Wider latitude to make judgment calls away from financial metrics
Reduced number of credit metrics
Raising the bar via “Business Position” rankings
Focus on qualitative issues in addition to quantitative
Cost of Capital Reflects Perception of Risk Note: 1 Utility S&P credit rating index spread against the 10-Year Treasury Utility Credit Spread 1 Source: S&P, Bloomberg Companies with lower credit ratings have higher and more volatile cost of capital Utility Ratings - Sep 2001 Utility Ratings - Sep 2004
Investors expected to focus on total return anchored by a strong dividend yield
If historical relationships hold, multiple compression may occur given interest rate forecasts
an R-square statistic of 78.9% suggests high correlation between Treasuries and P/Es over the last 27 years
P/E Analysis Credit strength and financial flexibility will continue to be focal points 4.13% 12.5x 5.30% 14.4x
Regulation vs. Perceived Risk in the Utility Industry 1 4 7 10 13 0 1 2 3 4 6 7 8 State Regulatory Rating Corporate Credit Rating Average Below Average AA A BBB BB B Above Average Source: Analysis includes 94 utilities. Credit ratings by S&P as of 10/7/04. State Regulatory Ratings by Regulatory Research Associates as of 4/12/04 Utilities operating under constructive regulatory environments have received better credit ratings 1 3 5 2 1 2 3 2 1
Avoiding the Vicious Cycle of Under-Recovery Restricted access to capital Higher borrowing costs Weaker credit metrics Need for rate increases beyond original amount Less-than-adequate returns and under-recovery of prudent costs Shift in business-risk perception makes this all the more crucial
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Industry Valuation Drivers: Long-Term Growth 5 (a) Based on rounded Lazard Core Utility Index median. As interest rates rise and dividend yield alone is no longer able to sustain current premium Industry valuations, investors will again begin to discriminate more on the basis of utilities’ total return propositions
Consolidation Strategy: A Fundamentally Consolidating Industry 6 (a) Includes 66 Electric Investor-Owned Utility Holding Companies.
One “win-win” solution would be to create a comprehensive regulatory environment supportive of utility consolidation that directs a significant portion of the derived merger synergies toward infrastructure investment
If 50% of merger synergies were directed towards investment in reliability and the top 100 utilities merged to create only 50, it could result in as much as $50 billion in derived cost synergies allocated towards system investment
In an environment with many pressures that may otherwise require rate increases, rate increases to fund investment may be politically challenging
Directing the shared cost savings in a merger could, therefore, create benefits for all constituencies
Regulators: achieve significant reliability spending while avoiding/mitigating rate increases
Ratepayers: avoid shouldering the entire burden of infrastructure investment
Utilities and shareholders: benefits of cost efficiencies, economies of scale and improved financial strength
Investment ultimately requires an appropriate return; if rate increases are unpalatable, then access to the embedded economies of scale from Industry consolidation could ease the burden of infrastructure investment and create benefits through further system reliability and financially stronger utilities