Pepco's Futility

 | Aug 10, 2012 | 6:15 PM EDT
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For the typical utility investor, Pepco Holdings (POM) represents far too much risk, even though most of its assets are regulated. Only speculators should own this company.

The company's horrible second-quarter results begin to tell the story. On the top line, total revenues were a surprise, totaling $1.18 billion, down 16.5% from $1.41 billion in the year-ago period. Earnings were $0.25 per share, much lower than the year-ago figure of $0.43. Earnings per share, as per GAAP, were $0.27, down 35.7% from in the year-ago period. Incredibly, the company reiterated its 2012 earnings-per-share outlook in the range of $1.15 to $1.30.

In addition to its earnings woes, Pepco has reputation problems with the public. According to the American Customer Satisfaction Index released in April 2012, Pepco ranks as the nation's second-worst-rated utility in customer satisfaction, at 69 points on the index -- a distinction it shares with PG&E (PCG). Yet as the ASCI press release optimistically notes, Pepco also had the largest improvement over the past year. That is, it was up from a dismal 54 points in 2011.  

By contrast, the nation's utility leaders scored 80 and above on the index, including CenterPoint Energy (CNP), Southern Company (SO), Dominion Resources (D), NextEra Energy (NEE), PPL (PPL), and American Electric Power (AEP). The worst-rated utility in 2012 is Northeast Utilities (NU), at 59 points.

Maintaining the public's confidence and understanding local politics are critical to obtaining favorable regulatory decisions. This is no less true in the Washington, D.C. area, which Pepco serves, than elsewhere. The company has about two million customers in the Mid-Atlantic region.

Yet Pepco appears focused on blaming regulators. In its August 7 conference call, management discussed the challenges to be faced in upcoming quarters. It believes it has a serious problem with state regulators, in Maryland particularly, and is being treated unfairly. While the company did receive rate increases effectively July 20, 2012, these were much less than those asked for or needed.

Whatever the case, the company is in a terrible fix. If it does not receive regulatory rate relief, it will lose revenues, impairing margins and diminishing funds to improve the customer's experience.

The key point is that management must find a way to motivate regulators to grant it rate relief. So far, its attempts to persuade regulators in a normal manner have not succeeded as hoped. Management said its Plan B has been to resubmit rate requests repeatedly until obtaining what it believes to be is a fair rate.

Plan C is to issue a dire warning to regulators and implicitly to investors. CEO Joseph Rigby said, "We [may] have to have a much more difficult conversation with both our regulators and our legislative leaders that this is just truly not sustainable." The company's regulated subsidiaries are now in a fragile position. And its unregulated subsidiary, Pepco Energy Services, is no salvation for investors either, but seemingly confused, aimless, and risky.

For the last decade, Pepco has experimented with deregulated energy products. First, it attempted to become a retail energy supplier selling deregulated electricity. Next, it tried owning some old oil-fired power plant assets and selling capacity and ancillary services, but not energy, into the grid. Finally, it became involved in a landfill gas-fired generation plant. Apparently, none one of these schemes worked out. Today, PES is winding down its retail energy business, deactivating old power plants, and booking impairment charges.

Currently, Pepco has a new idea: It wants to build a new business to sell energy-efficiency services to government organizations. Unfortunately, is has found few takers. "We're just seeing fewer projects out there," Rigby said. "So our pipeline hasn't been replenished like we were expecting."

In the conference call, Pepco's management was unable to offer any guidance. Instead, it said it will provide "a new outlook" in its next earnings call.

Speculators may like this company, gambling that Pepco's management will seek to sell the company. Stronger utilities could find Pepco an attractive opportunity for starting over.

In the meantime, Pepco's dividend is attractive but unsustainable. Its payout ratio is upside down: The company is paying investors more than it earns. But management is unlikely to change Pepco's dividend in the next few quarters.

For other investors, safer opportunities can be found with stronger utilities. Companies like PPL, American Electric Power, Dominion, Southern, and NextEra have better reputations, stronger financials and more secure dividends.

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