Financial review: The measure of management

Electric Perspectives, Sep/Oct 1995 by Moulton, Curtis

It used to be that all a utility had to do was provide financial statements, discuss its construction program, chat a little about the growth of the economy and electricity sales, and bond rating organizations, such as Standard & Poor's (S&P), would give you a bond rating. And probably not a bad one at that.

Well, maybe it wasn't that simple, but compared to the present, it sure seems that way. Today, as the electric utility industry is gradually deregulated, utility management plays an increasingly critical role in how S&P evaluates an electric company's long-term credit strength. This is a state of affairs that other industries--which don't have the benefit of captive customers and fairly sure return--are used to. For them, management (not regulation) generally charts the course and bears the greatest responsibility for current situation and future direction.

And for an investor-owned electric utility, not only is there greater analytical weight attached to how management is handling things, but there is also the fact that the industry is in transition--which demands greater management prowess.

Management is one of six key qualitative criteria that S&P reviews--the others are markets, competitive position, fuel and power supply, operations, and regulation. Ten years ago, S&P looked at most of these factors, but quantitative reports ruled the day. Of course, the quantitative is still critical, but management and competitive position are likely to be the two most important factors as the industry undergoes the transformation from a regulated to a competitive environment. And while other factors can influence results, the quality of management ultimately determines the company's success in trying times.

Your Record

So, what are we looking at when we look at management? S&P reviews four major areas: the record of achievement, strategic and financial planning, management depth and succession planning, and commitment to credit quality.

A company's ability to deliver electricity with high reliability and low cost is primarily due to the quality of management, and so the record of achievement in operations provides solid evidence of management quality. It's straight forward: Nothing speaks louder than results. High availability and capacity factors, low heat rates, and low production costs--both variable and fixed--demonstrate strong generating plant performance. Numerous and flexible interconnections and high reliability reflect strong transmission operations. Superior power quality and high reliability on the distribution end show strong operations there.

Financial achievement is achievement over the long term, shown by solid returns on assets and equity. Strong and steady operating margins over time provide a healthy history that bodes well for a utility's positioning for the future. Short-term earnings fluctuations (from increased or depressed sales due to unusual weather, for example) are meaningless, unless they signify the beginning of a longer-term trend. Quick earnings due to aggressive cost-cutting, for example, may have a long-term rebound effect if service suffers later on--the cost-cutting is not permanent but merely deferred. Depressed earnings due to the write-off of uneconomic plant may put the utility in a better earnings and competitive position further on down the road.

Your Planning

Financial and strategic planning are critical. What are management's goals and objectives? The perspective is for the long-term and oriented to credit quality. Still, S&P is interested in the short-term tactics that position the utility for the long term. A distant goal may be, for example, vertical disaggregation, but the important short-term tactic may be the formation of separate business units, to facilitate corporate unbundling later on. Another example would be installing a customer information system--expensive in the short term but perhaps necessary if the long-term objective is to improve customer service. For a few troubled companies, short-term hurdles are more important, but for most investor-owned utilities, S&P is interested in management's perception of the future and how it plans to get there.

Once you have goals, you need to establish benchmarks or achievement levels to indicate progress. A proper management analysis then can compare business strategies and financial plans over time, try to discern the reasons that they changed, and find out what that may indicate about management's approach to the future. How is management able to recognize and adapt to change? The purpose is to differentiate between managements with thoughtful, flexible solutions (showing pricing and service flexibility for industrial customers, for instance) and those afflicted with wishful thinking (stating, for instance, that their industrial customers are different from others and are not primarily interested in price).

To protect fixed-income holders over the long term, management is expected to have a well-considered game plan for meeting the challenges of increasing competition, unpredictable load growth, uncertain regulation, environmental costs, and evolving technologies. It must also develop revenue-enhancing services and products without adding undue risks. At the same time, management has to contain costs and avoid unjustified ones. It's not an easy task, and it demands careful thought. And it may take time to determine whether costs have been indiscriminately slashed or whether the utility has thoughtfully downsized--if a utility is successful at reducing costs but not at improving quality, it won't be successful. It's helpful for the utility to show specific details and examples of cost-cutting to the rating organization--that helps demonstrate systematic actions rather than ad hoc slashing.