Trailblazer Pipeline Company LLC Docket No. RP- -000
UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION Trailblazer Pipeline Company LLC ) ) ) Docket No. RP- -000 SUMMARY OF PREPARED DIRECT TESTIMONY OF PAUL R. MOUL ON BEHALF OF TRAILBLAZER PIPELINE COMPANY LLC Paul R. Moul presents evidence, analysis, and recommendations concerning the appropriate cost of equity that the Federal Energy Regulatory Commission should recognize in the cost of service for Trailblazer Pipeline Company LLC ( Trailblazer ). Witness Moul evaluates the risk of Trailblazer relative to two groups of companies, the Stand & Poor s Public Utilities and a Proxy Group, developed by Trailblazer Witness Barry E. Sullivan. Witness Moul analyzes and explains the selection of capital structure ratios and cost of debt for Trailblazer, both of which were based on the average of the Proxy Group, since neither Trailblazer nor its parent hold any debt. Witness Moul describes his analysis of the cost of equity for Trailblazer using the Discounted Cash Flow ( DCF ) and Two-Stage DCF methodologies, as well as three other models: the Risk Premium analysis, the Capital Asset Pricing Model, and the Comparable Earnings approach. Witness Moul supports his testimony with exhibits which contain detailed financial data on each Proxy Group member supporting his analysis and recommendation of a.% return on equity for Trailblazer.
UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION Docket No. RP- -000 Page of Trailblazer Pipeline Company LLC ) ) ) Docket No. RP- -000 PREPARED DIRECT TESTIMONY OF PAUL R. MOUL ON BEHALF OF TRAILBLAZER PIPELINE COMPANY LLC June, 0
Docket No. RP- -000 Page of TABLE OF CONTENTS GLOSSARY OF TERMS... I. INTRODUCTION... II. INTERSTATE NATURAL GAS COMPANY RISK FACTORS... III. FUNDAMENTAL RISK ANALYSIS... IV. COST OF EQUITY GENERAL APPROACH... V. DISCOUNTED CASH FLOW ANALYSIS... VI. TWO-STEP DCF MODEL... VII. RISK PREMIUM ANALYSIS... VIII. CAPITAL ASSET PRICING MODEL... IX. COMPARABLE EARNINGS APPROACH... X. CONCLUSION...
Docket No. RP- -000 Page of GLOSSARY OF TERMS AFUDC β b b x r Blue Chip CAPM Commission Company DCF FERC Flot. FOMC g GDP i IBES IGF MLP Opinion No. P-E Allowance for Funds Used During Construction Beta Represents the retention rate that consists of the fraction of earnings that are not paid out as dividends. Represents internal growth. Blue Chip Financial Forecasts Capital Asset Pricing Model Federal Energy Regulatory Commission Trailblazer Pipeline Company LLC Discounted Cash Flow Federal Energy Regulatory Commission Flotation costs Federal Open Market Committee Growth rate Gross Domestic Product The sum of the prospective yield for long-term public utility debt Institutional Brokers Estimate System Internally Generated Funds Master Limited Partnerships Coakley v. Bangor Hydro-Electric Co., Opinion No., FERC,, order on paper hearing, Opinion No. -A, FERC,0 (0), order on reh g, Opinion No. -B, 0 FERC, (0), vacated and remanded sub nom. Maine v. FERC, F.d (D.C. Cir. 0). Price-earnings
Docket No. RP- -000 Page of Pipeline Proxy Group Policy Statement r Rf Rm RP s SBBI Yearbook s x v S&P Tallgrass Equity Boardwalk Pipeline Partners LP, Dominion Midstream Partners LP, Enable Midstream Partners, LP, EQT Midstream Partners, L.P., Kinder Morgan, Inc., Spectra Energy Partners, LP, and TC PipeLines LP. Composition of Proxy Groups for Determining Gas and Oil Pipeline Return on Equity, FERC,0 ( Policy Statement ), reh g dismissed, FERC, (00). Represents the expected rate of return on common equity. Risk-free rate of return Market risk premium Represents equity risk premium Represents the new common shares expected to be issued by a firm. 0 SBBI Yearbook, Stocks, Bonds, Bills and Inflation Represents external growth. Standard & Poor s Tallgrass Equity, LLC TCJA Tax Cut and Jobs Act, Pub. L. No. -, Stat. 0 (0). TGE TEP Trailblazer v Value Line Tallgrass Energy, LP Tallgrass Energy Partners, LP Trailblazer Pipeline Company LLC Represents the value that accrues to existing shareholders from selling stock at a price different from book value. The Value Line Investment Survey for Windows
Docket No. RP- -000 Page of 0 I. INTRODUCTION Q. Please state your name, occupation, and business address. A. My name is Paul Ronald Moul. My business address is Hopkins Road, Haddonfield, New Jersey 00-0. I am Managing Consultant at the firm P. Moul & Associates, an independent, financial and regulatory consulting firm. Q. Please briefly state your professional experience and qualifications. A. My educational background, business experience and qualifications are provided in Appendix A that follows my direct testimony. Q. Have you previously testified before the Federal Energy Regulatory Commission ( Commission or FERC )? A. Yes. Q. On whose behalf are you submitting your prepared testimony in this proceeding? A. I am submitting testimony on behalf of Trailblazer Pipeline Company LLC ( Trailblazer or the Company ). Q. What is the purpose of your testimony? A. My testimony presents evidence, analysis, and a recommendation concerning the rate of return on common equity that Commission should recognize in the cost of service for Trailblazer. Q. Have you provided any exhibits with your testimony? A. My recommendation is supported by the detailed financial data set forth in Exhibit No. TPC-00, which is a multi-page document divided into thirteen () schedules.
Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Schedule Summary Cost of Equity and Cost of Capital Docket No. RP- -000 Page of Trailblazer Pipeline Company LLC Historical Capitalization and Financial Statistics Pipeline Group Historical Capitalization and Financial Statistics Standard & Poor s Public Utilities Historical Capitalization and Financial Statistics Cash Yields Historical Growth Rates Projected Growth Rates Analysis of Public Offerings of Common Stock Two-Stage DCF Model Interest Rates for Investment Grade Public Utility Bonds Common Equity Risk Premium Component Inputs for the Capital Asset Pricing Model Comparable Earnings Approach 0 Q. Based upon your analysis, what is your conclusion concerning the appropriate rate of return on equity for the Company in this case? A. Based upon my independent analysis, my conclusion is that Trailblazer should be afforded an opportunity to earn a rate of return on equity, as selected by Trailblazer Witness David J. Haag, of at least.%. See Ex. No. TPC-00. My cost of equity determination should be viewed in the context of increasing capital costs revealed by rising interest rates. Moreover, as I will describe below, there will be more risk faced by the Company with the passage of the Tax Cut and Jobs Act ( TCJA ) signed into law on December, 0. The Company has
Docket No. RP- -000 Page of 0 used a.% rate of return on equity in calculating the weighted average cost of capital in Statement F-. Exhibit No. TPC-00. I have reproduced the Company s overall rate of return on page of Schedule of my exhibit. The weighted average cost of capital, when applied to Trailblazer s rate base, is projected to provide a compensatory level of return for the use of capital and will provide Trailblazer with the ability to attract new capital on reasonable terms. Q. What is your understanding of the Company s operations? A. Prior to July 0, Trailblazer was a wholly owned subsidiary of Tallgrass Energy Partners, LP ( TEP ). As described more fully in the testimony of Witness Haag, following a corporate reorganization that was approved by the TEP unitholders on June, 0, Trailblazer is a now a wholly owned subsidiary of Tallgrass Equity, LLC ( Tallgrass Equity ). Tallgrass Equity is in turn majorityowned by Tallgrass Energy, LP ( TGE ), a newly formed entity that is taxed as a C-Corporation. I have considered the general nature of Trailblazer s operations in reaching my conclusions and recommendation. The testimony of Witness Barry E. Sullivan describes the nature of the Company s operations. See Ex. No. TPC- 00. I have relied upon the testimony of Witness Sullivan in forming my recommended rate of return on common equity. Q. How have you determined the cost of equity for Trailblazer? A. I established the cost of equity using publicly available capital market and financial data for a Proxy Group of seven gas pipeline companies ( Pipeline Proxy Group ) to assess the relative risk, and hence the cost of equity, for Trailblazer. In this regard, I relied on four well-recognized measures: (i) the
Docket No. RP- -000 Page of 0 Discounted Cash Flow ( DCF ) model, (ii) the Risk Premium analysis, (iii) the Capital Asset Pricing Model ( CAPM ), and (iv) the Comparable Earnings approach. The models that I used to measure the cost of equity for Trailblazer are based upon market data developed from the Pipeline Proxy Group, which consists of entities that have significant interests in Commission-regulated natural gas pipelines. Each of the members of the Pipeline Proxy Group have characteristics that comply with the Commission s policy for assembling a Proxy Group, as explained in the testimony of Witness Sullivan. As this proceeding progresses, it may be necessary to adjust the composition of the Pipeline Proxy Group or revise my analysis in light of transactions that may be announced, changes in the credit situations, or dividend cuts by members the Pipeline Proxy Group. Q. Please summarize the basis of your analysis for your recommended cost of equity in this proceeding. A. I acknowledge that the Commission routinely expresses its cost of equity determination in rate case decisions in terms of the DCF model, and, more specifically, its two-step form of the model. But the Commission also stated in Opinion No. that it was interested in the results of other models. Opinion No. indicates that the results of other models help guide the Commission toward selecting a return from the range indicated by the two-step DCF model See See Coakley v. Bangor Hydro-Electric Co., Opinion No., FERC,, order on paper hearing, Opinion No. -A, FERC,0 (0), order on reh g, Opinion No. -B, 0 FERC, (0), vacated and remanded sub nom. Maine v. FERC, F.d (D.C. Cir. 0).
Docket No. RP- -000 Page of Opinion No. at P. Hence, I have also provided the cost of equity results from other models. In general, the use of more than one method will provide a superior foundation to arrive at the cost of equity. At any point in time, individual methods may be unduly influenced by extraneous factors and/or market sentiment that may produce anomalous results. The use of multiple methods will help to mitigate such occurrences. Q. What is your recommendation based upon the Commission s two-step form of the DCF model? A. My DCF analysis using the Commission s two-step model for the Pipeline Proxy Group provides a median return of.%, prior to an adjustment for flotation costs. The.% median DCF return using the Commission s two-step model is derived from the Pipeline Proxy Group range of returns of.% to.%. See Ex. No. TPC-00, Sched.. Q. Please also provide the results of the additional methods you relied upon. A. The following table provides a summary of the indicated costs of equity using the DCF model as well as the Risk Premium analysis, CAPM, and Comparable Earnings approach. I have presented the results of my analysis by both including and excluding an allowance for flotation costs.
