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The Power of the Balance Sheet

Power company Duke Energy outperformed the utility index despite a drop in sales volume and a pending regulatory approval. CFO Lynn Good preaches t...
Marie LeoneSeptember 11, 2009

During the second quarter, sell-side analysts noted, the stock of Duke Energy Corp., the third-largest electric-power company in the United States, outperformed the utility index. Yet in that quarter, Duke reported flat earnings before interest and taxes compared with the same period last year, while sales volume slumped 6%.

Why does the market like Duke? Great execution of the finance strategy and a strong balance sheet, says its new CFO, Lynn Good, who was named to the position in July.

As an electric-power company — with 75% of its business regulated — Duke Energy has strong cash flow, but significant capital requirements. So the challenge is raising capital during a recession, and working to offset the recent decline in sales volume. To that end, CEO Jim Rogers and Good have announced some cost-cutting measures, and explained the company’s strategy of separating its capital needs for the next five years into three buckets: committed capital, so-called ongoing capital, and discretionary capital. According to Good, the bucket strategy keeps the company nimble.

Ongoing capital, which includes maintenance and programs to add customers, provides Duke with some flexibility as to when it can be spent. Discretionary capital, which affords the company even more flexibility in terms of timing expenditures, “allows us to respond to trends in our businesses by either delaying or not spending the dollars,” noted Good in a recent earnings call.

As a power-industry veteran, Good, 50, knows quite well which capital levers to pull and when, and no doubt a slow economic recovery will put her to the test, although her background could not have better prepared her for the task. Before being named finance chief at Duke Energy, she spent 18 months as president of the company’s nonregulated business, which includes power generation in the United States and Latin America as well as the telecommunications and renewable energy units.

Good’s electric-power roots can be traced back to the early days of her career. After graduating from Ohio’s Miami University, she signed on as an auditor with Arthur Andersen and was soon assigned to electric-power company clients. After being named a partner at Andersen, Good moved to Deloitte & Touche in 2002 before making the leap into the industry as vice president of financial-project strategy for Cincinnati-based Cinergy. She quickly was named controller, and in two years’ time was appointed CFO of the company.

Duke Lynn Good“In this environment, the reductions are prudent. Costs are the one thing we can control. We don’t control the weather. We don’t control the economy. But we can be good stewards of our resources.”Duke Energy CFO Lynn Good

Within a year, everything changed. In April 2006, Cinergy merged with Duke, and Good was tapped to be treasurer, paving the way for her recent appointment as finance chief. Today, Duke generates $13 billion in annual revenues, and at the end of 2008 reported net income of $1.4 billion.

Good talked with recently about how Duke is handling the sluggish economy, her thoughts on capital-raising efforts, and whether the “safe” utility stock will flourish when the market returns.

In the midst of a recession, Duke managed to raise $1.65 billion in fixed-rate debt during the first half of the year, with a weighted average rate of 6.1%. What’s your capital-raising secret?
We came into the crisis with a very strong balance sheet. We are rated A-minus by Standard & Poor’s, and BBB-plus by Moody’s. Our debt-to-cash ratio at the start of this crisis was probably in the 40% range. So we had some stability with regard to the balance sheet that enabled us to move through the crisis. And although we’ve seen deterioration in our sales volumes, we’re still profitable, and we’re still generating cash flow. Duke has had an extraordinary track record during this period of financial upheaval. By that I mean we’ve had access to the market almost every day — we’ve had no problems issuing our commercial paper — and there’s been a lot of appetite for our long-term debt.

Was the new capital earmarked for specific projects?
We are a capital-intensive business, so we finance some spending through the debt markets. We also have debt maturities that we’ve refinanced, which are a combination of both, maturities [coming due] and new issues. It was a routine issuance; it’s just ongoing capital-raising.

Would you consider taking advantage of low floating rates?
Because we are financing long-term assets [such as power plants], we are not interest-rate speculators. We have a targeted mix in our portfolio of fixed- and floating-rate debt — year in and year out. And we have not changed our view of that in light of current conditions.

You predict some further cost-cutting, such as an additional reduction in capital expenditures of between $200 million and $300 million this year, as well as a $150 million cut in operation and maintenance costs. Is the belt-tightening to offset the current “softness” in sales volume, or to better prepare for future shortfalls?
I would say the reductions are twofold. We are trying to size the cuts in our spending consistently with the shortfall in volume sales that we’ve seen in 2009. [Year-over-year, Duke’s sales volume for the second quarter was down 6%, or $45 million, mostly due to a slowdown in industrial customer operations.] So we’re trying to keep pace with that in some measure.

But we also launched an initiative at the beginning of 2009 to really look at our cost structure across the board, and to institute a level of capital and cost reduction into the future that’s sustainable. So that piece of it is longer term. In this environment, the reductions are prudent. Costs are the one thing we can control. We don’t control the weather. We don’t control the economy. But we can be good stewards of our resources.

