U-1034-99 Blickenstaff Testimony.pdf

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BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
INTERMOUNTAIN GAS COMPANY
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Case No. U-I034-99
PREPARED DIRECT TESTIMONY OF V. DALE BLICKENSTAFF
Q. Please state your name and business address.
A. My name is V. Dale Blickenstaff. My business address is the Idaho
First National Bank, P. O. Box 8247, Boise, Idaho 83733.
Q. What is your educational background?
A. I hold a Bachelor of Science Degree in business from McPherson College,
Kansas; a Master of Science Degree in Accounting from Fort Hays Kansas
State College; and a Doctorate in Business Education frOB the
Lniversi ty of Northern Colorado, Greeley, Colorado.
Q. Are you affiliated with any professional societies, or recognized
professional groups?
A. Yes, I am a Certified Public Accountant. I am also a member of the
American Institute of Certified Public Accountants and the Idaho
Society of Certified Public Accountants.
Q. Please describe your work experience.
A. I have served as a public school teacher, managed a ranch and farm
operation, taught collegiate level accounting and was Chairman of the
Accounting Department for Boise State University and served as Dean of
the School of Business, Boise State University.
During the summer of 1969, I was employed by Boise Cascade Corporation,
and before joining idaho First National Bank, in 1973, I served as
Executive Vice President of Preco, Inc., Boise, Idaho.
Q. What is your present position?
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A. I am Executive Vice President for Asset and Liability Management of
Idaho First National Bank.
Q. What are your responsibilities associated with that position?
A. I am responsible for Balance Sheet Management, which includes
establishing appropriate interest rates on loans and deposits,
determining the mix of assets and liabilities, and managing the
liquidity position of the bank. In addition I supervise (1) the
development of new product lines, (2) the Marketing Department, that
among other duties does feasibility studies for capital investment
projects, (3) the Investment Department that manages a securities
portfolio of approximately $500 million, (4) the Money Desk Department,
that develops and maintains short-term arbitrage positions, and (5) the
financial planning activities of the bank.
Q. How long have you been responsible for the asset and liability
management function?
A. I have had that responsibility since the spring of 1978. I was
responsible for the Investment and Financial Planning functions between
1974 and 1978.
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Q. How does the profitability of Idaho First compare to other similar
banks?
A. For most years we have been in the top 10% of our peer group of the 100
largest commercial banks and in some years were in the top five banks
in performance.
Q. Mr. Blickenstaff, what is your responsibility in this rate case?
A. I was asked to conduct a study with the objective of developing an
opinion on the fair rate of return on common equity for Intermountain
Gas.
Q. What material did you review as a basis for your study?
A. I examined various books and records of Intermountain Gas and other
published financial information.
Q. What standard have you used to determine a fair rate of return on the
total capital of Intermountain Gas?
A. I have used the cost of capital standard to determine the overall fair
rate of return for Intermountain Gas. This standard indicates that no
essential difference exists between the return required by the firm's
suppliers of capital and the return required by the firm's suppliers of
other factor resources, such as labor and raw materials. Each is a
current cost of supplying services to the customers, and each should be
met from current income. Just as the firm must compensate workers
adequately, or lose that quality of worker to competing firms, the
suppliers of capital must also be adequately compensated or the ability
of the firm to attract suppliers of capital will suffer.
Q. What approach did you use in determining a fair rate of return on
Intermountain Gas common equity?
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A. In order to determine an appropriate return on equity range for
Intermountain Gas Company, it was necessary to first determine the
"cost of capital" to the Company.
The cost of capital is defined by Myron Gordon in The Investment
Financing and Valuation of the Corporation (pages 217-223) as being the
rate of return on investment that leaves the value of a firm unchanged,
when stated on a real price per share basis. A determination of a rate
of return that is too high will result in an excessive burden on the
utility's customers and an economically unjustifiable transfer of
monetary resources to the investors in the utility. At the other
extreme, a rate of return that is too low will cause an economically
unjustifiable transfer of monetary resources to the utility's customers
from the investors in the company. This short-term reallocation of
monetary resources from investor to ratepayer cannot proceed
indefinitely, as additional new equity and debt capital will become
progressively more expensive to obtain and the resulting burden will
ultimately confront the ratepayer. The result is that while in the
near term the true effective cost of service to ratepayers can be
circumvented through reductions in the return on equity, the resulting
increased cost of obtaining additional capital may cause a long-term
impact of increasing the average cost of capital through enhanced
investor awareness of the relative investment risk.
Q. How did you define the return on equity to the individual stockholder
for your study?