Proxy Pipeline Group Excl. Flot. Incl. Flot. () DCF: Two-stage.%.% Single growth.0%.% Risk Premium.00%.% CAPM.%.% Docket No. RP- -000 Page of Comparable Earnings.0%.0% () Flotation costs are defined as the out-of-pocket costs associated with the issuance of common stock. Those costs typically consist of the underwriters discount and company issuance expenses. Based on the cost of capital model results shown above,.% is a reasonable recommendation for Trailblazer s cost of equity. It is noteworthy that in determining an appropriate cost of equity, I considered directly the results of a two-step DCF model. While the Commission s DCF model is known as the twostep DCF model, in reality, it is actually the familiar constant growth DCF model that contains a blended growth rate. The growth rate is a blend of the analysts forecasts of growth taken from several sources and a generic long-term growth rate taken from the forecast of the growth in the gross domestic product ( GDP ) also taken from several sources. The later GDP growth rate can be viewed as a generic, non-company specific rate of growth. My testimony will explain the results of my two-step DCF analysis, using the familiar components of yield and short term as well as long term growth.
Docket No. RP- -000 Page of 0 Q. How has the Commission assessed the presence of anomalous market conditions and how has it impacted its cost of equity determination? A. The Commission has looked at the level of interest rates and bond yields to determine whether market conditions are anomalous. As the data contained in Schedules and shows, anomalous market conditions presently exist due to low interest rates and bond yields. As I describe later in my testimony, actions by the Federal Reserve s Federal Open Market Committee ( FOMC ) are mainly responsible for these low rates. Indeed, the Federal Reserve has continued to maintain a large balance sheet through its holding of Treasury securities and mortgage-backed securities. While the Federal Reserve has stopped adding to its holdings, its balance sheet currently contains $. trillion of these securities. The Commission has found that these actions have created anomalous market conditions which the Commission has responded to by adjusting upward the point at which the Commission sets a return on equity in the range of returns resulting from a DCF analysis. See Ass n of Bus. Advocating Tariff Equity v. Midcontinent Indep. Sys. Operator Inc., Opinion No., FERC,, at P (0); Opinion No. at P. The Commission has repeatedly expressed the concern that a mechanical application of the DCF methodology would result in an equity return that is inconsistent with the landmark Bluefield Water Works & Improvement Co. v. Public Service Commission of West Virginia, U.S. () and FPC v. Hope Natural Gas Co., 0 U.S. () decisions. Q. In your opinion, what factors should the Commission consider when setting Trailblazer s rate of return in this proceeding?
Docket No. RP- -000 Page of A. The rate of return should be sufficient to cover the Company s payment of interest and dividends, compensate Trailblazer s equity investors for the use of capital, produce an adequate level of internally generated funds to meet capital requirements, support reasonable credit quality, be adequate to attract capital on reasonable terms, and compensate for the risk to which Trailblazer s equity capital is exposed. The proposed return fulfills these established standards of the opportunity to earn a fair rate of return set forth in Bluefield and Hope. That is to say, the proposed rate of return is commensurate with returns available on investments having corresponding risks. II. INTERSTATE NATURAL GAS COMPANY RISK FACTORS 0 Q. Please describe the business environment facing interstate natural gas companies. A. The Commission s general policy is to foster competition in the natural gas business through regulatory and commercial practices (e.g., permitting the discounting and negotiation of rates). These regulatory policies have elevated the risk profile of the natural gas transmission business based on changing relationships with pipelines shippers (e.g., a general move to transportation contracts with shorter terms). For the future, the business environment facing the natural gas business will be influenced by changing regulation, revenues being pressured by competition, shorter contract terms, and counter-party risks. Q. What is the competitive position of the natural gas transmission business environment?
