The US investor-owned electric utility industry just reported financial numbers for 2018.They were puzzling to put it mildly. According to the Edison Electric Institute (EEI), kilowatt-hour output rose 2.9%— an astoundingly robust increase. This sharply contrasts with recent history — almost a decade of no growth. This is also a strong departure from the electricity usage to US GDP ratio which had been in a long term secular decline and trending below 50%. Our current sub 3% US GDP rate would suggest a domestic kilowatt sales growth rate of under 1.5%.
The electricity industry sits at the confluence of a broad number of economic transitions. In the US, several unrelated forces have combined to restrain electricity growth: increasing efficiencies in usage (lighting, cooling and other commercial/industrial applications) and the transition in the US from a manufacturing to more service oriented economy. In regards to the latter, a large hospital may have the same number of employees as a steel mill but its operations require far less electricity.
The question is, have kWh sales finally snapped out of a long torpor during which the economy grew without any corresponding increase in kWh sales? Well, not exactly. US weather conditions — especially during the energy intensive air conditioning season— accounted for the reported sales gain. On a weather-adjusted basis, (we wonder if this phrase will soon have to be in quotes), the EEI estimates that sales rose only 0.1%—more indicative of what one would expect in a sluggish economy. Nonetheless, from a shareholders perspective growth is growth.
The electricity industry boosted by air conditioning sales as customers uncomfortably adjust to a warming planet is an irony wasted on no one. We kept expecting proliferation of electric vehicles to boost electricity sales. Instead, the climate or weather itself has proven a plus for industry sales.
Financially, the industry’s numbers were both revealing and discouraging. Revenues rose 1.5%, net plant 2.9% and capitalization 3.8%. Net income (excluding extraordinary items), the so called bottom line, dropped 2.2%. Given changes in share count this equates to a 4% decline in earnings per share. Interestingly, despite the weather influence, this looks like a continuance of recent industry financial trends: the top line grows at glacial pace while companies significantly increase assets. In utility parlance assets are called rate base. And more rate base equals more earnings growth. If this seems like a chicken and egg problem it is.
Reported earnings, which reflect non-recurring and supposedly extraordinary calamities, actually fell 19%. This includes the out-sized write off taken by California’s PG&E when it filed for bankruptcy. Is it unfair to draw financial conclusions using numbers that include supposedly unusual or non-recurring items? This is part of a much longer discussion. However, the industry steadily reports “nonrecurring” items almost every year (nonrecurring losses in 9 of the past 10 years, in fact). In the ten years ended 2018, the industry averaged $38 billion per year net income before subtracting those supposedly unusual losses and $29.5 billion taking them into account. The electric utility industry, like others, consistently writes off bad investments and otherwise incorrect assessments of risk and obsolescence. For all purposes, these are normal, recurring items.
From a purely operational standpoint, operating margin (revenues less cost of generation and gas purchased) fell 1%, and pretax operating income fell 13%. So how did net income before nonrecurring charges only drop 2%? Simple, the income tax rate dropped from 20% to 3%. And add on this caveat: if weather conditions had been “normal” (whatever that means) we estimate that utility operating margin would have declined by at least 2%. This translates into a decline in pretax operating income of at least 15 % and at minimum a 4% fall of net income before unusual items. As we said, weather propped up the industry’s numbers.
Despite higher kilowatt hour sales and revenue growth, industry finances deteriorated last year. Interest coverage, which measures levels of bondholder protection, fell from 3.1x to 2.7x and the industry average return on equity (ROE) adjusted to exclude extraordinary items) fell from 11.3% to 10.9%. Reported ROEs, that is earnings after disasters and miscalculations, declined from 9.0% to 7.0%. The EEI tends to revise its numbers, though, so the trends show direction more than magnitude. However, we should point out that given a 2% yield on ten year US treasuries, a 7% utility industry ROE would not be a departure from long term regulatory spreads.
The bottom line? In 2017 it looked as if the electric industry had finally broken out of years of financial stagnation. The year recently concluded now makes one wonder. The industry still faces big capital expenditures in all areas of operations: generation, transmission as well as distribution. While free cash flow deficits quadrupled from 2009 to 2018. This has occurred while both fuel and interest expense, the utility’s largest operating expenses, both declined dramatically.
There is an emerging consensus that electrification is a key ingredient in combatting global climate change. But at the end of the day electricity—no matter how vital or integral remains a commodity product. And everyone wants/needs the commodity, but the seller? Perhaps not so much. To us the recent financial numbers are like a warning light telling us the industry must improve its finances while keeping prices at reasonable levels— or some other, cheaper provider might.
By Leonard Hyman and William Tilles for Oilprice.com