Kate Stark, the electric utilities analyst at First Equity Securities Corporation was faced with a decision involving FPL Group on May 5, 1994. Three weeks earlier, she had valued FPL with a “hold” recommendation due to the belief that FPL would either keep its dividend payout at $2.48 or increase it slightly. Today however, she saw a report from Merrill Lynch stating that they were downgrading FPL stock due to management’s concern that the dividend payout was too high given the increasing risks facing the industry. This report caused Stark to reconsider his previous “hold” rating and she questioned if she would need to issue an updated report. Our problem was to determine if FPL is likely to change their current dividend policy and how such a dividend policy change would affect shareholders. From that analysis, we are to decide how Kate Stark should advise investors with regard to FPL stock. The Electric Utility Industry Evaluation
The electric utilities industry consists of three stages: the generation, transmission, and distribution of electricity. In the past, states had government agencies that regulated the prices and returns of utility companies. Due to several government Acts, the electric utilities industry became one with a large number of undiversified, intrastate companies operating under high federal and state government regulations. During the 1970’s and 1980’s, there began a rise of deregulation in many monopoly service industries, including the electric utility industry. By 1978, regulatory changes had started to break down electric utilities franchises as competition was introduced to the generation and transmission states. Deregulation of distribution, the final segment of the industry, was also starting at the onset of 1994. The state of California had proposed the addition of competition to the distribution of electricity when the California Public Utilities commission released a proposal to phase in retail wheeling beginning in 1996. The addition of retail wheeling allows customers to purchase electricity from other utilities than the local monopolies. Over time, all users would be given the option to pick their electricity supplier from a range of competitive bids. The week after this proposal, the three largest utilities in California lost a combined $1.8 billion of market value, an average 8% loss each.
The recent deregulation and reshaping of the entire industry has forced FPL to consider the impact. Although Florida is not considering retail wheeling as of this point, utility commissions in 23 states are considering such proposals and the effect is expected to domino to the rest of the country, including Florida, in the near future. When retail wheeling becomes authorized in Florida, FPL will gain many potential competitors that previously didn’t supply to the South/East Florida area. Florida has 4 major investor-owned utilities, 20 municipal and rural cooperative generating systems, 19 independent power producers, and several large investor-owned utilities of neighboring states that would all be competing for customers in Florida.
FPL needs to be concerned of similar implications as those that occurred in California. It is expected that deregulation will decrease market share and therefore reduce profits since FPL will no longer gain the benefit of being a monopoly. FPL needs to make certain that they will be able to handle competition from both in state as well as out of state utilities. As a result, it is possible that FPL may need to retain a larger amount of earnings than past years in order to prepare for the entry of competition into the industry. Cutting dividends would provide FPL with a significantly larger amount of retained earnings with which to adjust to the future industry challenges. Maintaining the high payout ratio may not be in FPL’s best interest if the challenges of reshaping the industry by retail wheeling are enacted in Florida. FPL Company Background...
Bibliography: Van Horne, James C., and John M. Wachowicz Jr. Fundamentals of Financial Management. 10th edition. NJ: Prentice-Hall, 1998.
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