A. The return on equity to the individual stockholdèr is defined as being
equal to the present value of the total annual dividends paid, divided
by the purchase price, plus or minus the present value of the change in
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the market price of the stock since the date of purchase ~ divided by
the purchase price. This approach was the basis for the return on
equity computations referred to by Gerald Rogue and Kishore Lall in
their article, "Corporate Finance: an Overview." The. following
formula illustrates that the price of a share of firm's common stock is
equal to the present value of the future benefits of ownership:
Where:
Re = PVD + PVMc
Re = Return on equity to the individual investor
PVD = Present value of dividends
PVMc = Present value of changes in price of stock
from date of purchase
The current yield to the investor is the annual dividend per share
divided by the purchase price.
Q. Have you based your line of reasoning in this case on any legal
precedents?
A. Yes, I have used the preceding definitional concepts in conjunction
with the generally accepted principles in the Bluefield Water Works
case (262 U.S. 697 (1923J) and the Hope Natural Gas Company case (320
U.S. 591 (1944J), to develop my opinion as to the fair rate of return
on common equity capital for Intermountain Gas Company. Specifically,
in the Hope Natural Gas case it was ruled that not only should the
return to the contribution of equity be commensurate with returns on
investments in other similar enterprises, but also such as is necessary
to maintain the credit of the company and attract capitaL. The
Bluefield Water Works case developed the concept that a rate of return
on equity may be reasonable at one time and yet become inappropriate
over time due to general money market and business conditions.
Q. Based on your study, in your opinion what is a fair rate of return on
Intermountain's common equity?
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A. Based on the results from the five approaches I used, it is my opinion
that the fair rate of return on common equity for Intermountain Gas is
in the range of 17.00% to 18.50%. The actual results ranged from
16.33% to 20.48%, depending on the method of calculation used.
Q. What methods did you use to reach your decision on a specific
recommendation for a fair rate of return for Intermountain Gas Company?
A. There are several generally accepted methods of calculating a return on
equity (ROE) requirement for natural gas utilities. While discussing
the results of each type of calculation, the practical strengths and
weaknesses of each approach will be mentioned. The market-to-book
ratio approach will be illustrated first. The market adjusted ROE for
Intermountain Gas Company is approached by adj usting the Company's
fiscal 1981 year-end return on average market value to arrive at a
return on equity required to produce a market to book ratio of 1.0X.
Intermountain Gas Company's average market value for the fiscal year
ending September 30, 1981 was $11.04 (average PIE ratio tiines earnings
per average common share). Dividing the 1981 dividend of $1.40 by
$11.04 results in a yield of 12.68%.
To achieve a 12.68% yield on the year-end fiscal 1981 book value of
$17.80, a dividend of $2.26 would be required:
Required Dividend to
Produce a Yield on
Book Equivalent to
Yield at Market
$2.26
= Book Value x Market Yield
$17.80 x 12.68%
The earnings required to produce a $2.26 dividend at the recent
industry average payout ratio (Dividend + Earnings) of 72% (Financial &
Common Stock Information, Gas Distribution Industry, Month ended
December 31, 1981, Edward D. Jones & Co.) is:
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Earnings = Dividend + Payout Ratio
$3.14 = $2.26 + 72%
The return on equity required to produce earnings of $3.14 at a book
value of $ 1 7.80 would be:
Required Return on Equity = Earnings + Book Value
17.64% = $3.14 + $17.80
Therefore, the earned return on equity of 17.64% would produce a
market-to-book average ratio of 1.0X.
However, the utility would normally obtain less than the market
acceptance price of any new equity issue, due to underwriting and other
issue costs. Therefore, the theoretical approach must be adjusted to
take into account the issue costs associated with investment banking.
A study by the Securities and Exchange Commission ("Cost of Flotation
of Corporate Securities,1951 -1955,"June 1957)indicates that
flotation costs as a percentage of gross proceeds averaged 27% for
security issues under $500,000~to as low as an average of only 5.4%of
gross proceeds for security issues between $20-$50 million. These
findings have been confirmed by non-governmental researchers, such as
Archer and Faerber, in their work, "Firm Size and the Cost of
Externally Secured Equity Capital," (page 82). Specifically, Archer
and Faerber found that flotation costs for a public sale of common
stock were related to firm size, and that small issues have higher
flotation costs. Therefore, within the historical range of issue costs
between 5 .4% and 27% of gross proceeds, a percentage was selected that
considered the relative size of Intermountain Gas Company. I have
selected a 9% flotation cost figure for use in the cost of capital
calculations for Intermountain Gas Company, and have placed it in the
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following formula (presented by Wilbur Lewellin in his work The Cost of
Capital, page 46) to determine the effective cost of a new security
issue.
