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Bennett Meier

FE AT A GLANCE

P/E ► 10.5   EV/EBITDA ► 4.75   ROA ► 6%   ROE ► 14.6%   Debt to Equity ► 2.82   Current Ratio ► 0.586   Interest Coverage Ratio ► 3.84

 

 

 

 

FirstEnergy (NYSE: FE) is the fifth largest electric utility in the United States, serving over 4.5 retail customers in Ohio, Pennsylvania, and New Jersey. The company took in $12.8 billion in revenues in 2007, producing 81 billion kW-hours of electricity.^[1]

The regions that FirstEnergy serves are supported in large measure by the manufacturing industries; these sectors have seen little to no growth in recent years and FE's total deliveries only increased 2.6% in 2007.^[2] (By comparison, Midwest competitor AEP's deliveries increased by 5.2%.)^[3] However, FE looks to retain or augment its earnings growth in its competitive markets by extending low-cost electricity generation to customers of other utility companies and increasing capacity at existing plants. Nearly 84% of the company's overall generation capacity comes from coal and nuclear sources, and this has largely insulated FE from the effects of rapidly rising oil and natural gas prices.^[4] While FirstEnergy has not jumped on the alternative energy bandwagon as quickly as some of its competitors, the company has taken some initial steps towards diversifying its generation portfolio. In 2006, the company announced that it had signed 20-year agreements to lease 250 megawatts of generation capacity from new wind farm projects in West Virginia.^[5] The company also plans to spend over 1.1 billion dollars in 2008 and 2009 on systems to reduce Sulfur Dioxide and Nitric Oxide emissions in its coal plants.^[6] By 2010, 81% of the company's total generation capacity is slated to be in the form of no- or low-emission plants.^[7] These measures are aimed at reducing the company's expenditures on emissions credits for NO_x and SO₂ as well as decreasing the company's exposure to regulatory fines. Government penalties can be as high as $32,500 per day that a plant operates out of compliance. ^[8]

FirstEnergy faces differing levels of government price regulation across the states in which it operates; Pennsylvania and New Jersey allow competitive electricity generation rates while Ohio rates will remain capped until new legislation takes effect at the start of 2009. If Ohio follows the same trajectory as other deregulated states in 2009, the removal of price caps in the state will lead to market generation rates higher than the previous caps. Higher markets prices will mean that FirstEnergy can charge more for its generation services, ushering in the opportunity for higher earnings.

Business and Financial Profile

^[9]

Unlike many of its deregulated peers, which have started consolidating around one step in the electricity supply process, FE still handles all three--generation, high-voltage transmission, and low-voltage retail distribution--through a network of utility and operations subsidiaries. FirstEnergy divides these subsidiaries into 3 core business segments, Energy Delivery Services, Competitive Energy Services, and Ohio Transitional Generation Services.

• Energy Delivery Services (58.3% of 2007 Operating Income) delivers electricity to 4.5 million customers in Ohio, Pennsylvania, and New Jersey via seven subsidiary utility companies. ^[11] These subsidiaries are Ohio Edison in Central and Northeastern Ohio, Pennsylvania Power Co. (Penn Power) in Western Pennsylvania, Cleveland Electric Illuminating Co. (CEI) in Northeastern Ohio, Toledo Edison Co. in Northeastern Ohio, Jersey Central Power and Light (JCP&L) in New Jersey, Metropolitan Edison Co. in Eastern Pennsylvania, and Pennsylvania Electric Co. in Western Pennsylvania. In addition, Energy Delivery Services oversees American Transmission Systems, Inc, a subsidiary company that owns and operates high voltage transmission lines and facilities across the FirstEnergy coverage area. In total, these subsidiaries own and maintain 117,642 miles of distribution lines and 15,014 miles of high-voltage transmission line. ^[12]
• Competitive Energy Services (34.1% of 2007 Operating Income) supplies power at market prices to its affiliated utility companies and the wholesale market in deregulated states. The segment owns or leases and operates 19 generation plants with a combined production capacity of approximately 14,127 MW.^[13] The segment also purchases energy from the wholesale market to make up the difference between sales obligations and production at any given time. The segment is composed primarily of three subsidiary companies. FirstEnergy Generation Co (FGCO) owns and operates the company's non-nuclear generation facilities. FirstEnergy Nuclear Generation Corp (NGC) owns, but does not operate, all three of FE's nuclear generation plants. FirstEnergy Nuclear Operating Company (FENOC) operates the company's fleet of nuclear generation facilities.
• Ohio Transitional Generation Services (6.1% of 2007 Operating Income) generates power for FirstEnergy's Ohio utility companies that supply electricity to non-shopping customers in Ohio.

