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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

albeit not compelling, transactions that faced PUHCA issues as a result of the interconnection requirement would be able to occur without concern (although PUHCA issues in this area were quite surmountable). For now, though, if PUHCA is repealed, a West Coast utility will not then merge with an East Coast utility in response because such a transaction (as well as many others that had faced actual PUHCA impediments) will not be viewed as making strategic sense in this marketplace, especially given all of the other consolidation opportunities available.

Furthermore, those registered holding companies that faced serious PUHCA issues in previous mergers, and which are concerned about such issues being revisited as part of a new transaction, would no longer have this concern. Last, over time utilities would find it easier to diversify into non-utility businesses (e.g., to buy water businesses).

Recent Historical Consolidation and Future Trends

Consolidation activity in the utility and power industry has been essentially non-existent in recent years following robust activity in immediately prior years (see Chart 1).

Consolidation activity was robust in earlier years because many industry participants recognized, among other things, the fundamentally consolidating nature of the industry-that is, some of the best opportunities for growth in the industry may be realized by combining two companies and capturing associated cost savings. Other reasons supporting consolidation included the benefits of receiving a premium for shareholders at levels reflecting fair value, and strategic justifications ranging from portfolio diversity to geographic diversity to increased investment flexibility to many others.

Notwithstanding these benefits, consolidation activity has slowed to a halt for a number of reasons. Those reasons include a focus by utility and power companies on alternative opportunities that had been considered more attractive, especially merchant energy and business diversification. Also, some industry participants soured on consolidation as a strategy because various transactions found limited acceptance in the marketplace or unwound as a result of changed circumstances. Additionally, a concern about suffering from the "dead money syndrome" (i.e., lack of market interest during the pendency of a merger) caused some to become discouraged about consolidation. On a related point, as some observed the regulators taking action to materially impair the economics of transactions or delay transactions far beyond what was expected, further concerns about consolidation developed.

Furthermore, the dramatic fallout from the downturn in merchant energy and related balance sheet crises has chilled consolidation activity. Most recently, the focus of many utility and power companies on improving operational performance ("back to basics") has prevented serious focus on consolidation strategies. Of course, now that the balance sheets in the industry have recovered, or are recovering, and the back-to-basics cycle is continuing, it is reasonably possible to imagine a re-emergence of consolidation activity.

The back-to-basics strategy, however, while perfectly sound, cannot be a sustainable way to increase earnings over many years. Simply put, cost savings and efficiencies cannot be infinitely identified and realized as a means of growing earnings (there are only so many savings and efficiencies that can be squeezed out of an entity, absent an M&A transaction) or supporting system investment,