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Transcript of New business model initiative
Phase 2: Linking to Value Creation
The New Millennium: The Future is NowAmericas Utilities Meeting 2000February, 2000
New Business Model Initiative
© Andersen Consulting 2000 2
Agenda
• Initiative Overview - Why This Is Important
• Emerging Hypotheses - Linking Shareholder Value to Strategies and Business Models
• Next Steps
© Andersen Consulting 2000 3
Our CEO Agenda Requires Articulating the Relationship of Shareholder Value Creation to Implementation Success
• Our Business Objective: Be the enablers in the execution of strategy
– Help our clients articulate their long-term strategies – Broaden the CEO agenda to include implementation - link our implementation
programs to his value strategies– GPU senior executive: “We want Andersen Consulting to be with us during the
journey…of implementing our eCommerce strategy.”
• Design and implementation cannot be separated from strategy - for example: – Retail access legislation - e.g., price freezes, mandatory reductions - will
establish jurisdictionally-specific cost break-even points– The appropriate CRM solution will need to meet these cost break-even
points
© Andersen Consulting 2000 4
• Understanding shareholder value creation in the energy industry today
• Articulating a long-term vision for the energy industry in the US
• Understanding major drivers of value creation and competitiveness in each major unbundled business segment, e.g., generation, trading, T&D, retail
• Developing differentiated perspectives of how each major business segment will evolve and how value potential will change as the markets mature
• Understanding key regulatory and competitive imperatives in each major region/state (e.g., Northeast, Mid-Atlantic, Texas, California, Southeast)
• Developing a framework(s) to identify key competitive imperatives in each business segment and region – for both incumbents and new entrants – based on our understanding of fundamental value creation
The Objective of the Business Model Initiative Is to Develop a US Market Vision That Links Shareholder Value Creation to Strategic Options
© Andersen Consulting 2000 5
Our Vision for the Industry in the U.S. Should be Specific Enough to Achieve Credibility with Senior Executives
Texas
California
Northeast
Mid-Atlantic
Midwest
Pacific Northwest
Southeast
• • •
Specific Regions/States
Generation Trading eCommerce T&D Retail • • •
End-Game
Transition Paths
Today — Status Quo
Time/Speed
BusinessSegments(Being de-aggregated in increasing numbers)
© Andersen Consulting 2000 6
Our Ultimate Objective Is to Develop a Coherent, Specific and Credible Long-term Vision That All Our Partners Can Present to their Senior Clients
Coherent • Builds upon the existing new utility business model foundation
Specific • Clients want our vision to be applicable to their business i.e., T&D in Texas; they are also very interested in our views on transition paths to the long-term end-game; and in the impact on their company share valuation
Credible • Our vision has to have roots in systematic economic and value creation/destruction analyses
Speed • We all need this vision and related strategy elements today
© Andersen Consulting 2000 7
Agenda
• Initiative Overview - Why This Is Important
• Emerging Hypotheses - Linking Shareholder Value to Strategies and Business Models
• Next Steps
© Andersen Consulting 2000 8
• Utilities traditionally created value through regulatory-mandated returns on capital investment – creating predictable cashflows and dividends that valued utility equity like bonds
• However, this traditional value model is breaking down.
• Traditional utility stocks are trading at p/e multiples of 13-15 – approximately 40% of the S&P 500 multiple …
• …And the linkage to traditional cash flow/share is eroding
Uncertainty Associated with Electric and Gas Deregulation Has Driven Nine Years of Industry Under Performance
0
500
1000
1500
2000
2500
S&P Tech IndexS&P500DJ Utilities Avg
© Andersen Consulting 2000 9
Most of Our Clients Are Not Capturing Market Value Today
• Most companies are characterized by stalled or empty growth - rather than fundamental value creation
• In particular, traditional sales and EPS growth indicators no longer appear good indicators of market performance
• Uncertainty associated with making the competitive transition is generally depressing valuations…
• … As are strategies that do not reflect the emerging value model
Performance Grid Stock Appreciation v. EPS Growth
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
-20% -1 0% 0% 10% 20% 30% 40% 50%
EPS Growth Rate
Stoc
k A
ppre
ciat
ion
Rate
Calpine
AES
Nimo
Con Ed
New Century
Ameren
MidAmerican
Enron
PECONEES
Duke Southern
TXU
Western
NiSource
CinergyAEP
Illinova DQE
Note: Axis’ cross at sample averages. Data represents 1997-99.
Avista
High-GrowthValue Capturers
Low-GrowthValue Capturers
Slow-GrowthStalled Companies Empty Growth
PG&E
© Andersen Consulting 2000 10
However, a Small Number of Top Performers Are Emerging - the Key Appears to be Alignment to Competitive Markets
• Companies embracing the new market structure stand apart from the pack: e.g. Enron, Calpine, AES, PECO
– Calpine: the only pure domestic unregulated generation play
– AES: 100% unregulated generation with significant international exposure
– PECO: aggressively growing nuclear portfolio; telecom
– Enron: integrated natural gas and electricity company with strong risk management and trading expertise
• Interestingly, the relationship to EVA appears to be breaking down - from an EVA/MVA standpoint, only PECO is outstanding (7th rank among utilities*).
