1 + r) 2 + (1+ r) N

N Ft - I = 0

t--~l (1 + r) t

15. M. Luftig and G. Enholm, Electric Utility Model Review in March--12 Year Update, Salomon Bros. (Mar. 1989); see also R. Bower, D. Bower, The Salomon Brothers Electric Utility Model: Another Challenge to Market Efficiency; FINAN. ANAL. J., Sept.-Oct. 1984.

16. 26 U.S.C.A. § 243.

17. Tax deferrals for qualified public utility dividends were provided by the Economic Recovery Tax Act of 1981 (P.L. 97-34 Section 243). This provision expired on December 31, 1985.

18. Exclusion of corporate dividends received by individuals under Internal Revenue Code Section 116 was repealed on October 22, 1986 by the 1986 Tax Reform Act (P.L. 99-514, Sec- tion 612).

19. Preferential treatment of long term capital gains was eliminated on Octo- ber 26, 1986 by the Tax Reform Act of 1986 (P.L. 99-514, Section 301).

20. Supra note 10.

June 1989 35

The pains and gains of electric utility stock ownership

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