Other than cost-cutting, what risk-management tactics do you use?
Well, certainly insurance. And then our risk-management function really looks at risk throughout the business — from macroeconomic risks to more specific risks related to commodities, such as coal, gas, and electricity. It’s a routine process. [Regarding our Latin American operations,] we do not hedge our foreign-exchange risks. We typically finance in the currency of the country, so again we have a capital structure that’s balanced. [Duke also has] a captive insurance company that insures a variety of things, and we make a judgment call on whether to self-insure versus buy a policy. Those decisions are made based on market conditions and other factors.

With respect to the financial health of your customers, have you had to tighten your credit policies to protect your receivables?
I wouldn’t say we’ve changed credit policies, but we are monitoring payments very closely. We have long-established credit policies related to how we deal with vendors, suppliers, and customers. We have seen some increase in delinquencies and bad debts from customers, but it hasn’t been material.

During the second quarter, an increase in competition from other power companies operating in Ohio put pressure on your unregulated business unit. As a result, about 10% of your retail customers in Ohio switched to another company. During a recent conference call, you addressed the impact of the switching. Would you talk about that?
The impact wasn’t significant. During our earnings call, one analyst posed a hypothetical question about what would be the impact on EBIT if we had a full year of customer switching at the rate that occurred as of June 30. The answer to that hypothetical question was $0.02 to $0.03 per share — but that is without any mitigation. By that I mean, we have the ability to compete in Ohio through our retail-services affiliate to win some of the customers back. So the two-to-three cents would assume that we would lose all of them.

In the second quarter, Duke experienced a 19% drop in industrial sales volumes. (Industrial sales account for 24% of the company’s 2009 sales.) Why weren’t industrial margins hit with the same percentage decline?
Industrial tariffs usually have a component of fixed demand charges, as well as a component of variable costs. So the impact to margin would be less than the impact of the 19%. In the first quarter, we disclosed that even though we had a 19% decline in industrial sales, and 5% overall decline, our margins were only down 2%. So that’s the order of magnitude of the impact. Margins just don’t sink as rapidly as volume because there is a demand component, a fixed charge, that industrial customers pay without regard to the amount of energy they actually take.

Duke’s nonregulated generation business reported second-quarter EBIT from continuing operations of $79 million, compared with $235 million year-over-year in Q2 2008. Among the causes for the decline, the company cited mark-to-market losses on economic hedges as compared with gains reported last year. Were these the same kind of fair-value accounting losses banks complained about earlier this year?
The variability in the mark-to-market impact was primarily driven by coal positions. Coal prices were increasing quite rapidly last year, and decreasing this year. So we had mark-to-market gains in one year and mark-to-market losses in another, creating a large delta, or a large difference between years. The only thing the item had in common with the banks is that it is called mark-to-market. [The contracts are related to] commodities — a coal contract — used to purchase coal. We are not marking-to-market on a portfolio of mortgages [like the banks]. We slide out contracts for a four-year period so we are fully contracted up, then some roll off, and we put in new contracts, every year. Prices were up last year and they’re pretty much down this year. Coal markets tanked, basically.

There are certain costs a regulated utility can recover by increasing rates if the expenditures are approved by state regulators. What does winning a rate case mean to your bottom line?
We don’t think of it as winning the rate case. We think of it as part of the process of being a regulated company. You serve, you deliver power, you upgrade your system, you upgrade your generation, and then — through regulation — you have an opportunity to earn a return on those investments. You secure that return through a rate case. We have two rate cases that we filed in North Carolina and South Carolina. They are cases where the increase in revenue is based upon the fact that we have deployed and spent capital to serve our customers in both states. So it’s power generation; it’s upgrades to transmission and distribution. What we are looking for in a rate case is a fair return on our investment — investments that are directly related to serving customers.

As a regulated utility, what performance metrics do you track?
We look at return on equity. We look at return on invested capital. We also look closely at cash-flow generation in both our regulated and nonregulated businesses. When you look at renewables and wind, in particular, you have to look at the cash flow, because those are investments that turn cash flow quite rapidly.

In the short term, how do you put your cash to work?
We finance our business and working capital through the commercial paper markets routinely. I’m paying a very low rate, 0.7%. On the long-term debt instrument, it’s going to be in the 5% range.

Since the start of the credit crisis, have the relationships with your bankers changed?
I wouldn’t characterize it as having changed. We have very good relationships with our bankers. I think in a capital-intensive business, and as active as we are in the capital markets, we need to maintain those relationships and we focus very strongly on them. As we look at renewing our credit facility, we would expect pricing to go up — the cost of liquidity is more expensive. But we haven’t seen anything remarkable in terms of covenants becoming more stringent.

Utility stocks have traditionally been a “widows and orphans” investment — always safe with exceptionally strong dividends — which is very attractive during a recession. How do you keep investors interested when the economy turns around?
I think most of the investors in Duke are going to be influenced by the dividends. It’s a big part of our valuation story, although we do have a growth story to go with that. We’ve talked about a 5% to 7% growth rate, assuming that over a five-year period we see some rebound in the economy. So if you are going to attract certain investors by talking about a higher risk profile, they’re going to be looking at the growth part of the story.

At any point in time, we have a mix of investors, but we’ve rarely moved away from those who are interested in the dividends. About 40% of our stock is held by retail investors — that’s where you see the interest in the dividends. Some of our institutional investors also hold for the dividends.

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