Re =P
P-b
Re =100%
100%-9%
Re =1.10
Where Re = Effective cost of new security issue
P = Gross percentage of proceeds from new
securi ty issue.
b Percentage gap between the gross anè
actual proceeds from the security issue
The $3.14 earnings determined previously as being necessary to produce
a market-to-book average ratio of 1.0X, would be adjusted to $3.45
($3.14 x 1.1), to obtain a return on equity that would be adequate to
provide a market-to-book average ratio of 1. IX, with issue and
underwriting costs taken into consideration. Therefore, in order for
Intermountain Gas to achieve a market-to-book ratio of 1. IX, the return
on equity would have to be:
Required Return = Earnings + Book Value
19.40% = $3.45 + $17.80
Q. You mentioned an industry average pay-out of 72%, is that true for
Intermountain Gas Company?
A. No, it is not true for Intermountain Gas. During fiscal year 1981, the
actual payout ratio for Intermountain Gas was 121.7%. For
Intermountain Gas to have maintained the industry average relationship
between dividends and earnings, while maintaining exi.sting dividend
levels, it would have had to achieve fiscal 1981 per common share
earnings of $1.94. This contrasts with much lower actual per common
share earnings of $1.15.
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Q. What is the view of rating agencies such as Moody's and Standard and
Poor's in regard to an acceptable payout ratio?
A. Standard and Poor's suggests a target payout ratio of 60% for utilities
expecting to achieve or maintain a rating of AA.
Q. Of what consequence is the difference between a high and low rating?
A. The lower the rating, or the downgrading of a rating, increases the
firm's cost of capital.
Q. Is it your opinion that Intermountain's payout ratio of 121.7% - twice
that of an acceptable level - is damaging to the firm?
A. Definitely, and I want to elaborate more on this later in my testimony.
Q. Did you attempt to determine a fair rate of return using comparative
information from companies similar to Iritermountain Gas?
A. Yes. I have compared the earnings of other natural gas utilities to
arrive at a fair rate of return for Intermountain Gas Company.
Forty-five companies from the natural gas distribution industry were
used as comparable investment alternatives (Financial & Common Stock
Information, Gas Distribution Industry, Month Ended December 31, 1981,
Edward D. Jones & Co.). For the most recent 12 months the 45 companies
had a mean return on equity of 12.8% (Exhibit 2, Schedule 1,
Appendix A). It is noteworthy that a wide range of ROE exists in the
industry, from a high of 29.4% by Louisiana General Service to a low of
5.7% by SE Michigan Gas. The median ROE for the same group of
companies during the same time period was 11.8%. Intermountain Gas was
included in the sample group and had a ROE of 6.5%, which was above the
ROE of only three companies in the sample group. While the mean ROE of
the sample group appears to be a good theoretical starting point for
determining an acceptable fair rate of return for Intermountain Gas
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Company, it must be pointed out that 39 of the 45 sample companies had
market prices below their book value. The practical result of the
situation is that, if 87% of the sample group sold new equity, a
confiscation of existing owners equity would occur. This illustrates
that the 39 companies are not earning their cost of capital and could
not issue new capital on reasonable terms.
Therefore, the 12.8% ROE found through a comparison to market
alternatives for similar investments appears unsuitably low for an
acceptable fair rate of return for Intermountain Gas Company. However,
by dividing the 12.8% mean ROE by the mean market-to-book ratio of .83,
an ROE of 15.42% can be determined to produce a market price equal to
book value for the sample groups. Adjusting to 1. iX market-to-book~
for issue cost consideration, results in an ROE of 16.96%.
Q. Was it possible to compare natural gas utilities to companies in other
industries to help determine a fair rate of return on common equity?
A. Yes, another approach is to compare earnings of industrials relative to
earnings of natural gas utilities. The approximate 1981 average ROE
for the Standard & Poor's 400 Industrials was 13.83% and the market to
book ratio for the same group of companies was 1.21X. To adjust the
market-to-book ratio to 1.0X for the S&P 400 a 11.43% rate of return
would be necessary:
Rate of Return
11.43%
ROE + Market/Book
= 13.83 + 1.21
A comparison of the price earning ratios of the Standard & Poor's 400
Industrials and the previously described sample group of natural gas
utilities is necessary to determine the relative amount an investor
will pay for each dollar of earnings in both groups of companies.
