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M&A 2002: The Need for Strategic Clarity
to reconcile their differences on deregulation, especially as they relate to market power and design, transmission expansion, and RTO policy.
There are a number of additional risk factors that are either implied in those previously described, or otherwise related. While some of these will be reduced significantly during the upcoming year as the Enron fallout settles, others will remain unresolved for perhaps another two to five years. These factors are significant, and acquirers who will be active in 2002 and 2003 will need a clear vision and a true commitment to the strategic wisdom of their acquisitions. Otherwise, they will have difficulty weathering the potential blistering criticism of shareholders and analysts.
Many of the near-term risks relate to the industry's intense focus on ensuring that "Enron doesn't happen here," and on convincing others that this is so. The resulting diversions and under-valuation of the equities markets should resolve themselves soon. However, other longer-term risks will endure including:
- A lack of a clear and common vision of the industry end-state;
- The potential regulatory reactions to the growth in real and perceived market power resulting from further consolidations of generating assets;
- Federal vs. states' rights issues, and a patchwork of state regulatory approaches to deregulation;
- Uncertainty of regulations regarding market-based rates, regulation of financial derivatives, and rational financial incentives for regulated entities;
- Increasingly intense boom-bust industry cycles;
- Commodity price volatility;
- Capital market challenges, including providing for growth into a 30-33 Tcf natural gas economy by the 2010-2015 period-driven primarily by the needs of the generating markets;
- Uncertainties regarding expanded FERC assertion of jurisdiction over transmission, and a lack of clarity on RTO policy;
- Uncertainty over PUCHA reform or repeal; and
- A lack of a coordinated, broad federal energy policy.
Implications for Mergers & Acquisitions
As indicated at the outset of this article, two distinct trends in future M&A activity are emerging:
1. Aggressive strategic acquisitions by companies with strong competencies and convictions, as well as the balance sheet to back them up. These acquisitions are made economic by the comparatively low P/Es of the diversified, competitively positioned, mid and upstream targets that operate in the more competitive markets.
2. Conservative horizontal mergers of pipes and wires companies, focusing on steady growth, cost synergies, and dividend policy. These are activities associated with the "back to basics" strategies of traditional domestic and certain international utilities that will operate, hopefully, under a higher quality degree of rational diversification and enlightened regulation.
The first group of acquisitions can and will be made by only those diversified utilities with strong balance sheets, experience in diversified energy operations, preferably a good currency with their own stock's strong P/Es, an appetite for the short-term risks required to achieve longer-term upsides, and the tolerance for potentially rocky roads. Companies like Duke Energy, Dominion, Entergy, and possibly AEP would seem philosophically inclined and strategically situated to take advantage of the current market.
In addition to domestic utilities, a number of cash-rich foreign companies appear focused on establishing strategic beachheads in the United States, both upstream and at the local distribution company level, even