Down to the Wires

Even as California rushes into the dark, Nstar tries to prove that utility deregulation can work.

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Few industries had a simpler capital structure than utilities did when James J. Judge joined Boston Edison Co.’s rate department in 1977. Revenue was guaranteed by ratepayers, who also secured debt. Regulators set returns based on costs, which not only made utilities a classic widows-and-orphans stock pick, but also created an environment that encouraged investment in capital assets, such as power plants. And like most monopoly utilities, Boston Edison generated all the electricity it delivered to customers.

“Historically, we were considered a sleepy industry,” admits Judge, who worked his way up through the finance ranks to become Boston Edison’s CFO in 1995, and is now CFO of Nstar, the new parent of both Boston Edison and its sister subsidiary, Commonwealth Energy System.

But the industry is wide awake now, and all eyes are on California, where deregulation has led to rolling blackouts, skyrocketing prices, and possible bankruptcy for several utilities. For Nstar, the challenge is to prove it won’t suffer the same fate–despite the fact that, like California utilities, it divested its generating capacity.

“If you looked at our balance sheet in early 1998, the largest assets were a large nuclear unit and about 2,000 megawatts of fossil generation,” says Judge. “Today, we find ourselves with no generation, yet we’ve doubled our size in terms of number of customers.”

To make that leap–from local metropolitan utility to regional holding company–has meant shedding all ties to power generation as well as creating an entirely new capital structure. And Judge’s “ability to map a comprehensive and complex financial strategy,” says CEO Thomas J. May, has been “instrumental in creating the vision and executing the strategy” that has led to Nstar. Wall Street may still be cautious about the investment value of the new entity, says Judge, but one thing is clear: “Over the past 30 months, there has been more dramatic change in this company and this industry than over the past 30 years combined.”

CORE DECISION

That change was dictated by the Federal Energy Regulatory Commission’s 1996 decision to open up the long-distance transmission wires to competing wholesale power generators. Customers who once had no choice but to buy energy generated by their local distributor could now shop around for the cheapest source. But for that alternative power to actually reach those customers, state legislators had to force local monopolies–such as Boston Edison–to deliver it over their distribution systems. And those monopolies had to decide whether they wanted to be unregulated generation companies (gencos) that sell power, regulated distribution companies (discos) that deliver genco power, or both.

At Boston Edison, Judge and his colleagues knew they couldn’t compete with generation giants such as Duke Energy Corp. and Enron Corp. And since regulators in Massachusetts were pushing for a complete separation between gencos and discos, the dual option was out. Consequently, given its track record as a well-run utility and its adeptness at working with regulators, Boston Edison opted for a pure disco strategy, focusing on owning and operating the “pipes and wires” that provide the last mile of service to customers. “We saw the generation business as being very volatile,” says Judge, “and in the long run, having relatively thin margins.”

In the short run, however, the decision meant losing a significant chunk of its old business–the generation component that had served New England and Boston Edison well for more than a century. And, nostalgia aside, the transition came at a price. The cost of power plants built in a monopoly environment couldn’t be fully recouped in the new competitive landscape, and Judge didn’t want his shareholders to eat the $725 million difference. “We were concerned about major write-offs and potential stranded cost disallowances, and we refused to believe that had to be accepted,” he says.

In 1997, Judge and his financial team began negotiating a unique securitization plan with state regulators. “We took advantage of a complex financing vehicle that allowed us to cash out of our remaining sunk investments in those generating assets without any major write-offs for shareholders,” explains Judge. With the basic outline of this plan included in deregulation legislation passed in November 1997, Boston Edison was ready to say good-bye to its power plants.

PURE DISCO

It didn’t take long. In May 1998, Boston Edison sold its six fossil-
fueled power plants to Sithe Energy for $657 million. Then, in July 1999, Boston Edison sold its Pilgrim plant–the first sale of a nuclear power plant in U.S. history–to Entergy Nuclear Generating Co. of New Orleans for $81 million.

Immediately after the sale of the nuclear plant, the securitization plan went into effect. As agreed, Massachusetts purchased $725 million in notes from a special entity set up by Boston Edison. The state then sold $725 million in bonds to the public, secured by a special transition charge that Boston Edison will collect from electric ratepayers during a period of 10 years. To keep ratepayers happy, the deal also included an immediate 15 percent rate reduction.

Because the rate reduction bonds were nonrecourse to Boston Edison, they were also off-balance-sheet, which was in line with Judge’s goal of “dramatically improving the strength of the company’s balance sheet.” With its generating assets sold and its stranded costs recovered, Boston Edison was now a pure disco.

“The company made the right choice by getting out,” says utility analyst Richard Baxter of Boston-based Yankee Group. “It was not big enough to survive in the evolving wholesale generation market.” But deregulation also kicked off a frenzy of consolidation that essentially put every utility in the Northeast in play. To thrive as a pure service provider, the company needed more customers and more services.

So, flush with cash from the power plant sales and the securitization, Judge went shopping. In December 1998, Boston Edison announced the acquisition of Commonwealth Energy, which added 630,000 gas and electric customers to Boston Edison’s base of 670,000 electric customers, and formed the basis for a new holding company, Nstar.

The merger stood out as a model of discipline among the industry’s increasingly expensive couplings. To create the new $4.4 billion company, Boston Edison paid Commonwealth Energy shareholders a premium of 17 percent. Current shareholders could receive shares of Nstar or cash, up to $300 million. This cash outlay was financed, again nonrecourse to Boston Edison, with the proceeds from the securitization. And the merger was completed in eight months–“record speed” in the industry, says Baxter.

While the price for Commonwealth Energy reflected what Judge calls “a relatively modest premium,” the speed of the deal reflected something more. Like the securitization and the sale of the Pilgrim plant, it was another indication that Nstar executives are adept at working with regulators.