Docket No. RP- -000 Page of 0 A. Witness Sullivan describes the business risks of natural gas pipelines generally and those facing Trailblazer specifically. Gas producers, marketers, distributors, and other end-users now have a broad array of choices that may reduce the need for traditional long-term contracts for transportation service. Shippers can more readily obtain short-term contracts, shifting risks to the pipelines. Indeed, shippers can also compete directly with pipelines by releasing their firm capacity to other shippers. Q. You indicated previously that the new federal income tax law will add to the Company s risk. Please explain. A. There are several major financial consequences arising from the changes in the federal income tax law associated with TCJA that will negatively impact the Company. First, a lower federal income tax rate will lower the Company s pretax interest coverage and will reduce credit quality and increase risk. For example, page of Schedule shows that with the marginal federal corporate income tax rate change, the pre-tax interest coverage would be. times with the capital structure shown in Statement F-. Under the old % marginal federal corporate income tax rate, the pre-tax interest coverage would have been. times. This assumes no other changes in tax provisions that may also impact the Company s financial condition. If taxes were eliminated entirely from the cost of service, then interest coverage would drop to. times, thereby increasing credit risk even further. Second, with a lower marginal federal corporate income tax rate, the Company s return variability will increase, thereby increasing its business risk. When the federal corporate income tax rate was formerly %,
Docket No. RP- -000 Page of 0 investors only needed to absorb % of any changes in revenues and expenses. At a % federal corporate income tax rate, investors will need to absorb % of changes in revenues and expenses. That is to say, the reduced federal income taxes will make investor returns more variable than formerly, thereby increasing the Company s business risk. And, to complicate matters, if no income taxes were included in the cost of service, then investors would need to absorb 0% of changes in revenue and expenses. That situation would make a pipeline s business risk significantly higher than other types of regulated businesses. That is to say, the reduced (or eliminated) federal income taxes will make investor returns more variable than formerly, thereby increasing the Company s business risk. Third, companies will require more investor supplied capital to fund their capital expenditures because the level of deferred taxes will decline and because the new tax law eliminates bonus depreciation. This will also impact another credit metric revealed by the percentage of internally generated funds to construction. This percentage will decline with the new lower income tax rate. In response to these financial challenges caused by the new lower federal corporate income tax rate, there may be the need to reduce the percentage of debt in a pipeline s capital structure to respond to higher business risk and weaker credit quality measures. Q. Is there any indication that the equity returns calculated with standard cost of equity models, such as the DCF and your corroborative methods, contain any provision for income taxes? A. No. Investors price financial assets, such as common stocks, based upon the cash flows that they will receive in the future. Whether those cash flows are
Docket No. RP- -000 Page of represented by dividends from a corporation, distributions from a Master Limited Partnership ( MLP ), or a liquidating dividend upon sale of a share of stock or unit, none of those cash flows can be associated specifically with income taxes. That is to say, the cash flows received by investors are non-distinguishable as to the compensation being provided. This is especially apparent from not only the DCF model, but also in the Risk Premium model, the CAPM and the Comparable Earnings method. The Risk Premium method uses a spread to reflect the higher risk compensation for common equity versus the lower risk associated with debt. Those spreads have no provision that would specifically account for income taxes. In the CAPM, income taxes are a non-systematic risk factor, which receives no compensation in the model. The CAPM measure of risk, i.e., the beta, measures solely systematic risk. And for Comparable Earnings, those returns are based entirely on after-tax results. Hence, none of the models have any provision for income rates specified in their results. III. FUNDAMENTAL RISK ANALYSIS 0 Q. Is it necessary to conduct a fundamental risk analysis prior to a determination of a pipeline s cost of equity? A. Yes. In addition to qualitative factors, it is necessary to establish a company s relative risk position within its industry through an analysis of various quantitative factors that bear upon investors assessment of overall risk. Items that influence investors evaluation of risk and their required returns are described above.
Docket No. RP- -000 Page of 0 Q. What comparison groups have you employed to assess the Company s position vis-à-vis other regulated companies? A. Trailblazer is compared to two groups of companies. Those groups are the Standard & Poor s ( S&P ) Public Utilities and the Pipeline Proxy Group. The S&P Public Utilities is a widely recognized index comprised of electric power companies and natural gas companies. The companies that comprise the group are identified on page of Schedule. I used this group as a broad-based measure of all types of regulated companies. The Pipeline Proxy Group includes: Boardwalk Pipeline Partners LP, Dominion Midstream Partners LP, Enable Midstream Partners, LP, EQT Midstream Partners, L.P., Kinder Morgan, Inc., Spectra Energy Partners, LP, and TC PipeLines LP. Q. What specific financial data have been considered in Trailblazer s analysis? A. I have compared financial data for Trailblazer to financial data related to the Pipeline Proxy Group and the S&P Public Utilities. The broad categories of financial data that I will discuss are shown on Schedule, Schedule, and Schedule. The data cover the five-year period 0 0. The source of the financial data for Trailblazer is its annual Form filings with the Commission. These schedules include data concerning the following factors that affect investors perception of the market required return. Size. In terms of capitalization, the size of Trailblazer is very much smaller than the average size of entities in either the Pipeline Proxy Group or the S&P Public Utilities. All other things being equal, a smaller company is riskier
Docket No. RP- -000 Page of 0 than a larger company because a given change in nominal revenues and/or expenses has a proportionately greater impact on a smaller company. Market Ratios. Market-based financial ratios provide a partial measure of the investor-required cost of equity. If all other factors are equal, investors will require a higher return on equity for companies which exhibit greater risk in order to compensate for that risk. That is to say, a firm that investors perceive to have higher risks will experience a lower price per share in relation to expected earnings. The five-year average price-earnings multiple was similar for the Pipeline Proxy Group and the S&P Public Utilities. The five-year average market-to-book ratio was higher for the Pipeline Proxy Group than for the S&P Public Utilities. The five-year average dividend yield was also higher for the Pipeline Proxy Group compared to S&P Public Utilities. There are no market-based financial ratios for Trailblazer. And hence, no conclusions can be drawn from these factors in the fundamental risk analysis of Trailblazer. Common Equity Ratio. The level of financial risk is measured by the ratio of long-term debt and other senior capital to permanent capital. Financial risk is also analyzed by comparing common equity ratios (the complement of the ratio of debt and other senior capital). That is to say, a firm with a high common equity ratio has lower financial risk, while a firm with a low common equity ratio has higher financial risk. The five-year average common equity ratio comparisons, For example, two otherwise similarly situated firms each reporting $.00 earnings per share would have different market prices at varying levels of risk (i.e., the firm with a higher level of risk will have a lower share value, while the firm with a lower risk profile will have a higher share value).
