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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

"little bit of this and some of that" in a hit-or-miss pursuit of the "right" strategy that will enable them to eke out a few basis points more on their returns. They wander reactively from one state or federal regulatory proceeding to another, without strategic clarity, thinking that tweaking a few rules and regulations constitutes competition. The equities of utilities in this sector will be punished by sub-par P/Es and higher volatility. Acquisitions of these companies by predators at less than maximum shareholder value will lurk in the alleyways, always ready to pounce on the unsuspecting and weak.

That the market for energy-type utilities has become less interesting for investors as a whole, at least until recently, is not news. Figure 1 shows the trend in the Dow Jones Utilities (DJU) index relative to the Dow Jones Industrial (DJI) index over the last 30 years. In the last two years in particular, the DJU has become more volatile relative to the DJI. In the wake of the California energy crisis, the PG&E bankruptcy, and the Enron implosion-all pursued by the stammering and stuttering of law and regulation-the market has come to attach high risk premiums to the companies that populate the DJU.

Further, the market has punished some of the more diversified, competitive energy concerns, perhaps because of the market's often misguided perception that they are similar to Enron. Rudden conducted a comparative analysis of the P/E ratios in March 2002 and March 2001 of 79 utility and energy companies engaged primarily in natural gas and power operations. The "strategic position" of these entities ranged from traditional local utilities (both pure distribution and vertically integrated) through upstream, deregulated (competitive) energy producers and marketers. The 79 companies were each categorized according to one of the five following strategic positions:

  • Regulated Local Utilities;
  • Regulated Regional Utilities (predominantly multi-state regulated operations);
  • Diversified Utilities-Regulated Bias (with relatively more regulated than non-regulated operations);
  • Diversified Utilities-Competitive Bias (with relatively more competitive, non-regulated operations); and
  • Competitive (primarily upstream natural gas and power production, marketing and trading).

The "strategic position" of each of the 79 companies reflects the nature of its business as it existed in March 2002, and not necessarily the direction in which each company plans to move in the future.

Figure 2 shows the approximate percentage of the 79 companies that are represented by companies in each of the five categories.

As expected, the results of our research indicate that the market has attached significant risk premiums to utilities and other energy companies that have entered headlong into competitive markets and have diversified upstream. () The P/E ratios of these entities in 2002 are not only less than those utilities that remained more or less traditional regulated entities, but have also plummeted since March 2001. This is no doubt attributable to the same external factors that drove the increased volatility of the DJU described above, but it is also driven by the near-rampant confusion over the end state of the industry and to a general crisis of confidence in the ability of the states and federal government