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8.8 PIE ratio for Standard & Poor's 400 Industrials
6.8 PIE ratio for the sample natural gas utilities
Expressing the PIE ratio of the sample natural gas utilities as a
percentage of the PIE ratio of the Standard & Poor's 400 Industrials
results in 77%, indicating that investors view each döllar of earnings
for the representative natural gas utilities to be worth 77 cents
relative to the $1.00 of earnings by the Standard & Poor's Industrials.
Relative Worth of Earnings = PIE Ratio Sample Group
PIE Ratio S&P 400 Industrials
77% = 6.8 + 8.8
The relatively smaller PIE ratio for the sample natural gas utilities,
compared to the industrials, indicates that investors perceive the gas
utilities as having greater risk due to the uncertainty of regulation
and the presence of a non-renewable resource.
This .may also be stated as investors willing to pay less for each
dollar of gas utilities earnings. A possible explanation for this PIE
disparity may be investors perceptions of the remote possibility of any
increase in earnings or even just maintaining the existing earnings per
share in the future.
Expressing the PIE ratio of the sample natural gas utilities asa
percentage of the PIE ratio of the Standard & Poor's 400 Industrials
results in 77%, indicating a similar comparison of the relative worth
of earnings between the two industry groupings. Therefore, to
determine the return on equity required for natural gas utilities to
achieve a market price equal to book value, the market adjusted rate of
return (11.43%) would be divided by the relative worth of earnings
(77%), to arrive at a 14.84% return on equity. Adjusting the return to
a 1. iX market price to book value, to account for issue costs, would
result in a 16.33% return on equity.
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A practical weakness existing in this approach is the assumption that
individual investors are objectively indifferent to investment in any
particular industry, after the consideration of relative risk between
industries has been made. It is possible, although not proven, that
significant numbers of investors in anyone industry may have a bias
that extends beyond the objectivity assumed to be used in the relative
risk consideration used in this approach. A practical example might be
a former utility employee, with a positive subjective impression of the
utility that precludes consideration of the relative worth of earnings
in the utility compared to other industrials.
Q. Did you use the discounted cash flow method to determine a fair rate of
return on common equity?
A. Yes, the discounted cash flow method can also be used to determine a
required rate of return for Intermountain Gas Company. This method is
based on investors' expectations of total return:
Ke =De
Po + g
Where: = Ke = Cost of Equity Capital
De = Expected dividend on common stock
Po = Current price per share of common stock
g = Expected annual percent growth in earnings
and dividend per share
I utilize the 1981 average bid price per share of common stock, $11.04,
the fiscal 1981 annual dividend of $1.40, and a 7.8% growth in
dividends per share (average change in representative group of 45
utilities over 12 months ending 9/30/81.) The result of this
calculation is shown below:
Ke = ($1.40~$11.04) + 7.8%
Ke = 12.68% + 7.8%
Ke = 20.48%
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Q. What do you perceive as the weakness of the Discounted Cash Flow
method?
A. I believe there is one weakness in the formula regardless of the firm
being analyzed. That weakness is in the Po factor (current price per
share) . If the market price is volatile, relatively wide swings in Ke
(Cost of Equity Capital) will occur.
Q. In your opinion are there other deficiencies in the D.C.F. formula?
A. Yes. recent earnings and dividend trends at Intermountain would suggest
to the knowledgeable investor that a g factor (expected annual growth
in earnings and dividend per share) of 7.8% is unrealistic.
Q. Then in the case of Intermountain gas you would discard the method?
A. No, I would not discard the method, I would only discount the results.
Note that even if the g factor were only 4% the cost of equity capital
to Intermountain remains a very high 16.68%.
Q. Does an investor generally expect a premium on an investment in common
equity relative to bonded indebtedness and did you use such an approach
in determining a fair rate of return?
A. The return to an investor in the equity of a natural gas utility
includes an equity risk premium. The equity risk premium can be used
to determine the fair rate of return for the utility. In relation to
bond financing of the same company, it is a generally accepted
principle that the investment community as a whole views common stock
in the company as being a greater risk. This increased risk causes
investors as a group to demand a premium in their expected return on
the common stock, and it is this premium which serves as the basis for
the equity risk premium. Investors have available what are generally
considered risk-free bond investment alternatives in the form of U. S.
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Government securities. Using this as a starting point, the yield on
U. S. Treasury bonds maturing in approximately 20 years (14%%, of
February 2002) has been in the 13.80% - 13.90% range throughout the
first quarter of 1982.
While historically utilities have used bonds with greater maturities, .
the current condition of the financial markets appears to preclude bond
offerings by most companies in excess of 20 years.
