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M&A 2002: The Need for Strategic Clarity

What type of merger strategy should energy companies pursue in light of new industry uncertainties?
Fortnightly Magazine - April 15 2002

What type of merger strategy should energy companies pursue in light of new industry uncertainties?

For the more strategically intrepid acquirer, opportunities abound in the utility and energy industry. However, they are strategic, and anyone thinking he or she can earn a quick basis point will be mistaken. The opportunities come in two varieties, but there are also investments to be avoided. These are the neighborhoods in which only the most energetic and visionary acquirers should play.

This article will first describe the nature of the mergers and acquisitions activity that might be expected within the natural gas, power and energy utility sector, and then explore the associated drivers and risk factors. This will include an analysis of the trends in price/earnings ratios (P/Es) for 79 companies that R.J. Rudden Associates, Inc. (Rudden) has grouped into five categories based on each company's current strategic position within the industry. Finally, we will identify a number of companies that we believe are good examples of the kinds of enterprises that might be active acquirers in 2002 and 2003, keeping in mind that "acquirers" can often become the "acquired."

Strategic Acquisitions

The first of the two types of opportunities mentioned above pertains to the strategic acquisition of utilities that have significant unregulated operations, as well as non-utility energy companies that conduct upstream businesses in predominantly unregulated power and natural gas markets.

Using relative P/E ratios as the metric, the prices of these acquisition targets are currently attractive, and in some cases, at the lowest levels in recent history. Of course, prices are low for a reason: risk premiums are currently high, and the underlying uncertainties within the energy sector remain formidable. In fact, the near-term upside potentials for utilities and diversified energy equities will be somewhat modest at best. However, acquirers who are willing to make investments with a long-term focus and clear vision of the end state will be winners. These acquirers will need to stay the strategic course over a bumpy and winding road of changing industry economic policy, and through potentially punitive scrutiny by state attorneys, legislators, and regulators; severe boom-bust cycles in both the capacity and commodities markets; and uncertain transmission policies.

Conservative Investments and Horizontal M&A

For the more conservative investor, the traditional local (and still vertically integrated) utilities, and the pipes and wires businesses that acknowledge themselves as just that, remain viable investment options. In these times, they offer some very attractive risk-adjusted returns. The fundamental value of these securities, backed by their managements' clear end-state visions of the industry, as well as an arguably better-defined regulatory future, make them solid performers in any conservative portfolio. As cash generators, they also represent excellent acquisition targets. Remember, research indicates that in the majority of acquisitions, the most measurable and immediate benefits accrue to the shareholders of the acquired company.

Dangerous Neighborhoods

But the middle ground-the bad neighborhoods-will remain a somewhat risky place for investors. This is the never-never world in which utilities remain fundamentally regulated, but fancy themselves as competitive as they meander towards an undefined future. They do a

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