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2004 - Capital Markets Challenge the Power Industry

Scott Shemwell's picture
President & CEO Strategic Decision Sciences

Scott Shemwell is the president and CEO of Strategic Decision Sciences. His firm provides its clients with Quantitative and Qualitative analysis and insight throughout the major decision...

  • Member since 2003
  • 14 items added with 10,079 views
  • Jan 21, 2004
In August 2003, the northeast United States suffered its worst blackout ever. Not long after, pundits suggested that the industry would need to invest some $100 billion to "fix" the problem. The industry is fragmented, in turmoil, saddled over capacity, and capital constrained. Natural gas prices are remaining high and environmental concerns omnipresent. Moreover, the power industry must deliver low cost, on-demand watts without disruption. Less than six months after the blackout, few seem to be concerned with those issues exposed in the late summer. Business as usual – once again. Nevertheless, the energy industry in general and the electric power segment in particular cannot afford to bury its collective head in the sand. The United States federal government has yet again been unable to develop an energy plan, however, it is not entirely clear that the American economic engine truly needs an energy policy. There is another powerful force in the economic ether. The free market tends to focus resources towards higher value add equilibrium. In this sense, the energy industry competes with every other industry sector and its top performers. Capital seeks the high ground. It searches for the highest return on investment against an acceptable risk profile.

It is unlikely the northeast power grid players will spend the proposed sum, nor will many of the anticipated solutions be implemented. Likely, the grid will continue to provide value to its customers, face occasional difficulties, and self-organize to meet the needs of contemporary markets. Self-organization is a chaos theory algorithm whereby organic agents rapidly evolve, faster than Darwinist statistical selection, into new vibrant beings. So it is with successful organizations, that collection of organic thinking beings we call human resources.

Access to Capital
Ask any purveyor of a solution and they will tell you they have a value proposition. The belief that their product, service, or answer will enhance their customer’s performance and hence shareholder value. Ever wonder why with all the value propositions available today that the P/E ratio of firms that procure these benefits is not higher? For all the billions invested in information technology (IT), major buyers should dramatically outperform rivals. For the most part, this statement is not correct. There is ample evidence that suggests that the simple implementation of commercial off the shelf software (COTS) does not in and of itself add value. Moreover, most major players in the segment have implemented similar IT solutions, thus mitigating any perceived advantage. An alternative view is that the 21st century, IT is simply the price of admission. The use of information tools to drive better decisions is a powerful value proposition. The capital market are merciless, their pursuit of high returns have led them down some of the reckless paths of the exuberant 1990s, but for the most part, the marketplace is the reality check of managerial prowess. Capital markets allocate capital in a relatively efficient process. John Nash, of “A Brilliant Mind” movie fame further developed the work of early game theorists von Neumann and Morgenstern. An interesting side bar, John von Neumann (1903-1957) developed the modern computer architecture, used in ENIAC and every computer since that executes the classic sequence of processing steps. Additionally, this thought leader developed a body of work on decision making under uncertainty. Worthy of note, this early work focused on capital management. Nash posited that efficiencies can be made optimal along an efficiency frontier, or set of points on a curve that represent the best performance possible. A mathematician by training, and an economist by instinct, Nash set forth some of the basic tenants driving the modern economy – the maximization of value.

The essence of capitalism is the amalgamation of treasure and its use to create even more wealth. Capital is agnostic; it knows no industry preference. As such, it will flow towards the highest, safest, risk adjusted return.

Cost of Capital
The cost of capital parameter is usually a function of debt and equity and any MBA student will advise that debt is cheaper than equity in that managerial control is greater with debt holders than with equity owners. This equation has changed. Corporate and investment institution scandals have altered the playing field. Recent studies have shown that firms with greater shareholder rights command higher multiples, regardless of the business cycle. Jokes referring to investor’s need to get “return of investment as a priority to return on investment,” litter the capital market landscape. This is true for debt holders as well. If the cost of equity and debt are high, the firm is at a structural disadvantage. Its ability to provide a return to its investors while offering customers superior service is constrained over competitors with lower cost structures. In an “eat or be eaten” world, lumbering organizations under the thumb of creditors and unhappy owners will most likely become corporate lunch.

The Silver Lining
Most organizations have a number of brilliant minds. Knowledgeable individuals who understand what must be done to add value and if given the tools and the charter will “make it happen.” Regulatory bodies are not excluding firms from self-organizing and driving institutional knowledge to optimal processes and higher shareholder value. On the contrary, governance concerns quite simply require management to know what is going on in the company and take steps to steward the firm under their charge. Tools are available to release organizational brilliance while providing necessary safeguards. Capitalizing on the information flow from both internal resources as well as supply chain partners and even customers, firms in the power industry can enhance operational excellence, increase free cash flow, and wealth. Optimizing enterprise performance requires robust governance, organizational creativity, facilitated by managerial processes fueled by timely and accurate information flow and analysis. Assessment will be more akin to the “lean manufacturing” practices used by discrete manufacturing, whereby, real-time decision-making is driving very high quality, six sigma, operational excellence, dramatically and continuously lowering costs. Coupled with a customer service mindset, valuations can be expected to rise in this segment as it has with others. The capital markets will view such performance as evidence of strong governance and operational excellence beginning an affable cycle of lowering cost of capital and enhancing value. Governance in 2004 will be a function of strong board and managerial excellence, regulatory compliance, and effective capital management. This is nothing more than fundamental blocking and tackling and for those firms that focus on the basics, the rewards will be forthcoming.

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