In theory it would appear that bonded indebtedness of natural gas
utilities would be somewhat more risky that indebtedness issued by the
U. S. Government. As long as the U. S. Government can raise huge
revenues through taxes, lenders can be very sure that the government
will be able to return their money plus interest on the anticipated
date due. The ability of a natural gas utility to repay its' debtors
is less certain due to factors such as the question of the long-term
availability of natural gas, the economy of the market area being
served and the rate setting mechanism.
Q. What equity risk premium is generally considered appropriate for
utilities such as Intermountain Gas?
A. A study done by Paine Webb-er Mitchell Hutchins, Inc. ("A Survey of
Investor Attitudes toward the Electric Power Industry, June 18, 1980")
indicated investors demanded a premium of approximately 4.2% between
double A electric utility bonds and U.S. Treasury bonds.
It is my opinion that investors view the natural gas utility industry
as being at least as risky as the electric utility industry. However,
to be conservative, the 4.2% described in the study will be utilized in
the formula below as the equity risk premium.
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Fair Rate of Return = Expected No-Risk Yield
on Capital + Equity Risk Premium
18.05% = 13.85% + 4.2%
The preceding methodology indicates that 18.05% is the required rate of
return on common equity for Intermountain Gas Company.
Q. Did you use the capital asset pricing model (CAPM) variation of the
risk premium approach to determine a fair rate of return on
Intermountain's common equity?
A. Yes, I reviewed the CAPM approach, but did not select it as being
necessary to serve as a basis for my recommendations. Specifically,
the CAPM approach I reviewed is based on work done by Professor William
Sharp, when he was teaching at the University of Washington.
In an article entitled "A Simplified Model for Portfolio Analysis," in
1963, Professor Sharp used the following formula to determine a fair
rate of return on equity. The variation of his formula that is
commonly used today is stated as:
E = Rf + B (MR - Rf)
Where:E =
Rf =
B =
(MR -Rf)=
Expected return on common stock of
the firm
Risk-free rate of return
Relative risk of the firm's common
stock to the average risk of the
market
The expected return on the total
stockmarket in excess of therisk-free rate.
Q. Why did you not use theCAPM approach as an alternative basis for your
recommendation?
A. The CAPM approach is an alternative method of calculating the cost of
capital that is a derivative of the risk premium approach that I have
already used as one of the methods that serves as a basis for my
recommendation. Due to the similarity of the basic risk premium
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approach and the CAPM approach, I have chosen to not use the CAPM
approach as a basis for my recommendation.
Q. Why did you use so many different methods to estimate Intermountain's
stockholder's minimally acceptable rate of return?
A. The final fair rate of return allowed Intermountain Gas will have a
substantial impact on the revenue requirements of the Company. The
magnitude of this question demands that sensitivity be applied to the
determination of any recommendation. By using several approaches it is
possible to check for the internal consistency of the recommendation,
to ensure that the recommendation is not biased by anyone particular
approach to a conclusion beyond what is reasonable.
Q. Will you summarize the results of your alternative approaches as to the
fair rate of return determined by each and restate your overall
recommendation?
A. The following table summrizes the relative fair rate of returns as
determined by each of the approaches used:
Hethod Fair Rate of Return
1.
2.
3.
4.
5.
Market-to-Book Ratio Approach
Relative Earnings to Comparative Companies
Industrials Relative to Natural Gas Utilities
Discounted Cash Flow
Equity Risk Premium
19.40%
16.96
16.33
20.48
18.05
Given the results of the preceding approaches in determining a fair
rate of return for Intermountain Gas Company, it is my opinion that a
fair rate of return in the 17.00% to 18.50% range is the minimum
acceptable return to maintain the financial integrity of the Company
and to minimize the possible long-term burden on ratepayers from
understating the required fair rate of return. In addition, the
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relative instability of the financial markets of the entire nation make
this a somewhat conservative estimate.
Q. Would you comment on the instability in the financial markets that you
mentioned in relation to your expectations for the national economy.
A. Interest rates have been extremely high and volatile over the past
several years. The prime interest rate charged by commercial banks to
their most credit worthy commercial loan customers began 1981 at 21~%,
declined to 17% in April, returned to 20% during the summer, and then
fell to 15.5% in early 1982, before returning to 17% in February, 1982.
Several leading economists, including Otto Eckstein of Data Resources
Inc. and S. I. Nakagema (the chief economist for Kidder, Peabody &
Co.), have stated that in their opinion during the first half of 1982
the Federal Reserve System will take the pragmatic approach of dealing
with the recession by allowing the growth of the money supply (Ml) to
exceed its 1982 target range of 2~% to 5~%. In fact, since November,
1981 the annual rate of growth of the money supply has been in excess
of 10% (even including the large $3.1 billion drop in the week ended
February 10th). Keynesian economic theory suggests that expansionary
monetary policy (a relatively rapid growth in the money supply) will
initially lower interest rates, through the increase in the supply of
loanable funds relative to the demand for loanable funds. However,
another facet of Keynesian economic theory indicates that expansionary
fiscal policy in the form of a budget deficit andlor a tax cut are
possible routes back to full employment from the current recession.