Emerging Winners
0% 10% 20% 30% 40% 50% 60%
Average IOU's
Enron
PECO Energy
Calpine
AES
Profit Margin (1998) Sales Growth Rate (1996-99)Stock Appreciation Rate (1996-99) EPS Growth Rate (1996-99)
*Public Utilities Fortnightly, 12/99
© Andersen Consulting 2000 11
Deregulation is Increasing the Gap Between “Winners” and “Losers”
Simple Average Running 1yr Return by Strategy - DJ AdjustedGrouping by Corporate Strategy
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
Stoc
k Ap
prec
iatio
n
Supply Companies Distribution Companies Vertically Integrated Companies Diversified Companies
© Andersen Consulting 2000 12
The Challenge : Deregulation is Essentially Redistributing Risk and the Ability to Create Value in Any Specific Market Segment
• The Market Is Dis-aggregating Into Three Fundamental Segments
• As deregulation disaggregates the market into discrete segments, it essentially shifts/redistributes risk, and the ability to create value in any market
• Examining stock performance versus competitive intent can provide some insights into what business models are associated with superior value
Mass CommercialIndustrial
ValueCreationPotential
High Value Creation OpportunityMedium Value Creation OpportunityLow Value Creation Opportunity
— Value Chain —
Volatility
GenerationMarketing
&Trading
Transmission Distribution
Retail Services
Upstream: Supply Downstream: Retail
Moderate High Low Low Moderate Moderate Moderate
C: C: C:VAS: VAS: VAS:
Calpine, AES
Enron, Duke, Williams
DQE, Con Edison
PGE, Green Mountain, Utility.com
Vertically Integrated
Supply
Retail
Delivery
© Andersen Consulting 2000 13
• There are several key questions to understand in each market segment– Value creation model in each market segment– How each market will evolve and the impact on value creation over time– Linkages between each major segment; e.g. supply to trading, supply to
retail– Continuum of potential competitive positions and their value potential
over short and long-term– Business capability requirements associated with each segment; i.e.
profile of “winner”
Capturing Shareholder Value Long-term Requires Understanding How Value Will Be Created Along the Energy Value Chain Segments
© Andersen Consulting 2000 14
Some Clear Messages Are Emerging
• Strong generation, particularly those of focused merchants, and pure distribution plays are outperforming all other strategies
• Market certainty is being valued• The market is discounting complexity,
uncertainty and strategic “dabbing”, e.g. vertically integrated companies in states with impending retail access
• Strategies focused on aggressive sales growth and attention to EPS measures are not being rewarded
– Growth-based mergers without strong strategic synergies, e.g., CPL/FPC, PSCo/NSP, WR/KCPL
– Diversification plays are also being viewed with skepticism, e.g. Connectiv, SCANA, and Avista
– Though some, such as PECO’s and Montana Power telecom investments, have been successful to-date
Note: Bubble size represents standard deviation on stock appreciation. Datafor 1997-99.
Performance GridStock Appreciation v. EPS Growth
-30%-20%-10%
0%10%20%30%40%50%
-5% 0% 5% 10% 15% 20% 25%
EPS Growth Rate
Stoc
k Ap
prec
iatio
n Ra
te
RegulatedSupply PA/NJ
Diversified VerticallyIntegrated
Distribution
UnregulatedSupply
M&ACA
© Andersen Consulting 2000 15
0.28
12.72
7.67
17.99
1.81
13.74
10.21
0.77
18.91
10.28
71.2549
0 20 40 60 80
Beta
ROE
ProfitMargin
P/E Ratio
Utility Avg AES Calpine
For Example, Established Pure-Play Supply Companies Are Trading at 2x Multiples of the Industry
1.33%
2.80%
0%
1%
1%
2%
2%
3%
3%
RegulatedGeneration
UnregulatedGeneration
Market Comparison of Unregulated vs. Regulated Suppliers . . .
. . . From a Financial Standpoint, Maintaining Ownership of Assets
Under Regulation Appears Unattractive
© Andersen Consulting 2000 16
• The unregulated U.S. supply market is rapidly developing - and commoditizing– Merchant activity is accelerating - shifting the asset
profile in markets toward more flexible, efficient capacity– Large traders - increasingly squeezing the middle - are
emerging, predominately asset-backed– Since 1995, the volume of wholesale physical power
marketed has grown at a continuously compounded annual rate of 91% to approximately 2,500 Twh in 1999
– However, electronic trading is increasing and may reshuffle the competitive structure
The Emerging Supply Value Model :A Commodities Market Model
© Andersen Consulting 2000 17
Value Creation in the Unregulated Supply Market Will be Driven by the Competitiveness of Asset Portfolios and the Ability to Manage Volatility
• Fundamental value is driven by increasing the spread between the market price of power and the asset portfolio marginal costs - or the “spark spread”
• Generation is equivalent to owning a call option on the “Spark Spread’.