2007 Revenue and Operating Income by Business Segment

Net income from Energy Delivery Services fell 3% in 2007 despite a weather-driven 14% increase in revenues. Most of the drop came from the increased price of wholesale electricity purchased in times of peak demand. On the other hand, Competitive Energy Services' net income rose 25% in 2007, buoyed by increased demand for cheap wholesale electricity.^[15]

From 2003 to 2008, FE experienced average earnings growth of 32.3%, though this growth is mostly attributable to FY 2004. Earnings doubled that year as the company finally recovered from operational failures at a critical low-cost generation plant. In 2002, the company's Davis-Besse nuclear plant was locked down for 2 years after inspectors found considerable corrosion on a reactor head. This forced the company to resort to other, more costly plants to supply some of its base load-load power until 2004 when David-Besse reopened.

Trends and Forces

^[16]

FirstEnergy More Insulated from Rising Oil and Natural Gas Prices than Competitors

In the period between 2002 and 2008, the price of natural gas in the United States has risen more than 170%.^[17] This upward trend has mirrored similar price movements in the market for crude oil, which has risen from below $20/barrel in late 2001 to upwards of $140/barrel in July of 2007.^[18] The rising price of these fuels has cut substantially into utility companies' bottom lines, as these energy sources accounted for nearly 20% of all electricity production in 2006.^[19] While FirstEnergy is not entirely immune to these price increases--11% of the company's total generation capacity is fueled by natural gas or oil^[20]--it is much less exposed than the industry as a whole. Nationwide, over 47% of the electricity industry's total production capacity comes from plants burning oil and natural gas.^[21] FE makes up for this difference with a higher-than average emphasis on nuclear (28% of FE's total generating capacity) and coal burning plants (56% of FE's total generating capacity).^[22] Prices for these fuels have also increased since 2002, though not at nearly the same rate. (The price of coal has risen 41% since 2002^[23], while the price of reactor-grade uranium contracts rose 131% over the same time period.^[24])

Deregulation in Ohio Offers Opportunity for Higher Revenues, Chance of Backlash

Historically, the price that utility companies could charge consumers for electricity generation has been capped by state regulators. These price caps were originally put in place to combat the pricing power that arose from utility companies' near-monopoly position. Since the mid-1990's, however, many states have started deregulating their energy industries with the intent of lowering prices by letting retail customers "shop" for the company that generates their electricity. New Jersey and Pennsylvania both have market-rate generation prices and Ohio has recently taken legislative steps in the same direction. In most states, however, utilities rates have actually increased in the short term following the removal of rate caps as companies move to align their prices with their costs. Energy rates in deregulated states increased 26.1% on average from 2002 to 2006 while in regulated states they climbed only 16%. ^[25] If electric prices in Ohio react as they have in other states, FirstEnergy will be able to charge more for its services in a competitive environment. There is a risk, however, to price increases. The Ohio legislation slated to go into effect in 2009 requires utilities to prove that competition exists in the marketplace. As utility prices rise, it becomes harder and harder to make that case and more and more likely that the state would re-instate their price-capping system.

Nuclear Insurance Regulations Open FirstEnergy to Risk of Other Companies' Failures

Under U.S. law, public liability for a single nuclear incident at a generation facility is capped at $10.8 Billion.^[26] Companies are required to carry $300 million worth of private insurance in the event of such a disaster, but the rest of the liability is covered by the rest of the nuclear generation units operating in the United States, each responsible for up to $100.6 million worth of contributions. Since FirstEnergy owns/leases and operates 4 nuclear units, it could be liable for contributions of up to $402.4 million dollars (around $60 million annually) under its legal obligations.^[27]