A potential conflict between restrictive monetary policy of the Federal
Reserve System and the expansionary fiscal policy of the U. S.
Government may occur because of the impact of government borrowing on
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the availability of loanable funds to finance private spending.
Although, in my opinion, the danger of this crowding out of private
borrowings is relatively low during the current recessionary
environment, an increased possibility of it may occur later in 1982.
Monetary economic theory as described by economist Milton Friedman
mentions the 6-18 month time lag between changes in the growth of the
money supply and expansionary impacts on the economy. If we view the
last four months of monetary policy as being expansionary, significant
economic impacts would be expected during the second half of 1982
according to monetarist theory. This possib le timing of economic
recovery coincides with the Federal tax cut and forecasted increased
need for U. S. Government financing to fund the anticipated increasing
deficit. ifhat sequence of events might we expect during 1982, given
existing monetary and fiscal policy? First, during the spring of. 1982
monetary policy may temporarily reduce the rate of interest as it makes
potential loanable funds more available through growth in the money
supply.
Then, this expansionary monetary policy and planned expansionary fiscal
policy (tax cut) will probably cause an increase in current spending
and an increase in GNP during the summer of 1982. At higher levels of
income caused by economic expansion, the demand for loanable funds will
increase, placing upward pressure on interest rates during the fall of
1982. Using this background and my general understanding of the
national financial markets, it is my opinion that volatility and
relati.vely high levels are likely to continue to be characteristics of
the interest rates and the financial markets during 1982 and 1983.
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Q. In your opinion how does this economic scenario impact the cost of
capital?
A. It suggests that the cost of capital will remain very high for firms
such as Intermountain Gas. This is especially true when measuring the
cost of capital using the equity risk premium method. With risk-free
government bond interest rates remaining high, the investor will insist
on receiving a premium for a higher risk.
Q. How does this recommendation of a fair rate of return on equity for
Intermountain Gas differ from the direct testimony you presented to the
Commission at the previous rate hearing for Intermountain Gas?
A. I previously recommended a minimum allowed rate of return on
Intermountain common equity of 17.50% in the previous rate hearing,
whereas my minimum recommendation at this time is 17.00%.
Q. Beyond the justification shown by various methods you have used to
calculate a fair rate of return, what basis have you for this change in
your minimum recommendations?
A. It is my opinion that at any point in time one of the five methods I
have used more accurately depicts the required Return on Equity. At
the present time I believe the risk premium method to be the best
measure, with the market-to-book method second, followed then by the
other three. Therefore, although the market-to-book approach would
suggest a higher minimum return than in the previous rate hearing, the
decline in the result of the equity risk premium method along with the
current money niarket and business conditions justifies a downward
adjustment from 17.5% to 17.0%. The Bluefield Waterworks case, which I
referred to earlier, established that a rate of return on equity may be
reasonable at one time and yet become inappropriate over time due to
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general money market and business conditions. The money market and
business conditions have changed since my previous minimum
recommendation on a fair rate of return on Intermountain's equity and
these changes are also a basis for my revised recommendation.
Q. Did you review the actual return on stockholders equity achieved by
Intermountain Gas during the last several years, and did you use that
information as a basis for any additional investigation?
A. Yes, the downward trend in the return on stockholder's equity from a
high of 11.7% in 1979, 6.7% in 1980, and only 6.3% in 1981 was a point
of concern to me. I decided to look beyond the reasons of relatively
warm years and increasing consumer conservation which appear to serve
as a basis for the Company's reasoning for a partial explanation of
recent financial results. I compared some basic financial ratios of
Intermountain Gas to those of other natural gas utilities. The results
of these comparisons are shown below.
Percent Return on Payout to Mkt.to
Equity Equity Earnings Book
Intermountain Gas Co.39%6.5%122%53%
Other 44 Sample Companies
Maximum 80%29.4%185%170%
Minimum 24%5.7%16%41%
Median 42%11.8%67%78%
Mean 43%12.8%72%83%
*Most recent 12-month data available 12/31/81.
