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Business & Money

Is the industry on the verge of a new consolidation wave? Should it be?
Fortnightly Magazine - September 15 2003

so that eventually the back-to-basics strategy will stall, causing companies to look for alternatives.

In addition, for most utility and power companies, it will not be reasonably possible from a market or practical point of view to pursue earnings growth through merchant energy or non-utility businesses (such as telecom). For some, there would be no market acceptance of such pursuits, or near-to medium-term financial challenges to prevent efforts in this area. Also, more generally, the actual shareholder value proposition of certain of these pursuits may be difficult to identify. This may further cause companies to look for alternatives.

Additionally, as a result of changing interest rates, a possible rotation to growth stocks as the economy recovers, and a changing dividend policy in other industries in response to a change in tax laws, it is possible that the industry will experience significant pressure on stock price appreciation. These market pressures may produce an increased interest in taking other reasonable actions to catalyze share prices, including consolidation.

Moreover, as a result of the market expectation of earnings growth for regulated utilities based on Wall Street equity research estimates of 5 to 7 percent, companies may increasingly seek alternatives. However, the organic growth prospects of many utility and power companies fundamentally relates to demographic and macroeconomic trends, which suggest much lower growth rates. Some of this earnings gap expectation can be filled with effective implementation of a back-to-basics strategy, but the benefits of such a strategy will likely not be sustained over the long term.

By comparison, the cost savings and other synergies available from mergers have the potential to fill the earnings gap and otherwise create incremental shareholder value. If one considers the announced synergy levels from certain industry transactions and applies a reasonable price/earnings multiple to the net present value of such synergy levels, the potential economic force of industry consolidation becomes more evident (see Chart 2).

In many instances, it will be the case that the ability to access these synergies, taken together with organic growth prospects, will compare favorably to standing alone. If industry participants agree with this observation, consolidation activity will be more likely. Furthermore, some strategically logical industry mergers would have the effect of improving balance sheets of industry participants, thereby increasing the attractiveness of otherwise appealing mergers and presumably making them more likely to occur (especially as companies continue to focus on balance sheet questions and increasingly focus on system investment needs).

Certainly, the size of certain companies limits their ability to take advantage of some opportunities as they arise. In some cases, therefore, consolidation activity can be justified on the basis that increased size and scale will allow the relevant combined company to pursue investment opportunities the constituent companies could not beforehand. Continued recognition of other scale benefits, such as increased market liquidity, should also support consolidation activity. In addition, to the extent industry participants make effective use of selected transaction techniques that have, to date, not been used extensively in the utility and power industry, as compared to other industries, consolidation activity could be facilitated. These