Stock price
is a forward looking measure, incorporating both the market's information
regarding past performance and its expectation of future performance.
Historical earnings performance, book value of assets and liabilities,
return on equity, and other traditional financial measures may once have
been reliable predictors of future earnings, particularly in a heavily
regulated industry, but today, these measures simply do not tell the whole
story.
But we all know this old warning
to investors to be as true as ever: "In times of transition, past
performance is no indicator of future success." Financial statements
measure past performance - indicators of future performance are non-financial
by definition. For example, the ability to increase market share through
product innovation and/or strategic alliances are intangibles that materially
affect a company's future profitability. While historical performance
is an important measure of a company's health, it is in itself
insufficient to create wealth: wealth is created from expectations of
how a company will perform. Clearly, non-financial performance is telling
investors something about a company that is not contained in its financial
statements.
Companies that ignore non-financial
performance risk lower valuations, higher earnings forecast inaccuracies
and higher hurdles to returning adequate shareholder value. Further, the
greater that the uncertainty and volatility is in a sector, the greater
the significance of non-financial performance to investor decision-making.
More importantly, only those
companies that use times of industry transitions to create superior returns
for their shareholders control their own destiny, and only they can be
sure to survive the wave of consolidation that is an inevitable consequence
of deregulation and increased competition.
The global electric and gas
energy industry is undergoing significant change driven by market restructuring,
energy convergence and technological innovation. Areas such as environmental
sustainability are leading to an increase in global regulatory and social
pressures, which, together with the global reallocation of investor funds
triggered firstly by the bursting of the Internet bubble, and more latterly
as a result of global economic uncertainty, are having a profound affect
on the industry. Furthermore, deregulation in a great number of economies
has opened up new opportunities for electric and gas energy companies,
breaking the traditional model of a geographically focused integrated
utility company with earnings linked to the size of the company's
asset base.
The once stable platform from
which companies in this sector operated is now one charged with new risks
and new opportunities. In this changing business environment, it is becoming
increasingly important for executives, board members and investors to
re-examine the business models that support and drive value.
Managing
Risk
Both executives and investors
recognised that the ability to manage risk in the changing business environment,
while effectively operating in the regulatory environment, was key to
success. However the executives consistently rated the key success factors
as more important than the investor. This points to an important omission
in the current dialogue between energy companies and investors: while
energy executives have a dynamic, forward-looking perspective on their
business and can appreciate the value of their risk management processes
to limit the downside and leverage the upside of uncertain future events,
they do not seem to share this perspective with investors, who simply
see - ex-post - a successful or failed strategy. Perhaps investors will
change following profit warnings from the California Crisis.
For investors, speed of integration
and operation in the regulatory environment - the former being easy to
quantify while the latter is public by nature - are higher profile issues
that they can easily evaluate. The high importance they attach to "strategy
execution" raises the question: How do investors measure it and
how can company executives communicate it to shareholders?
Our study shows that investors
look at the speed with which senior executives integrate newly acquired
businesses and assets and at the company's ability to navigate
its regulatory environment. Other important factors for investors are
the quality of risk management processes, executive compensation and the
ability to be an active consolidator.
Executives and investors both
agreed that the quality of a company's strategy contributed heavily
to overall shareholder value.
However, in this area, there
was very little consensus amongst investors and executives as to the best
strategic approach for maximizing shareholder value. It would appear that,
with the fracturing of the electric and gas energy value chain, each company
is trying to leverage its core competencies to maximize value. It is clear
that no one approach is the answer for all companies. One of the more
interesting observations in this area is that, in the US, investors rated
diversification into non-traditional businesses as creating more shareholder
value while executives rated diversification into traditional non-regulated
businesses as driving more value. If lessons learnt in the UK after it
began deregulation were any indicator, it would seem that the executives
are focused in the right direction.
In telecommunications, liberalization
coincided with great changes in technology. There is evidence that electric
and gas energy companies are on the brink of a similar revolution - at
least for those companies nimble enough to embrace it.
* Generator engineering: the
past five years have seen a 20% increase in efficiency of thermal power
plants.
* Digital switching: replacing mechanical switching increases the efficiency
of the grid; faster switching means that lines can be loaded to maximum
capacity rather than leaving a safety margin.
* Fuel cells: these offer zero emission, and readily available capacity
in locations where conventional plant may be unacceptable.
* Convergence with IT: the technology to transmit data over power wires
- already run to every room in a house - opens up many business opportunities..
As in the telecommunications
sector, the winners may be new entrants to the market. Established utilities
are notorious for piloting new technologies for years and never rolling
them out. New entrants to the market won't think twice.
Effective
Management of the Customer Base
Most of the executives did
not rate the quality of the customer base as being very important to creating
shareholder value. Given the relative importance placed on customers in
other industry segments, this may be an area where first movers that effectively
manage the quality of their customer base, could achieve a significant
increase in shareholder value.
It would appear that, even
in a liberalized market like the UK, the full value of the customer base
is not being reflected in the share price. Companies have been too preoccupied
with volume rather than quality and need to turn their attention to effective
customer relationship management in order to extract full value.
Disparity
of importance
In a number of areas investors
rated the importance of key factors much lower than executives. This disparity
indicates that, in many aspects, executives are more advanced in anticipating
the success factors in this industry as it transitions from a heavily
regulated market of integrated monopolists to a lightly regulated, open
market of specialized energy companies. Therefore, now more than ever,
electric and gas energy companies need to be able to articulate to all
stakeholders - particularly those outside of the company - simply and
with a high degree of certainty, the impact industry transition issues
will have on future earnings of the company. Additionally, the expectations
of investors and executives of what a winner will look like run the risk
of being disconnected. The losers of such a disconnect are investors and
executives alike: investors will not achieve the risk / return profile
they seek, and executives will not get the support their actions and decisions
deserve.
Winning organizations will
be those that truly understand where and how value is created (or destroyed)
and how performance improvement can be embedded into routine operational
financial and non-financial activities.
Managing
the Changing Organization
For most electric and gas energy
managers, the transition from public to private sector was relatively
easy as they focused on cost efficiency and improving customer service
standards. Now, electric and gas energy company managements find themselves
having to create and manage very different organizations. For example,
in a fully deregulated market, customer churn adds a new dimension to
earnings stability. In future, managers will need to attach as much importance
to the determination and delivery of their trading strategy as they have
traditionally given to driving down operating costs and satisfying customer
needs.
Electric and gas energy managers
need to embrace the changes that are taking place and the opportunities
that are presented. While doing so they must ensure that their organizations
adopt and maintain world class risk management policies and practices
that will truly enable them to ensure that the agreed strategy is being
delivered. For European executives in particular, the recent experience
of their Californian counterparts provides a dramatic and timely reminder
of the real threat to shareholder value of the trading exposures carried
by utilities in free markets.
Comprehensive
Performance Management is Key
The results of the study suggest
that comprehensive performance management is a prerequisite for directing
the organization towards future success and winning the investor support
needed to be among the winners in a consolidating industry. Electric and
gas energy executives should target their communiques to the markets accordingly.
To secure an organization's
future, a CEO of today's energy company must have a clear vision
of where to create shareholder value and be a master at acquiring and
rapidly integrating other entities.
Ernst & Young believes
that the results from this study will help electric and gas energy executives
and investors align measures for success in their sub-sector, align expectations
of the changing risk/reward profile and focus their dialogue on the most
relevant indicators for future success. |