A closer view of these statistics illustrated that Intermountain had
the second lowest market to book ratio of the 45 companies, the fourth
highest payout ratio of the 45 companies, and was tied for third lowest
return on equity of the 45 companies. There generally was an inverse
relationship between a company's payout ratio and the market-to-book
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ratio. The financial market appears to be discounting a company's
ability to maintain a payout ratio in excess of the industry average.
Q.Did you attempt to determine exactly why Intermountain Gas has provided
stockholders with such a low return on equity?
A.Yes, I used the Earnings Power Formula to compare the financial results
of Intermountain Gas with nine other natural gas distribution
companies. The results of this comparison are shown for 1980 on
Exhibit 2, Schedules 2-8, Appendix B. The Earnings Power Formula is:
Q.
Profit Asset Equity Return on (ROE)
Margin x Turnover x Multiplier Equity
Net Income Gross Income Assets Return on (ROE)
Gross Income x Assets x Shareholders Equity
Equity
Of what value is the earnings power formula?
A.First it describes the three key factors that determine ROE. Second,
it is the initial step into an indepth analysis of profitability.
Third, it sorts out the mass of complex, financial data, gives it some
order, and permits conclusions and evaluations to be made.
Q.What do you mean by "The Three key factors that determine ROE. "?
A.The management of any firm can only influence or manage these three
basic financial factors. All other financial decisions and elements
are subsets. The earning power formula is a representation of both the
balance sheet and income statement.
Q.Would you please elaborate?
A.Yes, lets start with the Equity Multiplier (Exhibit 2, Schedule 3).
The only decision that impacts the assetlequity relationship is debt.
If a firm has no debt (has not borrowed money or issued bonds), the
assets of the firm will equal equity; and the ratio will be 1: 1. The
multiplier is. impacted solely by liability management.
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Q. Please discuss the factor "asset turnover" (Exhibit 2, Schedule 4).
A. As the formula indicates, asset turnover (gross income/assets) is
determined by the ability of the firm to generate gross income. The
level of gross income can be traced to only three elements or
decisions. One is the price received for the product being sold,
another is the volume of the product being sold, and finally the asset
mix will influence gross income. This factor is not influenced at all
by decisions regarding expenses, it deals solely with income
generation. It is often described as asset management.
Q. Please describe profit margin (Exhibit 2, Schedule 5).
A. Profit margin, as the ratio (net incomelgross income) indicates, is
impacted by management's ability or opportunity to flow the gross
income of the firm to the bottom line. Only three broad areas of
expense erode gross income. The first is the cost of the product, the
second is the operating expense, and the third is income tax. The
lower the dollar level of these three areas, the higher the margin will
be. Profit margin is impacted only by expense control.
Q. What were the results of the comparisons of Intermountain with nine
other natural gas distribution companies?
A. Once again using the earning power formula we see the following
results:
1980
Intermountain Profit Asset Equity ROExx Multiplier =1'1argin Turnover
1.29%x 1.4883X x 3.56X =6.83%
Average of nine
other companies 3.47% x L.2657X x 3.41X =14.98%
Q.What conclusion can you draw from the results?
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margin and the primary contributor to Intermountain's very low return
on equity.
Q. How does Intermountain compare with other firms in controlling
operating expense?
A. Annual reports do not provide income statements in great detail. Only
broad categories such as operation and maintenance, depreciation,
interest, and general taxes are presented. To compare Intermountain
with other firms I selected only operations and maintenance expense.
Q. Why only these categories?
A. Operations and maintenance are the only expenses over which management
has day-to-day control.
Q. What did your analysis of operations and
maintenance expense reveal?
A. Exhibit 2, Schedule 7, Appendix B illustrates that Intermountain's
operation and maintenanceloperating revenue ratio to be less than the
average of the nine firms, and lower than all but two firms. This
suggests to me that Intermountain is doing an excellent job of
controlling operations and maintenance expense. One should keep in
mind that an increase in operating revenues resulting from an increase
in price would also cause an improvement in the ratio. Intermountain's
control of expense is also supported by data appearing on pages 22-23
of their 1981 financial and statistical report.
Q. Would you please summarize your conclusions as to the causes of
Intermountain's low level of ROE.
A. The primary problem is that the cost of their product is far too high
in relation to the sale price. The absence of an acceptable level of
gross margin prevents any opportunity for an appropriate ROE.
Q. In your opinion, what is the solution?
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A. In the short run, the only realistic solution is an increase in rates.
I am assuming that the cost of gas to Intermountain will not be
reduced. If the cost of gas to Intermountain is reduced, another
solution would be to not reduce the rates charged to the customer.
Over the long run Intermountain must participate in the promotion of
industrial development in Southern Idaho. This will increase volume
and operating revenues. Intermountain must develop a record of stable
earnings in order to attract capital at a reasonable cost.