• Integrated risk management expertise and strategic siting of facilities are vital
Profit fromgeneration
Return onCall Option
Fixed Cost• capital expenditure• cost of capital • depreciation• non-fuel O&M
Fuel Sales andPurchases
Supply/DemandBalance
Profit fromtrading
Volatility ofSpark Spread
Option Premium
Power Salesand Purchases
Plant Heat Rate
Option Strike
Volatility ofgas price
Volatility ofpower price
Supply/DemandBalance
Fluctuationsin Supply
Fluctuationsin Demand
Fluctuationsin Supply
Fluctuationsin Demand
Storage
Transportation• inter and intra-regional
System Reliability
Transmission Availability• frequency of line outages
Imports
Exports
Intra-regionalflows
Generation Availability• frequency of unit outages
Weather
Trading Activities
Regional Characteristics
© Andersen Consulting 2000 18
Effective Management of Financial Exposure to Price Volatility Is Critical to Market Success
• The degree of volatility and how it is managed will evolve as the markets mature
– Shifts in capacity mix, availability, and transmission bottlenecks
– Improved understanding of optionally inherent to owning assets
– Development of ISO/RTO’s and related market controls
• The ability to manage assets in a manner that is responsive to market signals will drive financial performance of power market participants
Annualized One Day Volatility of Returns
0%
5000%
10000%
15000%
20000%
25000%
CinergyComEd
PJM
Entergy
FL/GA Border
ERCOT
Mid-Columbia
© Andersen Consulting 2000 19
The Supply Market Is Evolving to an Asset Optimization Model Built Around Commercial Re-integration
The Financial Markets Tend to Support a Re-integrated Commercial Business
Model . . .
. . . However, a Continuum of Trading Models Exist
Generation and Contractual Supply Portfolio
Trading Retail
Wholesale and LargeIndustrial Markets
Mass Residential
and Middle Market
External MarketPrice-Takers Hedgers Market
Markers
• IPP’s/Developers• Owns assets• No trading skills
• Owns assets• Trade around
their physical positions
• Speculation• May or may
not own assets• Trade without
or beyond their asset base
© Andersen Consulting 2000 20
The Financial Markets Appear to Recognize Specific Trading Business Models
• A fully hedged position appears the winning trading strategy among suppliers - highest profit margin with the most certainty
• Speculative plays can yield superior returns but with higher volatility
• Speculative trading have led to some significant debacles - Illinova, LGE, Cinergy, Federal, PCA
Performance by Trading Strategy
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Sales Growth Rate
Profi
t Mar
gin
Speculators
Riders
Hedgers
Note: Bubble sizes represent the standard deviation of profit margin as a percentage of total profit margin. Data for 1997-99.
© Andersen Consulting 2000 21
The Ability to Create Value in the Supply Market Will Be Influenced By Market Structures and Distinct Characteristics of Regional Models
Lack of Customer Phase In
Sales &Trading Trans Dist RetailKey Issue Gen
Shopping Credit or Standard Offer
Power Exchange Rule - Must Run
Power Exchange Rule - Must Bid
Brand Name
Market Power / Divestiture
Stranded Cost
POLR - Default
Mandatory Rate Reductions
Performance Based Rates
Facilities Operated
Accounting and Billing - Data Ownership
N F G
Positive ImpactUnclear ImpactNegative Impact
CaliforniaPJMMidwestNEPOOL
© Andersen Consulting 2000 22
Preliminary Hypotheses for the Deregulated Supply Market...
• Utilities should strip away generation assets from beneath the regulatory umbrella to the extent possible
• Market price will rise in the short-term but will likely decline significantly with new capacity - this is a game of chicken, and it is possible that parties will not back down until markets have become over-supplied.
• Sell marginal assets now - they will become less, not more, competitive and excess cash in the industry is lending to overvaluation of existing assets.
• However, the difference between winners and losers will be driven by the ability to understand risk and basic asset optimization
• Market development will drive players to an integrated market maker position - development only and non-asset trading positions will be tenuous
– Players that effectively manage risk and volatility - and have efficient assets - will succeed– Traders without assets are being largely shaken out– Speculators that own assets will struggle initially but will become more successful as market
liquidity and transparency improve
© Andersen Consulting 2000 23
• THE PLAY:
– Ride the volatility in the markets over the next few years, acquiring generation aggressively and trading around the assets.
– At first signs of waning interest in generation assets, SELL. – Ride the market on a reduced portfolio of assets for a few years until over-supply
begins to take effect on capacity retirements. – As retirement rates increase, scour the market for strategically located efficient
assets and BUY as companies who bought at the top release assets to cut losses
These Hypotheses Point to Strategies That Impacting the Extent and Timing of Capability Investments - For Example...
© Andersen Consulting 2000 24
Agenda
• Initiative Overview - Why This Is Important
• Emerging Hypotheses - Linking Shareholder Value to Strategies and Business Models
• Next Steps
© Andersen Consulting 2000 25
Status/Next Steps
• Work effort approximately 50% complete– Focus to date on fundamental shareholder value analysis
– Supply market analysis
• 3-4 weeks behind schedule due to staffing difficulties
• Next steps– Complete assessment of wholesale markets/market structure
– Begin deeper assessment of retail and asset business segments
– Schedule workshop(s) on emerging findings
© Andersen Consulting 2000 26