Going forward, regulatory savvy “must be a core competence for a regulated company,” notes Andrew Levi, New York­based director of the global utility group of CS First Boston. Even though regulators now set utility returns through market-based incentives rather than through traditional rate cases, they will still wield power over Nstar’s financial future. “Clearly, our bread and butter is our regulated electric and gas business,” notes Judge. “I don’t think you are going to see us diversify or lose that focus.”

BUMPS IN THE ROAD

Still, not wanting to be left out of the upside on the unregulated side, Judge has worked hard to expand the services that fit Nstar’s distribution model. The results have been mixed. Case in point: its partnership with Princeton, New Jersey­based telecom, Internet, and cable provider RCN Corp., which combined its switching capabilities with Nstar’s ability to construct wire networks, and may ultimately allow Nstar to bundle RCN’s services with its gas and electric offerings.

To date, Nstar has invested about $250 million in RCN, and Judge expects to invest another $100 million. Throughout 1999, the investment paid off, with Nstar earning more than 100 percent and boosting its stock price in the process, says Levi. But Nasdaq’s April 2000 plunge hurt. Nstar held its 5 million RCN shares, which sank from a high of $70 a share in February to about $15 by mid-December. “The only bad decision Nstar has made over the last several years was holding that stock,” says Levi. Nstar bought the stock at a low price, so it didn’t suffer big losses, he notes, “but there were some big gains [that weren’t realized].”

There have been other setbacks. Power shortages in California forced San Francisco­based Pacific Gas & Electric Co., Rosemead-based SoCalEdison, and San Diego Gas & Electric Co. to buy high- priced power on the spot market last summer. SDG&E passed those prices on to customers, creating a public relations disaster. Meanwhile, PG&E and SoCalEdison terrified investors by building up billions in “deferrals”– losses on pricey power purchases that can’t be recouped until regulators approve rate increases.

The highly publicized plight of these California companies hurt Nstar’s stock, which dropped from $46 in May to $39 in August. Adding insult to injury was investor flight to the generation sector of the utility market, where shortages were causing a boom in profits, which dropped Nstar to $36 by November. Nstar closed the year just above $42. “What I have been trying to do,” says Judge, “is get the word out that Massachusetts is not California.”

Indeed, although Nstar also got hit with higher prices last summer, they weren’t anything like the spikes caused by western power shortages. And Nstar got relief from state legislators, who promptly raised rates to cover the higher costs.

That’s a far cry from California, where rate hike negotiations reached an impasse that threatened utilities with bankruptcy and led Gov. Gray Davis to call for radical changes to deregulation. “We must face reality,” said Davis in his January 8 State-of-the-State Address. “California’s deregulation scheme is a colossal and dangerous failure.”

Massachusetts legislators, Judge notes, allow utilities to charge customers a fairly high rate. “It is high to avoid creating deferrals, but the byproduct of that price is that it encourages third-party providers to develop a competitive market.” Approximately 10 percent of Massachusetts customers are now purchasing electricity from alternative providers. And with generation competition growing, analysts agree that the disco strategy–which guarantees a captive audience–is a safer long-term bet in New England than is generation.

PLUGGED IN

Convincing Wall Street, however, may take some time. The Dow Jones utility index, for example, still lumps gencos and discos together, causing Nstar to pale in comparison with California gencos. But both Levi and Baxter agree that Nstar is on the right track. “Nstar stock is trading at 10 times our 2002 estimate, with a 9 percent growth rate and a 5 percent yield,” notes Levi.

“What Nstar needs to do now is weather the storm of having analysts figure out how to value these companies,” adds Baxter. By focusing on serving customers and providing new offerings like cable TV and Internet access through RCN, he says, “Nstar will be seen as a customer-service company, rather than as a utility, and will be valued as such.”

Judge agrees. Despite the recent setbacks, he notes that “during this last three-year period, we clearly outperformed the industry in terms of total shareholder return. And if you look at analyst estimates going forward, the expectation is that that trend will continue.” In other words, says Judge, Nstar has the power not only to survive, but also to thrive.

Tim Reason is a staff writer at CFO.

Nstar: Has It Got the Power?

Nstar CFO James J. Judge insists that the company will continue to make “smart deals” similar to its acquisition of Commonwealth Energy System. And it appears to be in good shape to do so.

Between year-end 1997 and year-end 1999, Judge bought back a total of $535 million in high-cost debt, reducing the company’s weighted average cost of long-term debt by 50 basis points. And cash from securitization and the sale of its power plants also went to buy back Nstar stock–about 11 million shares of common stock by the fourth quarter of 2000. Additional financing for the repurchase program came from the commercial- paper market, which Emilie O’Neil, Nstar’s director of corporate finance and cash management, estimates saves Nstar at least 50 basis points over traditional bank lines.

“The redeployment of the cash positioned us with a capitalization structure on our balance sheet that was much more stable and secure than it had been previously,” says Judge. “We now have bond ratings that are the strongest we have had in over 20 years, and our equity ratio, a key indicator of financial strength, is the strongest it has been in over a decade.”

Judge says the target equity ratio for the utility subsidiaries is about 50 percent, which allows the utilities to maintain their credit ratings, keep the cost of capital low, and achieve allowable returns. At the Nstar holding-company level, the ratio is closer to 40 percent, allowing Nstar to buy back shares and finance unregulated capital requirements. “A 40 percent equity ratio is fairly conservative, especially for a regulated wires company,” admits Judge, “but we think it is important to maintain a strong balance sheet.” And that, he says, allows Nstar “to be well poised for future transactions if they meet our criteria.” –T.R

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