The daily drubbing of bad news within the energy merchant sector might indicate that the downgrades, asset sales and layoffs are characteristic of the entire energy industry, said Standard & Poor’s (S&P) in a recent report. However, the sector’s problems began “well before” California’s power crisis and Enron Corp.’s bankruptcy, and then were hit by collateral damage. Despite the upheaval, however, companies that have kept their solid, less dynamic cash flow from physical energy assets still retain their “investment-grade characteristics.”

S&P noted that the “credit quality of most participants engaged in the generation and delivery of electricity remains healthy. This is not to say that there has not been collateral damage caused by the headliners. Indeed, it is hard to escape the effect of daily press accounts of the energy industry that always seem to lead off with something like, ‘In yet another blow to the industry…'”

However, the companies that “have stuck close to their roots, or not strayed very far, remain in good financial shape with reasonable leverage ratios and cash flow generation.” Where deregulation “survives,” as in Texas, “the plan of industry reorganization is clear and readily understandable, it stretches out over many years, the native traditional wires businesses appear well protected, and generation resources are well suited to comfortably meet load projections.”

Just like the “last round of diversification mania in the 1980s, corporate managements are de-emphasizing their non-utility investments, and, if at all possible, focusing investors’ attention on the amount of consolidated cash flow or operating earnings that their utility business provides.” Those vertically integrated utilities and transmission and distribution utilities “are the antithesis of asset-light strategies, relying instead for earnings growth on the revenue-generating capabilities of hard, tangible and easily definable assets.”

Companies emphasizing their vertically integrated structures are retaining their “A-” rating, said S&P, but “utility holding companies that have ventured too far afield from their core competencies have suffered a weakening in their market capitalization, and in many instances rating downgrades.”

Noted S&P, “Whether deregulation is the cause of the market turmoil, which we do not believe, is probably irrelevant. Perception is the key, and between the California meltdown in 2000 and early 2001, and Enron, any forward momentum for a few years in this respect is likely stalled. Only about one-third of the country’s generation actually operates in a competitive environment.”

Traditional utilities that have moved into non-regulated activity have seen their credit quality suffer, said S&P, which noted several examples, including Public Service Enterprise Group, Allegheny Energy Inc., XCEL Energy Inc. and the “big” Wisconsin utilities. “On the other hand, in response to Standard & Poor’s concerns over the credit impact on its utility subsidiary of non-regulated ventures, PPL Corp. structurally insulated its electric utility through a ring-fencing structure to create an explicit foundation on which to separate the default characteristics of the different family members.”

S&P said its “greater concern is with the absence of attention that regulators appear to give to utilities’ non-regulated investments, and the threat to utility credit quality that these present. A survey of regulators and commission staffs sponsored by Standard & Poor’s earlier this year would indicate that credit quality is fairly low on the hierarchy of priorities. Nevertheless, regulatory outcomes over the decades have generally supported strong credit characteristics for this industry.”

The credit ratings agency also noted that many companies are “revisiting” their roots, using as an example Aquila Inc., which is pulling out of the merchant sector by this summer. “Aquila Inc. now impresses on investors the fact that 70% to 75% of operating earnings come from the ‘traditional side of the business.’ The company’s president was recently quoted as saying, ‘…we’ve become known for our trading expertise in the merchant energy sector, but our roots run deep in the regulated utility network business, where the company has 85 years of experience.’ This is a dramatic change of emphasis indeed from early in the year when the company was encouraging investors to recognize the energy merchant strategy as its core strategy.”

S&P said it expects entities that emphasize their vertically integrated operations to remain “solidly investment-grade despite the turbulence swirling around them. For many investors, companies with such an emphasis offer a refuge from the chaos and uncertainty affecting their more aggressive counterparts.”

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