Docket No. RP- -000 Page of based on permanent capital, were 0.0% for Trailblazer,.% for the Pipeline Proxy Group, and.% for the S&P Public Utilities. Ex. No. TPC-00, Sched. at ; id. Sched. at. Since Trailblazer has no debt in its capital structure, the consolidated capital structure ratios of TEG have been proposed pursuant to Commission policy. The common equity ratio contained in Statement F- is.% for TEG. Ex. No. TPC-00. Hence, the Company s rate-setting common equity ratio contains more financial risk than the Pipeline Proxy Group that has a higher common equity ratio. Variability in Return on Book Equity. Greater variability (i.e., 0 uncertainty) of a firm s earned returns signifies relative levels of risk, as shown by the coefficient of variation (standard deviation mean) of the rate of return on book common equity. The higher the coefficient of variation, the greater degree of variability. For the five-year period, the coefficients of variation were 0. (.%.%) for Trailblazer, 0. (.%.%) for the Pipeline Proxy Group, and 0.0 (0.%.%) for the S&P Public Utilities. Trailblazer has experienced much more variability compared to the Pipeline Proxy Group and the S&P Public Utilities. As such, the risk of Trailblazer exceeds the risk of the Pipeline Proxy Group. Moreover, as I indicated previously, the recent changes in the federal income tax law will likely make these variability statistics higher in the future. Operating Ratios. I have also compared operating ratios (the percentage of revenues consumed by operating expense, depreciation, and taxes other than
income). Docket No. RP- -000 Page of The five-year average operating ratios were.0% for Trailblazer,.% for the Pipeline Proxy Group, and.% for the S&P Public Utilities. Ex. No. TPC-00, Sched. at ; id., Sched. at ; id., Sched. at. The operating ratio for Trailblazer is in the same order of magnitude as the Pipeline Proxy Group. It is difficult to make a comparison of the operating ratios for pipeline companies to the S&P Public Utilities because no material amount of purchased products is included in a pipeline company s base rates. For the S&P Public Utilities, the cost of purchased products and/or fuel expense acts to elevate their operating ratios. With an absence of any cost of purchased products, a lower operating ratio would be expected for pipeline companies. Coverage. The level of fixed-charge coverage (i.e., the multiple by which available earnings cover fixed charges, such as interest expense) provides an indication of the earnings protection for creditors. Higher levels of coverage, and hence earnings protection for fixed charges, are usually associated with increased grades of creditworthiness. The five-year average interest coverage (excluding Allowance for Funds Used During Construction ( AFUDC )) was. times for the Pipeline Proxy Group and. times for the S&P Public Utilities. Ex. No. TPC-00, Sched. at ; id., Sched. at. There are no interest coverage ratios available for Trailblazer. Again, pre-tax interest coverage will decline 0 prospectively with the implementation of the recent federal income tax changes. The complement of the operating ratio is the operating margin which provides a measure of profitability. The higher the operating ratio, the lower the operating margin.
Docket No. RP- -000 Page 0 of Quality of Earnings. Measures of earnings quality usually are revealed by the percentage of AFUDC related to income available for common equity, the effective income tax rate, and other cost deferrals. These measures of earnings quality usually influence a firm s internally generated funds. Typically, quality of earnings has not been a significant concern for Trailblazer, the Pipeline Proxy Group, and the S&P Public Utilities. That is to say, with the percentage of AFUDC that is low and the effective income tax rate that is near statutory rates, the quality of earnings is good. Internally Generated Funds. Internally generated funds ( IGF ) provide an important source of new investment capital for a utility and represent a key measure of credit strength. The IGF percentage to capital expenditures was.% for Trailblazer,.% for the Pipeline Proxy Group, and.% for the S&P Public Utilities. Ex. No. TPC-00, Sched. at ; id., Sched. at ; id., Sched. at. Betas. The financial data that I have been discussing relate primarily to company-specific risks. Market risk for firms with traded stock is measured by beta coefficients. Beta coefficients attempt to identify systematic risk (i.e., the risk associated with changes in the overall market for common equities). The 0 Value Line Investment Survey for Windows ( Value Line ) publishes such a statistical measure of a stock s relative historical volatility to the rest of the The procedure used to calculate the beta coefficient published by Value Line is described on page of Schedule. A common stock that has a beta less than.0 is considered to have less systematic risk than the market as a whole and would be expected to rise and fall more slowly than the rest of the market. A stock with a beta above.0 would have more systematic risk.