Q. Are you familiar with the balancing account proposed by the Company in
this case?
A. Yes, I understand it to be a band on the allowed gross margin in this
case.
Q. Should this mechanism be adopted by this Commission, what impact do you
believe it will have on the prospective investors' view of
Intermountain Gas Company?
A. I believe it would certainly be favorable. The increased stability of
reported earnings caused by the band, in itself, should cause a
positive perception by the investor. More importantly, that earnings
stability will provide current-year profits at least covering the
common dividend level which, as I have pointed out, is of immediate
concern to Intermountain's investors.
Q. If revenues do not increase to acceptable levels, or the balancing
account is not adopted, what do you see as the next step?
A. Intermountain cannot continue with a payout ratio in excess of 100%.
If dividends remain in excess of earnings, the shareholders equity will
eventually be destroyed. In addition, restrictions placed on retained
earnings will prevent a high percentage payout. If revenues cannot be
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increased to acceptable levels, the Intermountain Board of Directors
must cut the level of dividends.
Q. In your opinion, what would be the impact of a cut in dividends or even
an omission of dividends on the cost of capital for Intermountain Gas?
A. Historical evidence exists which indicates that either a cut in
dividends or an omission of dividends has a significant negative impact
on the cost of capital, both equity and debt, for a utility. As an
example, Con Edison omitted a dividend during the spring of 1974.
Following the announcement of the change in dividend levels the common
stock price of Con Edison declined from $19.13 on April 4th to $9.50 on
April 30th. To fully visualize what impact this negative 50.34% change
in the price of the stock would have on a company such as Intermountain
Gas, one only has to go back to the cost of capital calculations shown
earlier and make some modifications for a hypothetical case. As an
example, using the discounted cash flow method of determining a fair
rate of return on common equity, the following might be one possible
outcome of omitting one year's dividends, with an associated 50% cut in
the value of the common stock and the anticipation that the dividend
would be restored the next year.
Ke ($1.401$5.50) + 7.8%
Ke = 25.45% + 7.8%
Ke 33.25% = Cost of Capital
Certainly the extremely high cost of capital would prohibit the
issuance of new stock in the year the dividend was eliminated. In the
case of Con Edison the price of the common stock did not recover to the
levels existing before the dividend omission until August 1976.
Although the negative impacts of a dividend reduction would not be as
great as those associated with a dividend omission, I have used the
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extreme case as an example of the damage to the public interest that
can occur if the dividend policy of a utility is suddenly changed. The
rapid increase in the cost of capital to a utility reducing a dividend
level will eventually be borne by the ratepayers as the utility is
forced to tap the capital markets at increasingly high interest rates
associated with the perceived increased risk to lenders of capital.
The utility must maintain an acceptable level of service and will be
forced to use the capital markets for those funds it is unable to
generate internally. The Con Edison example is by no means unique in
its illustration of the effect of a downward change in the level of
dividends on the price of utility stock. General Public Utilities
Corporation also reduced its dividend in April 1979. The price of a
common stock for the utility declined from $16.25 on April 2, 1979 to
$8.88 on May 23, 1979. The Potomac Electric Power Company also reduced
the level of dividends in July 1969. The price of the common stock of
Potomac Electric Power declined from $18.25 on July 15, 1969, to $15.13
on August 1,1969, following the reduction in dividends. The financial
markets do react to downward changes in the dividend level of a utility
relatively quickly and with a result that causes the cost of capital
for the company to increase. The consistent payment of dividends by
utilities has led some investors to purchase utility stock for a
reliable source of income. This consistent payment of dividends has
even led the stock in at least one large non-natural gas utility to be
referred to as "widows and orphans" stock. It can be argued that,
given the historical record of the 1970's and the 1980's, investors are
relatively unlikely to purchase utility stock for the express purpose
of either capital appreciation or speculation due to the earnings
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trends of ùtilities. The remaining objective reason for holding
utility stock is the steady income from dividends. Without consistent
dividends and a growth in dividends approaching the general change in
the cost of living, investors seeking an income stream may be attracted
to other investments.
Without being attractive to investors seeking either income, capital
appreciation, or speculation, the potential increased cost of capital
may prove to have much greater negative impact on ratepayers in the
long run, compared to the cost of a justified and adequate return on
capital in the short run. Capital, because of its scarcity~ is an
economic good controlled by the unrepealable law of supply and demand
and I urge the Commissioners to grant a return on capital guideline
that is competitive in the marketplace.
Q. Does this conclude your direct testimony?
A. Yes, it does.
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