Extreme Seasonal Temperatures Increase Demand for Electricity

US consumers rely heavily on electricity to cool their homes in the summer and, to a lesser extent, to warm their homes in the winter. It follows that colder winters and hotter summers lead to higher electricity demands. 2007 was a year of particularly heavy temperature swings; heating degree days (the number of degrees that a day's average temperature is below 65 degrees Fahrenheit) in FE's coverage area increased by 11.2% and cooling degrees (the number of degrees that a day's average temperature is above 65 degrees Fahrenheit) increased 16.7% over 2006 levels.^[28] This increased weather volatility was primarily responsible for the 2.6% increase in KWH deliveries on the year, corresponding to a 60 million dollar rise in distribution revenues. In that same year deliveries to residential customers, for whom heating and cooling make up a larger proportion of total electricity usage, KWH deliveries increased by 4.3%. ^[29]

FE Less Exposed than Competitors to Potential Future Greenhouse Gas Regulations

Just as FirstEnergy's high concentration of nuclear generation units (28% of total capacity^[30] compared to the industry average of 6%^[31] ) has helped insulate the company from rising fuel prices, it also serves as a buffer against future restrictions on plant emissions. In July 2008, seven western states in the US and three Canadian provinces collectively proposed a plan that would institute a cap and trade system on Carbon Dioxide emissions in those states. While these programs do not directly affect FE, they indicate that the American public is increasingly willing to regulate greenhouse gases. Any such federal program would put additional short-term financial burdens on the electricity industry as many electricity companies would have to pay for allowances to emit more than their CO₂ quota. FE, with its high percentage of non-emitting nuclear plants, would need to buy fewer allowances than its fossil fuel-heavy competitors and this would translate into lower operations costs and higher margins.

Competitors

Like all utility companies, FirstEnergy's distribution services are still regulated by state governments. While this regulation places limits on distribution costs that can be added to electricity bills, it also ensures that the distribution companies have a service monopoly over the areas they serve.

This is no longer the case on the generation side of the business and FE faces competition from a number of generation companies in the Northeast and Midwest. Most notable among these companies are American Electric Power Company (AEP), Duke Energy Corporation (DUK), Entergy (ETR), Exelon (EXC) and Public Service Enterprise Group (PEG).

References

1. ↑ | FE, 2007 Annual Report, pp. 7
2. ↑ | FE, 2007 Annual Report, pp. 19
3. ↑ | AEP, 2007 Annual Report
4. ↑ | FirstEnergy, Corporate Profile: Generation System
5. ↑ | FirstEnergy website, "FirstEnergy Signs Power Purchase Agreements for Two Wind Projects Being Developed in West Virginia," 3/15/2006
6. ↑ | FE, 2007 Annual Report, pp. 13
7. ↑ | FE, 2007 Annual Report, pp. 13
8. ↑ | FE, 2007 Annual Report, pp. 51
9. ↑ | Google Finance: FE, Annual Income Statement
10. ↑ | Google Finance: FE, Annual Income Statement
11. ↑ | FE, 2007 Annual Report, pp. 9
12. ↑ | FE, 2007 10-K Report, Item 2: Properties, pp. 35
13. ↑ | FE, 2007 10-K Report, Item 2: Properties, pp. 31
14. ↑ | FE, 2007 Annual Report, Results of Operations, pp. 17
15. ↑ | FE, 2007 Annual Report, Results of Operations, pp. 19-20
16. ↑ | FE Corporate Profile: Generation System
17. ↑ | Energy Information Administration: U.S. Natural Gas Electric Power Price
18. ↑ | WTRG Economics, "History and Analysis: Crude Oil Prices"
19. ↑ | Energy Information Administration: Net Generation by Energy Source
20. ↑ | FirstEnergy, Corporate Profile: Generation System
21. ↑ | U.S. Energy Information Administration, "Existing Capacity by Energy Source"
22. ↑ | FirstEnergy, Corporate Profile: Generation System
23. ↑ | U.S. Energy Information Administration, "Annual Energy Review: Coal," pp. 217
24. ↑ | U.S. Energy Information Administration, "Uranium Purchased by Owners and Operators of U.S. Civilian Nuclear Power Reactors"
25. ↑ | USA Today, "Shocking Prices Follow Deregulation," 8/10/2007
26. ↑ | FE, 2007 10-K Report, Item 1A: Risk Factors, pp. 26
27. ↑ | FE, 2007 10-K Report, Item 1A: Risk Factors, pp. 26
28. ↑ | FE, 2007 Annual Report, Results of Operations, pp. 19
29. ↑ | FE, 2007 Annual Report, Results of Operations, pp. 19
30. ↑ | FE, Corporate Profile: Generation System
31. ↑ | Energy Information Administration: Net Generation by Energy Source