Docket No. RP- -000 Page of market. A comparison of market risk is shown by the Value Line betas which are. as the average for the Pipeline Proxy Group (see page of Schedule ) and. as the average for the S&P Public Utilities (see page of Schedule ). The systematic risk for the Pipeline Proxy Group is well above that of the S&P Public Utilities. Q. Please summarize your risk evaluation of Trailblazer, the Pipeline Proxy Group, and the S&P Public Utilities. A. The risk of Trailblazer is greater than the Pipeline Proxy Group and S&P Public Utilities. As such, the Pipeline Proxy Group provides a very conservative basis to measure the Company s cost of equity. IV. COST OF EQUITY GENERAL APPROACH 0 Q. Please describe how you determined the cost of equity for the Company. A. Although my fundamental financial analysis provides the required framework to establish the risk relationships among Trailblazer, the Pipeline Proxy Group, and the S&P Public Utilities, the cost of equity must be measured by standard financial models that I identified above. Differences in risk traits, such as size, business diversification, geographical diversity, regulatory policy, financial leverage, and bond ratings must be considered when analyzing the cost of equity. It is also important to reiterate that no one method or model of the cost of equity can be applied in an isolated manner. Rather, informed judgment must be used to take into consideration the relative risk traits of the firm. It is for this reason that I have used more than one method to measure the Company s cost of equity. As I describe below, each of the methods used to measure the cost of
Docket No. RP- -000 Page of equity contains certain incomplete and/or overly restrictive assumptions and constraints that are not optimal. Therefore, I favor considering the results from a variety of methods. V. DISCOUNTED CASH FLOW ANALYSIS Q. Please describe the DCF model. A. The DCF model seeks to explain the value of an asset as the present value of future expected cash flows discounted at the appropriate risk-adjusted rate of return. In its simplest form, the DCF return on common stock consists of a current cash (dividend) yield and future price appreciation (growth) of the investment. The dividend discount equation is the familiar DCF-valuation model and assumes future dividends are systematically related to one another by a constant growth rate. The DCF formula is derived from the standard valuation model: P = D/(k-g), where P = price, D = dividend, k = the cost of equity, and g = growth in cash flows. By rearranging the terms, we obtain the familiar DCF equation: k= D/P + g. All of the terms in the DCF equation represent investors assessment of expected future cash flows that they will receive in relation to the value that they set for a share of stock (P). The DCF equation is sometimes referred to as the Gordon model. My DCF results are provided on page of 0 Schedule for the Pipeline Proxy Group. The DCF return is.0% using the constant growth model and.% as the median using the two-step DCF model, excluding the adjustment for flotation costs. Although the popular application of the DCF model is often attributed to the work of Professor Myron J. Gordon in the mid-0 s, J. B. Williams exposited the DCF model in its present form nearly two decades earlier.
Docket No. RP- -000 Page of 0 Among other limitations of the model, there is a certain element of circularity in the DCF method when applied in rate cases. This is because investors expectations for the future depend upon regulatory decisions. In turn, when regulators depend upon the DCF model to set the cost of equity, they rely upon investor expectations that include an assessment of how regulators will decide rate cases. Due to this circularity, the DCF model may not fully reflect the true risk of a utility. Q. What is the dividend yield component of a DCF analysis? A. The dividend yield reveals the portion of investors cash flow that is generated by the return provided by dividend receipts. It is measured by the dividends per share relative to the price per share. The DCF methodology requires the use of an expected dividend yield to establish the investor-required cost of equity. For the twelve months ended March 0, the monthly dividend yields are shown on Schedule and reflect an adjustment to the month-end prices to reflect the buildup of the dividend in the price that has occurred since the last ex-dividend date (i.e., the date by which a shareholder must own the shares to be entitled to the dividend payment usually about two to three weeks prior to the actual payment). For the twelve months ended March 0, the average dividend yield was.% for the Pipeline Proxy Group based upon a calculation using annualized dividend payments and adjusted month-end stock prices. Ex. No. TPC-00, Sched. at. The dividend yields for the more recent six- and three-month periods were.% and.%, respectively. Id. I have used, for the purpose of
Docket No. RP- -000 Page of the DCF model, the six-month average dividend yield of.% for the Pipeline Proxy Group. The use of this dividend yield will reflect current capital costs, while avoiding spot yields. For the purpose of a DCF calculation, the average dividend yield must be adjusted to reflect the prospective nature of the dividend payments, i.e., the higher expected dividends for the future. Recall that the DCF is an expectational model that must reflect investor-anticipated cash flows for the Pipeline Proxy Group. I have adjusted the six-month average dividend yield in three different, but generally accepted, manners and used the average of the three adjusted values as calculated in the lower panel of data presented on Schedule. This adjustment adds basis points to the six-month average historical yield, thus producing the.0% adjusted dividend yield for the Pipeline Proxy Group. Id. Q. Are your calculations of the dividend yield for the Pipeline Proxy Group consistent with the Commission s Policy Statement issued April, 00 ( FERC,0)? A. Yes. I have employed a six-month timeframe to calculate the dividend yields. For each month within the six-month period, I have used an average of the Under the / growth approach, the procedure to adjust the average dividend yield for the expectation of a dividend increase during the initial investment period will be at a rate of one-half the growth component, which assumes that two dividend payments will be at the expected higher rate during the initial investment period. Under the discrete approach, the g in the DCF model reflects the discrete growth in the quarterly dividend, which is required for the periodic form of the DCF in order to properly recognize that dividends grow on a discrete basis. The quarterly approach takes into account that investors have the opportunity to reinvest quarterly dividend receipts. Recognizing the compounding of the periodic quarterly dividend payments (D 0 ), results in this third DCF formulation. This DCF equation provides no further recognition of growth in the quarterly dividend. A compounding of the quarterly dividend yield provides another procedure to recognize the necessity for an adjusted dividend yield. Composition of Proxy Groups for Determining Gas and Oil Pipeline Return on Equity, FERC,0 ( Policy Statement ), reh g dismissed, FERC, (00).
Docket No. RP- -000 Page of 0 monthly high and monthly low price for the traded units/common shares and the most recent annualized quarterly distribution per unit/dividends per share. Q. What factors influence investors growth expectations? A. As noted previously, investors are interested principally in the dividend yield and future growth of their investment (i.e., the price per share of the stock). Future earnings per share growth represent the DCF model s primary focus because under the constant price-earnings multiple assumption of the model, the price per share of stock will grow at the same rate as earnings per share. In conducting a growth rate analysis, a wide variety of variables can be considered when reaching a consensus of prospective growth, including earnings, dividends, book value, and cash flow stated on a per share basis. Historical values for these variables can be considered, as well as analysts forecasts that are widely available to investors. A fundamental growth rate analysis is sometimes represented by the internal growth ( b x r ), where r represents the expected rate of return on common equity and b is the retention rate that consists of the fraction of earnings that are not paid out as dividends. To be complete, the internal growth rate should be modified to account for sales of new common stock this is called external growth ( s x v ), where s represents the new common shares expected to be issued by a firm and v represents the value that accrues to existing shareholders from selling stock at a price different from book value. Fundamental growth, which combines internal and external growth, provides an explanation of the factors that cause book value per share to grow over time. Hence, a fundamental growth rate analysis is duplicative of expected book value per share growth.
Docket No. RP- -000 Page of 0 0 Neither the b x r plus s x v formulation of growth nor the book value per share growth rate accurately computes the returns for the gas pipeline and storage companies under a DCF analysis because the value of a firm is determined with market prices that reflect additional factors that are not considered in these formulations of growth. As the Commission has noted in its Policy Statement: Consistent with the premise of the DCF model that a stock is worth the present value of all future cash flows to be received from the investment, investors base their DCF analyses on the MLP s entire cash distributions, including projected cash flows generated by external investments, which to date is the bulk of the investment for the MLP model. In addition, because MLPs rely substantially on external capital to finance growth, the fact one MLP currently pays out more of its earnings than another MLP does not necessarily mean that the first MLP s long-term growth prospects are less than the second MLP s. Policy Statement at P. The Commission went on to comment that: A fundamental problem with this approach is that the Commission has consistently held that the br + sv formula only produces a projection of short-term growth, similar to the IBES projections. This follows from the fact that the inputs used in the formula are all drawn from Value Line data and projections reaching no more than five years into the future. In addition, there would be great uncertainties in projecting any of the inputs to the formula, such as the retention ratio, the amount and timing of equity sales, and the projected price of the sale for any longer period. Moreover, setting the br component at zero assumes that an MLP can only grow through the use of external capital. This does not reflect accurately the retention and investment flexibility vested in an MLP s general partners or the fact that some MLPs may reinvest a fairly high proportion of the free cash available. Therefore, this methodology does not appropriately adjust the long-term GDP component that the Commission now uses for corporations. Id. at P 0.
Docket No. RP- -000 Page of 0 Growth also can be expressed in multiple stages. This expression of growth consists of an initial growth stage where a firm enjoys rapidly expanding markets, high profit margins, and abnormally high growth in earnings per share. Thereafter, a firm enters a transition stage where fewer technological advances and increased product saturation begin to reduce the growth rate and profit margins come under pressure. During the transition phase, investment opportunities begin to mature, capital requirements decline, and a firm begins to pay out a larger percentage of earnings to shareholders. Finally, the mature or steady-state stage is reached when a firm s earnings growth, payout ratio, and return on equity stabilizes at levels where they remain for the life of a firm. The three stages of growth assume a step-down of high initial growth to lower sustainable growth. Even if these three stages of growth can be envisioned for a firm, the third steady-state growth stage, which is assumed to remain fixed in perpetuity, represents an unrealistic expectation because the three stages of growth can be repeated. That is to say, the stages can be repeated where growth for a firm ramps-up and ramps-down in cycles over time. Q. How did you determine an appropriate growth rate? A. I follow an approach that is not rigidly formatted because investors are not influenced by a single set of company-specific variables weighted in a formulaic manner. The growth rate used in a DCF calculation should measure investor expectations. Investors consider both company-specific variables and overall market sentiment (i.e., level of inflation rates, interest rates, economic conditions, etc.) when balancing their capital gains expectations with their dividend yield
Docket No. RP- -000 Page of 0 requirements. Investors are not influenced solely by a single set of companyspecific variables weighted in a formulaic manner. Therefore, all relevant growth rate indicators using a variety of techniques must be evaluated when formulating a judgment of investor-expected growth. Q. What data for the Pipeline Proxy Group have you considered in your growth rate analysis? A. I have considered the growth in the financial variables shown on Schedules and. In this regard, I have emphasized projected growth rates in earnings per share for the Pipeline Proxy Group. While analysts will review all measures of growth as I have done, it is earnings per share growth that influences directly the expectations of investors for utility stocks. Forecasts of earnings growth are required within the context of the DCF because the model is a forward-looking concept, and with a constant price-earnings multiple and payout ratio, all other measures of growth will mirror earnings growth. So, with the assumptions underlying the DCF, all forward-looking projections should be similar with a constant price-earnings multiple, earned return, and payout ratio. The historical growth rates were taken from the Value Line publication that provides this data. As to the issue of historical data, investors cannot purchase past earnings of a pipeline, rather they are only entitled to future earnings. In addition, assigning significant weight to historical performance results in double counting of the historical data. While history cannot be ignored, it is already factored into the analysts forecasts of earnings growth. In developing a forecast of future earnings growth, an analyst would first apprise himself/herself of the historical
Docket No. RP- -000 Page of 0 performance of a company. Hence, there is no need to count historical growth rates a second time, because historical performance is already reflected in analysts forecasts which reflect an assessment of how the future will diverge from historical performance. As shown on Schedule, the historical growth of earnings per share was in the range of -.0% to.% for the Pipeline Proxy Group. Of course, negative growth provides no indication of investor growth expectations that encompass positive returns. Q. Is a five-year investment horizon associated with the analysts forecasts consistent with the traditional DCF model? A. Yes. The constant form of the DCF assumes an infinite stream of cash flows, but investors do not expect to hold an investment indefinitely. Rather than viewing the DCF in the context of an endless stream of growing dividends (e.g., a century of cash flows), the growth in the share value (i.e., capital appreciation or capital gains yield) is most relevant to investors total return expectations. Hence, the sale price of a stock can be viewed as a liquidating dividend that can be discounted along with the annual dividend receipts during the investment-holding period to arrive at the investor expected return. The growth in the price per share will equal the growth in earnings per share absent any change in price-earnings ( P-E ) multiple a necessary assumption of the DCF. As such, my companyspecific growth analysis, which focuses principally upon five-year forecasts of earnings per share growth, conforms with the type of analysis that influences the actual total return expectation of investors. Moreover, academic research focuses on five-year growth rates as they influence stock prices. Indeed, if investors
Docket No. RP- -000 Page 0 of 0 really required forecasts which extended beyond five years in order to properly value common stocks, then I am sure that some investment advisory service would begin publishing that information for individual stocks in order to meet the demands of investors. The absence of such a publication suggests that there is no market for this information because investors do not require infinite forecasts in order to purchase and sell stocks in the marketplace. Q. What are the analysts forecasts of future growth that you considered? A. Schedule provides projected earnings per share growth rates taken from analysts five-year forecasts compiled by Institutional Brokers Estimate System ( IBES )/First Call, Zacks, Morningstar, SNL, and Value Line. IBES/First Call, Zacks, Morningstar, and SNL represent reliable authorities of projected growth upon which investors rely. The IBES/First Call, Zacks, and SNL growth rates are consensus forecasts taken from a survey of analysts that make projections of growth for these companies. The IBES/First Call, Zacks, Morningstar, and SNL estimates are obtained from the Internet and are widely available to investors. First Call probably is quoted most frequently in the financial press when reporting on earnings forecasts. The Value Line forecasts also are widely available to investors and can be obtained by subscription or free-of-charge at most public and collegiate libraries. The IBES/First Call, Zacks, Morningstar, and SNL forecasts are limited to earnings per share growth, while Value Line makes projections of other financial variables.
Docket No. RP- -000 Page of 0 Q. What are the projected growth rates published by the sources you discussed? A. As to the five-year forecast growth rates, Schedule indicates that the projected earnings per share growth rates for the Pipeline Proxy Group are.% by IBES/First Call,.% by Zacks, 0.% by Morningstar,.% by SNL, and.% by Value Line. The analysts forecasts consider all factors that cause a firm to grow. Such factors include growth from internal sources, such as earnings that are retained and not paid out as distributions/dividends; external sources, such as the use of borrowed capital or sale of new units/shares to finance new projects; and acquisitions through business combinations, or in the case of MLPs, the dropdown of projects from sponsoring partners. As such, no adjustment is necessary to the analysts forecasts because all factors, including new capital obtained through the issuance of debt and equity, have been incorporated into the forecasts. Q. What other factors did you consider in developing a growth rate? A. A variety of factors should be examined to reach a conclusion on the DCF growth rate. However, certain growth rate variables should be emphasized when reaching a conclusion on an appropriate growth rate. From the various alternative measures of growth identified above, earnings per share should receive the greatest emphasis. Earnings per share growth is the primary determinant of investors expectations regarding their total returns in the stock market. This is because the capital gains yield (i.e., price appreciation) will track earnings growth with a constant price-earnings multiple (a key assumption of the DCF model). Moreover, earnings per share (derived from net income) are the source of dividend payments and are the primary driver of retention growth and its
Docket No. RP- -000 Page of surrogate, i.e., book value per share growth. As such, under these circumstances, greater emphasis must be placed upon projected earnings per share growth. In this regard, it is worthwhile to note that Professor Gordon, the foremost proponent of the DCF model in rate cases, concluded that the best measure of growth in the DCF model is a forecast of earnings per share growth. Hence, to follow 0 Professor Gordon s findings, projections of earnings per share growth, such as those published by IBES/First Call, Zacks, Morningstar, SNL, and Value Line, represent a reasonable assessment of investor expectations. Q. What growth rate do you use in your DCF model? A. The forecasts of earnings per share growth, as shown on Schedule, provide a range of average growth rates of.% to 0.%. The average across all companies is.%. Although the DCF growth rates cannot be established solely with a mathematical formulation, it is my opinion that an investor-expected growth rate of at least.00% is a reasonable estimate of investor-expected growth within the array of earnings per share growth rates shown by the analysts forecasts. Indeed, my.00% growth rate is obtained from the analysts growth forecasts that cover a five-year period, which are the growth rates that investors employ for DCF purposes. Improved economic growth argues for a robust DCF growth rate. Economic growth is expected to accelerate with the implementation of the new federal corporate income tax provisions. Gordon, Gordon & Gould, Choice Among Methods of Estimating Share Yield, The Journal of Portfolio Management (Spring ).